Price Floors

Price Floor Diagram

Below is a graphical representation of a price floor applied to a market at equilibrium.

Fig 1. - Price floor applied to a market at equilibrium

Figure 1 above shows how a price floor affects supply and demand. The price floor (applied at P2) disrupts the market equilibrium and changes supply and demand. At the higher price of P2, suppliers have the incentive to increase their output (from Q to Q3). At the same time, consumers who see the increase in price lose value, and some decide not to purchase, which decreases the demand (from Q to Q2). The market will provide Q3 of the goods. However, consumers will only purchase Q2 creating a surplus of unwanted goods (the difference between Q2-Q3).

Advantages of Price Floor

The advantage of a price floor is to secure a minimum compensation for the suppliers in the markets it is applied. Food production is one of the most important markets protected by price floors and other policies. Countries are careful to guard their food producers against the volatility of the commodities market. One could argue that to some degree, food production should be exposed to competition to breed innovation and efficiency. A strong agricultural food industry maintains a country's autonomy and security. With global trade active between over a hundred countries producing either the same food or substitutes, this provides a lot of competition to every farmer.

Countries set a price floor for agricultural goods to keep their food production sector healthy. This is done because countries fear relying on international trade for food, as that trade can be cut for political leverage. Therefore all countries try to maintain a specific percentage of domestic food production to maintain autonomy. The food commodity market can be very volatile and prone to massive surpluses, which can drive down prices and can bankrupt farmers. Many countries run protectionist anti-trade policies to protect their food production. For more information on food, and economics, check out this deep dive!

Disadvantages of Price Floor

One of the disadvantages of a price floor is that it distorts market signals. A price floor provides more compensation to manufacturers, which they can use to improve the quality of their goods. This is a benefit in most circumstances, however, some goods are preferred as low-quality, low-cost by consumers. Check out this example that 9/10 dentists have not read.

That's a silly scenario where price ceilings result in inefficiently high-quality goods. So what is a product that consumers prefer in low quality? For instance, the prominence of disposable cameras in the early 2000s. There were many high-end expensive cameras but consumers loved the convenience and low cost of cheap plastic throw-away cameras.

Consumers enjoyed the low-quality camera's as they could be bought in many stores cheaply and taken anywhere as fears of breaking one only resulted in a lost dollar.

Lost Efficiency and Deadweight Loss

Similar to price ceilings, price floors generate deadweight loss through the loss of free-market efficiency. Suppliers will produce to where marginal revenue is equal to marginal cost (MR=MC). Marginal revenue increases when a price floor is set. This contrasts with the law of demand which states, that when price increases, demand decreases.

Fig 2. Price Floor and Deadweight Loss

Figure 2 represents how a price floor affects a market at equilibrium. When a binding price floor is placed above the initial equilibrium, all market transactions must abide by the new price. This results in decreased demand (From Q to Q2), while the increased price incentivizes producers to increase supply (from Q to Q3). This results in a surplus where supply exceeds demand (from Q2 to Q3).

In the case of minimum wage, the price floor is set by both the federal government, which can be exceeded by the state government. The minimum wage reduces the demand for labor (from Q to Q2), while the supply of labor or workers increases from (Q to Q3). The difference between the supply of labor and the demand for labor (from Q2 to Q3) is known as unemployment. Workers get additional value for their labor which is the green shaded area of the graph, the extra value created by the price floor is the green rectangle of producer surplus.

While price floors are an imperfect solution, many are still to be found in the modern world. Policymakers have many options and strategies to minimize the damaging effects of price floors. Despite how commonplace price floors are, most economists still advocate against them.

Advantages and Disadvantages of Price Floors

The advantages and disadvantages of price floors can be summarized in the table below:

Economic Impact of Price Floor

The direct economic effect of a price floor is a surge in supply and a reduction in demand also known as a surplus. A surplus can mean many different things, for goods that take up relatively low space it may not be significantly hard to store them until the market can handle the supply. A surplus can also exist in perishable goods which can be disastrous to the manufacturer if their products spoil, as they don't earn their money back but still have to spend resources to dispose of the waste. Another type of surplus is unemployment, which the government addresses through various compensation and support programs as well as work programs.

Government Surplus Gymnastics

The surpluses created in any perishable goods industry as a result of a price floor are quite ironic and even speak to the flaws of a price floor. Governments impose a price floor, in most cases these practices sometimes just shift the problem. Suppliers get a higher sale price, but there are not enough buyers willing to pay the higher price, which creates excess supply. This excess supply or surplus creates market pressure to push prices down to clear the surplus. The surplus can't be cleared because the price floor prevents lowering the price to meet demand. So if a price floor is repealed while a surplus is present prices will drop lower than the original equilibrium, which could hurt suppliers.

So a price floor leads to a surplus and a surplus lowers the price, so what do we do? How this is handled varies depending on the current leadership's belief in the role of government. Some governments such as in the EU will buy food products and store them in warehouses. This led to the creation of a butter mountain - a surplus of butter stored in a government warehouse so vast it was referred to as a 'butter mountain'. Another way governments can manage a surplus is to pay farmers not to produce, which sounds pretty sweet. While giving out money to do nothing seems wild, when you consider the alternative of governments buying and storing surpluses it isn't so unreasonable.

Price Floor Example

Most examples of price floors include:

• minimum wages
• agricultural price floors
• alcohol (to discourage consumption)

Let's take a look at more examples in detail!

The most common example of a price floor is the minimum wage, however, there are several other instances of them throughout history. Interestingly, private companies have enacted price floors as well such as the National Football League, read this example for more.

Minimum Wage

The common price floor you've probably heard of is the minimum wage, in fact, 173 countries and territories have some form of a minimum wage.³ The difficulty of the minimum wage discussion is that people are the suppliers. Those people's livelihood hinges upon having a job so that they can afford necessities. The dispute over minimum wage comes down to choosing between the most economically efficient outcome for some workers or attempting to have a less efficient outcome that helps workers more effectively.

Advocates against increases to the minimum wage claim that it's the cause of unemployment and it hurts business which creates more unemployment. The economic theory of price floors actually backs up the claim against the minimum wage. Any disruption from free-market equilibrium creates inefficiency, such as a surplus of labor or as it is known, unemployment. By the nature of inflation, most employees in the US make above minimum wage. If the minimum wage were removed there would be more demand for labor, however, the wages may be so low that workers choose not to supply their labor.

According to recent data, nearly a third of Americans make less than $15 an hour, which is approximately 52 million workers.² Many countries have regular mechanisms that allow the minimum wage to adjust to inflation or can even be adjusted by government decree. However, raising the minimum wage would create a binding price floor and lead to a surplus in unemployment. While paying fair wages seems like the moral solution, there are many business factors to consider, which have more lucrative incentives to funnel profit to instead. Many US corporations have received criticism for low wages or layoffs while simultaneously paying dividends, stock buybacks, bonuses, and political contributions.