China rare earth embargo on Japan

Closing exemplar for the political externality category. China's territorial dispute with Japan over the Senkaku/Diaoyu islands led to a rare-earth supply cutoff that threatened the billion-dollar Hitachi-and-others rare-earth-magnet industry overnight.

So what's the externality on neodymium magnets? Wind turbines use them — yes, wind turbines use the magnets — but the externality was a political one. Almost all the rare earths come from China now. Five, six, seven years ago, because the Chinese believe they own these islands between China and Japan, they decided to cut off the supply of rare earths to Japan. They just said, we're not going to sell them to you anymore. Overnight. And all of a sudden Hitachi and a bunch of Japanese companies that make rare-earth magnets — their billion-dollar business was about to go under, because the Chinese decided politically. That's an externality in the rare-earth magnet business.

Canonical political-externality case. Chinese de facto monopoly (90% of world production), embargo on Japan, MIT faculty response funded to develop clean rare-earth extraction.

About eight years ago — you were maybe in elementary school — it turns out China has tremendous rare earth metal reserves. They're not really that rare; it's a misnomer. The United States has tremendous reserves too, but China has lots of rare earth ores. It is a very dirty process — you think you're in the Black Hole of Calcutta to go see a rare earth metal plant. People die at an early age who do this, because they do it by technology that's a hundred years old. The Chinese had dropped the price — the law of comparative advantage. We had produced rare earth metals back in the 1970s and 1980s, but as China opened up after Richard Nixon, the Chinese decided they had all these reserves, they had cheap labor, they weren't worried about pollution, and they could produce rare earth metals cheaper than anybody else. So all the American mines and factories shut down — it's a dirty industry, they were going to get fined by the EPA anyway, so send it to China.

Used as the canonical modern example of externalities — China's monopoly came not from ore but from willingness to absorb pollution and pay low wages. Five-year hurdle for alternative supply.

We talked about rare earth metals, and how China basically decided to hold Japan hostage, and by extension the rest of the world in electronics, by withholding the rare earth metals. Not because they had a monopoly on the availability of the rare earth metal ores, but because they had been willing to accept the pollution and to pay their workers very low wages, because that's the going rate in China. They had a de facto monopoly with a hurdle of probably five years before someone else could enter the market. You can't just stop all the production of electronics in Japan for five years — you're going to have to pay the price somewhere. Same type of thing as the oil embargo of '73.

Lead example of a *political externality*. Tom uses the case to make the point that monopolistic positions in commodity inputs trigger five- to ten-year diversification responses from the rest of the world, citing the 1972 Arab oil embargo as the structural parallel.

One externality that's political happened with rare earths in 2011. China manufactures ninety-seven percent of all the rare earths in the world. This is a manufacturing plant — pretty neat, huh? Is that where you want to work? No one else really wants to work there either, but the Chinese are willing to put their people in those plants. They didn't have ninety-seven percent in the past, but they have thirty-six percent of all the rare earth reserves. Rare earths are not very rare — we've got 130 million tons of reserves in the world. That's more than twenty years' supply at 30, 31,000 tons shipped per year. They're actually very plentiful. That's a bad name for them.