Game theory in the rough diamond market – buy the box?

INTERACTION

OBJECTIVE

SELLER STRATEGY

BUYER STRATEGY

CONFLICT

Buyer — Seller

• Restrict supply to raise prices (within elasticity constraints) using market power.
• High price – low quantity setting tracks market demand. The slowdown in 2009 led to a 25% reduction in production volume.

• Option for seller to exclude a buyer from participating in the market.
• Asymmetric exclusion payoffs – much worse for the buyer who receives nothing.
• Credible threat as the seller impact is small with the volume likely to be re-distributed to other buyers.

• Captive nature of the agreements in place creates short run incentives for seller to recover additional margins if required (e.g. management targets etc.).
• A reject box strategy should only be used if the value saved from one off rejection is greater than the value lost from harming the long run relationship.
• Costs to the relationship include the increased probability of future exclusion (removing all future profits) + expected loss from poorer stone allocation.
• Empirically, rejection rates are low – suggested to be around 10%, rising to 20-25% under difficult market conditions.

• Buyer rationality anticipates the strategies of the seller – the small but positive payoff provided for buyers and the use of exclusion – and realise they need to toe the line as set by the seller.

COMMONALITY

Buyer — Seller

• Repeated games drive the seller to offer a price for the buyer so they still play the game.
• Price for small but positive buyer margins
• Comments by a managing director of De Beers confirm the strategy of sufficient buyer return to play the game over the long run.

“We look at the actual polished price .. take into account the labor costs, other expenses and economic factors like interest and box quotes… We are looking for our clients to make money, because there’s very little point in our clients not making money… are trying to get to a price that is a sustainable market price.”

• Buyers are engage in mutually beneficial term structure contracts to ensure access to supply.
• Removal of quantity risk for both parties
• Improved material planning
• Buyers are price takers by game design leading to limited cost to this strategy apart from minimum quantity requirements imposed by the term contract.

CONFLICT

Buyer — Buyer

• The seller wants to foster competition within the buyers to minimise buyer power.
• Strategies might include preferential treatment on a rotating basis to avoid favouring buyers.
• If the willingness to pay varies enough between buyer’s then it might be a preferable strategy to permit buyer-buyer conflict through bidding for stones (high demand goods are likely to go up in price but poorer stones may go below their typical fixed price leaving an uncertain total effect).
• Extent of conflict depends upon the homogeneity of buyers’ stone preferences
• Similar preferences lead to strong conflict to secure access to stones because all buyers chase the same stones.
• If preferences vary then the competition weakens because buyers chase the categories they prefer.
• Market evidence of two market buyer types; cut & polishers and intermediary suppliers to secondary markets.
• Cut and polishers typically specialise in a category of diamonds increasing heterogeneous preferences. Intermediaries lead to homogenous preferences in the market because each player chases the same arbitrage trades.

COMMONALITY

Buyer — Buyer

• Sellers explicitly forbid communication between buyers as part of the contract to become a sightholder.
• The threat to exclude a buyer is less credible as the proportion of buyers colluding increases because payoffs to the seller start to become increasingly costly and painful to act upon.
• Buyers can benefit from to collusion to lower prices but it comes at the risk of being excluded by the seller from the game.

• A uniform cost structure lowers the risk of being long run unprofitable without all other companies being similarly impaired.
• Risks of rejecting an unprofitable box become smaller because a buyer knows it will also be unprofitable for the others leading to multiple rejections
• Evidence suggests some economies of scale exist given the large working capital requirements (to manage this cash flow mismatches) – an estimated 30 percent of the clients receive up to 70 percent of goods.