A Cartel’s Response to Cheating: An Empirical Investigation of the De Beers Diamond Empire

Abstract

Cartel theory suggests that serious punishment in the form of price competition is the predicted response to cheating by a cartel member, but recent work on cartel operations suggests that some cartels might use a richer set of more measured responses to support their arrangements. Levenstein (1997) and Genesove and Mullin (2001) describe cartels that used limited retaliation, as well as communication, to maintain collusion. However, even these cartels reacted to massive public cheating with the retaliatory response predicted by traditional theory. The record of the diamond cartel, headed by De Beers, suggests that in some circumstances a cartel might be flexible in its response to cheating even when that cheating is massive. In this paper, we study a particular episode of such cheating by one of the diamond cartel's principal members, namely, Russia. Our findings suggest that De Beers did not respond with aggressive price com petition, but rather used a policy that combined accommodation and negotiation. Key to this result were the importance to De Beers of preventing diamond prices from falling and the firm's willingness and ability to absorb excess diamonds into inventory. De Beers, as head of the diamond cartel, influences the entire diamond trade from mining to retail. The bulk of its direct involvement, however, aside from mining, is in the purchase and sale of just-mined diamonds, or rough. The Central Selling Organization (CSO)1 buys the rough from