Price Floors

You can probably recall that the minimum wage discussions have long held political popularity. In 2012 fast-food workers organized a walk-out in NYC to demonstrate as part of their "fight for $15" labor movement. The labor movement believes that any pay less than $15 an hour isn't capable of paying modern living expenses. The federal minimum wage has been at $7.25 since 2009. However, many believe this hasn't kept up with inflation. In fact, ex-President Obama claimed that, when adjusted for inflation, the minimum wage was actually higher in 1981 when compared to the price of goods at that time.1  Minimum wages are a most common examples of a price floor. Read on to find out what is the definition of price floors in economics, their advantages and disadvantages and how we can illustrate price floors on a diagram! And, don't worry, the article is full of real life examples of the price floors!

Price Floors Price Floors

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Table of contents

    Price Floor Definition

    A price floor is a government-imposed minimum price for a product or service designed to regulate the market. Agricultural price floors are a common example, where the government sets a minimum price for crops to ensure that farmers receive a fair price for their produce. This helps ensure that farmers can cover their production costs and maintain their livelihoods, even in market volatility.

    A price floor is a government-imposed minimum price for a good or service set above the equilibrium market price.

    An example of a price floor could be the minimum wage. In this case, the government sets a price floor for the hourly wage rate employers must pay their employees. The intention is to ensure that workers receive a minimum standard of living and are not exploited by employers who may be tempted to pay wages below a living wage. For instance, if the minimum wage is set at $10 per hour, no employer can legally pay their employees less than that amount

    Price Floor Diagram

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

    price floors applied to market at equilibrium studysmarterFig 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).

    Not all surpluses are good! A surplus created by a price floor is excess supply that will not be bought quickly enough, creating supplier problems. Consumer and Producer surpluses are good surpluses as they add value received from the efficiency of the market.

    Price Floor is a minimum price set to protect vulnerable suppliers.

    Binding is when a price floor is implemented above the free market equilibrium.

    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!

    Price Floors and Food Economics

    Maintaining food supply is a high priority for every nation, especially developing countries. Governments use various tools to protect their food production. These tools range from price controls, subsidies, crop insurance, and more. A nation must navigate a difficult balance of maintaining affordable food for its citizens while also guaranteeing its own farmers make enough money to grow food next year. Importing cheap food from other nations exposes the country's farmers to vast amounts of competition that can disrupt their financial stability. Some governments limit trade or impose price floors so foreign food products are forced to cost as much or more than homegrown foods. Governments may also impose a non-binding price floor as a fail-safe if prices were to rapidly decline.

    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.

    Suppose a price floor was set on dental floss. Dental floss manufacturers receive large compensation for their product and decide to improve it. They design floss that is tough and can be washed and reused. When the price floor is removed, the only kind of floss is the expensive, durable and reusable kind. However, there is consumer backlash as they prefer single-use disposable cheap floss because they think it's cleaner and easier to throw away.

    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.

    price floors deadweight loss studysmarterFig 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:

    Advantages of Price Floors:

    Disadvantages of Price Floors:

    • Provide minimum compensation to suppliers in the market, ensuring they receive a fair price for their goods or services.
    • Protect the domestic food production sector of a country
    • Maintains stable prices and prevents producers from going bankrupt.
    • Distort market signals
    • Can lead to inefficiencies in the market, as goods or services may be produced at a higher cost than what they are worth to consumers.
    • May result in surplus production

    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.

    The NFL recently repealed a price floor on the resale of their tickets, which previously required the resale cost to be higher than the original price. This defeats the purpose of resale, as genuine resale scenarios are a result of people who thought they could attend but no longer can. Now, these consumers struggle to resell their tickets at a higher price, when many would gladly sell at a discount to make some of their money back. This created a surplus of tickets, where sellers wanted to lower their prices but couldn't legally lower the price through the ticket exchange. In most cases, citizens turned to off-market or black market sales to skirt around the price floor.

    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.

    Low minimum wages have been found to hurt rural workers the most, however rural areas predominantly vote for legislators that advocate against raising the minimum wage.

    Price Floors - Key Takeaways

    • A price floor is a fixed minimum price a good can be sold at. A price floor needs to be higher than the free market equilibrium to be effective.
    • A price floor creates a surplus which can be costly for producers, it also decreases the consumer surplus significantly.
    • The most common price floor is the minimum wage, which exists in almost every country.
    • A price floor can result in inefficiently high-quality goods which are undesirable to consumers who in some cases prefer low quality at low cost.
    • The negative effects of a price floor can be mitigated by other policies, however, it is still costly no matter how it is handled.

    References

    1. Barack Obama on January 28, 2014 in the State of the Union Address, https://obamawhitehouse.archives.gov/the-press-office/2014/01/28/president-barack-obamas-state-union-address.
    2. Dr. Kaitlyn Henderson, Crisis of low wages in the US, https://www.oxfamamerica.org/explore/research-publications/the-crisis-of-low-wages-in-the-us/
    3. Drew Desilver, The U.S. differs from most other countries in how it sets its minimum wage, Pew Research Center, May 2021, https://www.pewresearch.org/fact-tank/2021/05/20/the-u-s-differs-from-most-other-countries-in-how-it-sets-its-minimum-wage/
    Frequently Asked Questions about Price Floors

    What is a price floor?

    A price floor is a minimum price which a good can not be sold for less. To be effective, the price floor needs to be set above the market equilibrium price.

    What is the importance of setting a price floor?

    A price floor can protect vulnerable suppliers from free market pressures.

    What are some examples of a price floor?

    The most common example of a price floor is the minimum wage, which guarantees a minimum compensation for labor. Another common example is in agriculture, as many nations put price floors to protect their food production.

    What is the economic effect of price floors?

    The economic effect from a price floor is a surplus. Some producers may benefit but some will have difficulty selling their goods.

    What is the effect of a price floor on producers?

    Producers receive a higher price than the free market would dictate, however producers may have difficulty finding buyers.

    Test your knowledge with multiple choice flashcards

    Which of these is bad for the market?

    A market is at equilibrium at $4, which of these values would make a price floor binding?

    Which of these is a form of a price floor?

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