An Economic Analysis of the rise in Prices of Diamonds and its price elasticity of demand.

Abstract:

From an economic analysis of the determinants that influence the demand of diamonds and of the price elasticity of demand of diamonds, it was concluded that diamonds are a normal commodity and are inelastic as they have few substitutes that are not inferior.

Petra Diamonds Mining Group is a diamond producer that operates at a global level. According to Derby (2010: 4), the prices of diamonds rose 48 percent from January to November 2009. This price rise was well above the average national annual interest rate. (Trading Economics, 2010:1). This means that there were other determinants that played a crucial role in the change of diamond prices above and beyond inflation in the given period as we can calculate the price elasticity of the demand of diamonds if we have data of the price movement and quantity demanded movement.

There are a number of determinants that can cause shifts in demand and supply. South Africa is an exporter of diamonds. This means that the global financial crisis of 2008 affected the demand of diamonds negatively. (FEINS, 2010:1). This is because people began losing their jobs, which meant that average incomes were lower than previously. The global economy did begin to recover in 2009. Average incomes were higher as the job sector began to stabilize and as a result of this, the demand for diamonds began to rise as people could once again afford them which also meant the market equilibrium price for diamonds rose too.

“Although an increase in income leads to an increase in demand for most goods, it does not lead to an increase in the demand for all goods.” (PARKIN et. al., 2010: 65). Diamonds are a normal good because demand increased when income increased versus an inferior good which demand would decrease as income increased. Please see diagram A. in appendix A. for a model of the influence of income on the demand curve of a normal good cet. par.

Another reason for the rise in price during 2009 was the fact that producers cut the output of diamonds. (DERBY, 2010: 1). This decreased the supply of diamonds in the market, which in turn increased the equilibrium price of diamonds within the market. (PARKIN et. al., 2008: 69). This is an example of the diamond industry causing a price adjustment by shifting supply. This shortage of diamonds forced the price up. Please see diagram B. in appendix A. for a model of effects of a cut of supply on equilibrium price and equilibrium quantity demanded cet. par.

In response to the forthcoming Christmas sales period, of 2009, diamond dealers began to rebuild their stockpiles of diamonds. (DERBY, 2010: 1). This seasonal increase in the quantity demanded added to the increase in the price of diamonds and occurred because the marginal benefit of diamonds increased.

Johan Dippenaar, the chief executive of Petra Diamonds Mining Group, predicted that price gains during 2010 would rise at steady rate and not exceed 20 percent. (DERBY, 2010: 1). This is because of increasing demand from China and a reduced reliance of the US market. (DERBY, 2010: 1). It is also because Petra predicted a total annual production of 1.2 million carats for 2010 from 1.09 million carats in 2009. (DERBY, 2010: 1). This is an increase of 9.91 percent from 2009 and may be due to some form of technological advancement and would result in the supply increasing.

When supply increases, the price of a commodity falls. Dipenaar predicts that prices would rise by only 20 percent. If supply were the only factor predicted to rise, the price would fall. The price is, however, predicted to rise. One can then deduce that Dipenaar has also predicted that the demand will increase proportionally more than the supply for diamonds in 2010.

If Petra is predicting a producing 1.2 million carats of diamonds for 2010, then we can assume that the quantity demanded of diamonds is 1.2 million. This is because they would not produce a surplus, as this would lower the price of diamonds, which would not be in their self-interest.

We know that the price is predicted to rise in 2010 by no more than 20 percent. We also know that the predicted change in quantity demanded from 2009 to 2010 is 9.91 percent. The price elasticity of the demand of a product is the percentage change in quantity demanded divided by the percentage change in price. (PARKIN et. al., 2008: 83). We then have all the data to work out the price elasticity of diamonds.

If one calculates the elasticity of diamonds with a price rise of 20 percent and a change in quantity demanded of 9.91 percent, the price elasticity of diamonds equals 0.5. This means that the price elasticity of the demand of diamonds is inelastic. One would expect this of diamonds, as they have substitutes that are all inferior to them.

In conclusion we have analyzed some of the determinants that influence the demand of diamonds and have seen that there is not much that can be substituted for a genuine diamond. The global financial crisis of 2008 negatively affected the demand of diamonds as the buyers in the diamond market had reduced average incomes and thus could not afford to pay what they once were able to.

The quantity demanded of diamonds increased because of the December sales period, which helped raise the price of diamonds. Diamonds are a normal good because their quantity demanded increases as the global economy stabilized and buyers incomes began to rise. We have also attempted to understand the logic behind Petra’s 2010 forecast of production and price rises. We have analyzed the price elasticity of the demand of diamonds and found it to be inelastic.

List of references:

· DERBY, R, 2010. Petra expects diamond price recovery to slow. Star. 23 February. Pg 4.

· FEINS, W, 2010. The Legacy and Future Of South Africa Diamond Industry. VNRAO. [Online]. Available: http://www.vnrao.net/business/2649-the-legacy-and-future-of-south-africa-diamond-industry.html. [Accessed 8 March 2010].

· TRADING ECONOMICS, 2010. South African Inflation Rate. [Online]. Available: http://www.tradingeconomics.com/Economics/Inflation-CPI.aspx?symbol=ZAR. [Accessed 8 March 2010].

· PARKIN, M, POWELL, M, MATTHEW, K, 2008. Economics (7e). Essex, England: Pearson.

· PARKIN, M, KOHLER, M, LAKAY, L, RHODES, B, SAAYMAN, A, SCHöER, V, SCHOLTZ, F, THOMPSON, K, 2010. Economics: Global and Southern African Perspectives. Cape Town: Pearson.