Price Floor Definition, Graph, Examples and Effects
Price floor definition
What is a price floor? A price floor implies that the government has fixed the minimum permitted price for a specific good. The price floor is alternatively called the minimum price. In the price floor graph, a minimum price is set above the market equilibrium.
When the government implements a floor price on a particular good, no producer can sell lower than that price. Producers can mark the floor price as the minimum price of that good. If producers sell lower than the floor price, this is an illegal market activity.
There is an another type of price control which is called as price ceiling. A ceiling price implies that the government has fixed the maximum permitted price for a specific good and in price ceiling graph, it is set below the market equilibrium.
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Why are price floors implemented by governments?
Price floors are implemented by governments to address the problem of high unreasonable market prices. Price floors are designed to make sure that producers receive the benefits. Because when the market price is too cheaper for the producers, the government sets a floor price on the good. Producers may then sell their goods for one or more than the floor price.
The government believes that price floors can, at least temporarily, make profitable the producers. A price floor is created by governments to ensure social welfare and development.
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Binding vs non binding price floor
What is a binding price floor (effective floor price)?
when is a price floor binding? A price floor is binding when it is set above the market equilibrium price. In other words, an effective price floor will be laid above the equilibrium price is determined by the market forces. However, a binding price floor causes a surplus in the market.
What is a non-binding price floor (ineffective floor price)?
What is a non-binding price floor? A price floor is non-binding when it is set on or below the market equilibrium price. In other words, an ineffective price floor will be laid on or below the equilibrium price is determined by the market forces.
When government imposes a non-binding price floor, producers sell the product at market equilibrium price. Because if they sell the product at a price below the market equilibrium price, there will be a surplus in the market. So, in this situation price floor will be ineffective.
Price floor graph
I will explain the impact of the minimum price using a graph of the price floor.
Assume that government imposes a minimum price on butter. So, the following price floor graph shows the impact of the floor price on butter.
The equilibrium quantity of butter is Q*, and the equilibrium price is P*, as seen in the above graph before the floor price. Following that, the government sets a minimum price (or “Pmin”) for butter.
Surplus
Price floors create a surplus. There is a market surplus of butter (The supply exceeds the demand). Qs is higher than the Qd. Because of this, some producers could not able to sell their butter.
Black market price
Price floor creates black market price. According to above graph of price floor, there will be a black-market price which is the “price – Pb”. The “price – Pb” is the market price that relates to the “Qd” quantity of demand. Suppliers can sell the Qd quantity to the consumers under the “Pb” price in the black market. So, ultimately because of the price floor, some producers are not able to sell butter while only some producers can buy butter at the black-market price. So, the floor price creates market inefficiency.
Price floor examples in real life
Following are major real world examples of price floors.
Price floor example 1 – minimum wage
The minimum wage is an example of a price floor. The minimum wage is a typical price floor that you have probably heard of; in fact, there is some kind of minimum salary in 173 countries and territories. Recent statistics show that roughly a third of Americans—or 52 million workers—earn less than $15 per hour.2 Many nations have established systems that regularly change the minimum wage to reflect inflation or even allow for governmental decree adjustments. But increasing the minimum wage would establish a legally binding price floor and increase unemployment.
Price floor example 2 – alcohol
Scotland became the first nation in the world to impose a price floor on alcoholic beverages in 2018. The minimum price per unit of alcohol was set at 50 pence (70 cents), which targeted inexpensive but potent alcoholic beverages. The intention was to reduce consumption of inexpensive alcoholic beverages that are very hazardous as well as their negative impacts. For instance, it is estimated that alcohol abuse costs Scotland £3.6 billion ($4.9 billion US) a year in healthcare, law enforcement, public disruption, and property damage.
Price floor example 3 – Interest rates
Interest rate pricing limits apply to both consumers and businesses. They could resemble a floor or a cap. The lowest price or minimum rate of return for that money each quarter or for any given period of time is referred to as an interest rate floor, particularly when discussing interest levied on loans or deposits.
Price floor example 4 – Agriculture
A good example of a government-imposed price floor is agriculture. Under the terms of the Treaty of Rome, the Common Agricultural Policy (CAP) was established throughout Europe in 1957. Its primary goal was to bring stability to the agricultural markets, where farmers were frequently impacted by supply changes brought on by natural events like droughts. By establishing a minimum price, the policy seeks to support the costs of commodities like wheat, rice, beef, butter, and dairy products. As a safety net, the European government will buy the farmers’ goods if they are unable to sell them at market rates.
Effects of price floor
In this section, we will consider that what is the result of a price floor.
1. Protect the producers
One of the main effects of price floors is the protection of the producers. The government believes that price floors can, at least temporarily, protect the producers. Because usually at minimum price implementations, producers can sell their products at higher prices than earlier.
2. De-motive the consumers.
Overconsumption of some goods such as alcohol is not good for health. So, the government imposes price floors on these types of goods to discourage consumption.
3. Beat economic efficiency and competition
What is the economic effect of price floors? A price floor creates economic inefficiency. Although the government assumes floor prices protect the producers, it is not the reality. Floor prices are not successful. Many famous economists and other well-reputed parties have also said that the government should not continue earlier floor prices. The removal of these policies has been a global trend to create market-driven economies and increase economic efficiency.
4. Price floors create surplus
A price floor results in a shortage in the market, there will be black market prices. For example, a binding minimum wage creates unemployment (labor supply is higher than labor demand). Socio-Economic Research Centre executive director Lee Heng Guie stressed the point that setting prices artificially low will just reinforce current demand patterns (Tay, 2023).
5. Black market price
Black market price means an illegal price. When the government implements a floor price on a particular good, no producer can sell lower than that price. Sellers can mark the floor price as the minimum price of that good. If producers sell lower than the floor price, this is an illegal market activity. However, in the real world, some producers sell lower than the floor price and it is considered as black market price.
A price floor example with graph
As a result of natural disaster, price of a wheat kilo decreased up to $1. At this price the market demand and supply were 2 million of wheat kilos.
We will draw the market equilibrium as follows
Calculate consumer surplus
Consumer surplus = (maximum demand price– equilibrium price) * equilibrium quantity /2
So, consumer surplus equals to blue coloured area
Consumer surplus = (2 – 1) *2/2 = $1 million
Calculate producer surplus
producer surplus = (equilibrium price – minimum supply price) * equilibrium quantity /2
So, producer surplus equals to green coloured area
producer surplus = (1– 0) *2/2 = $1 million
Calculate economic surplus
Also, the economic surplus is $3 million.
Economic surplus = producer surplus + consumer surplus
Economic surplus = 1 + 1 = $2 million
The USA government has implemented a floor price of $1.5 on the wheat kilo. So, floor price of $1.5 on the wheat kilo is above the market equilibrium price. We will draw the impact of price floor on a graph as follows.
Binding price floor graph
Surplus
Price floors create a surplus. Surplus on a supply and demand graph can be calculated as supply–demand. According to the above binding price floor graph, at the price of $1.5 (floor price), demand is lower than supply. Demand is 1 million wheat kilos and supply is 3 million wheat kilos. So, there is a shortage (supply exceeds the demand).
Surplus = Supply – Demand = 3-1 = 2 million of wheat kilos
Black market price
In this situation, some producers like to sell the wheat kilo at a price lower than the floor price of $1.5. Some times this price may be lower than the previously market price also ($1). This can be considered as a black market price. A black market price means the price which is higher or lower than the government implemented maximum or minimum prices. So, floor price of RM1.5 that is implemented by the government has become an only a legal price. Market price is lower than it.
According to above graph of price floor, the black-market price can be down up to $0.5. The $0.5 is the market price that relates to the 3 million of quantity of demand. Suppliers can sell the 3 million of wheat kilos to the consumers under the $0.5 in the black-market. Because there is sufficient demand for wheat kilos under this price.
Consumer and producer surplus with price floor
Consumer surplus after price floor equals to purple coloured area in above graph.
How to calculate consumer surplus with a price floor
Consumer surplus = (maximum demand price – price floor) * quantity of demand/2
Consumer surplus = (2 – 1.5) *1/2 = $0.25 million
How to calculate producer surplus with a price floor?
Producer surplus after price floor equals to green coloured area in above graph . It is comprised with a rectangular area and triangle area.
Rectangular area
Producer surplus = (Floor price – Black market price)* quantity of demand
Producer surplus = (1.5 – 0.5) * 1 = $1 million
Triangle area.
Producer surplus = (Black market price – Minimum supplied price) * quantity of demand/2
Producer surplus = (0.5 -0) *1 / 2 = $0.25 million
Total amount of producer surplus after price floor equals to $1.25 million ($0.1 million + $0.25 million).
Economic surplus
the economic surplus is $0.8 million.
Economic surplus = producer surplus + consumer surplus
Economic surplus = 1.25 + 0.25 = $1.5 million
Deadweight loss of price floor
A deadweight loss is a cost to society created by market inefficiency, which occurs when supply and demand are out of equilibrium. In this price floor example, deadweight loss from price floor is presented in the pink-coloured area. Also, the difference between economic surplus presents the deadweight loss of the price floor.
Deadweight loss of price floor = Economic surplus before price floor – Economic surplus after price floor
Deadweight loss of price floor = 2 – 1.5 = $ 1.5 million
