A price floor is a control placed on a good, service, or commodity to stop its price from falling below a certain limit. Therefore, a price floor is the lowest legal price a good, service, or commodity can sell for in the market. One of the best-known examples of a price floor is the minimum wage, a control set by the government to ensure employees receive an income that affords them a basic standard of living.
Understanding price floors
A price floor is also known as a price support since it prevents a price from falling below a certain level.
In the agricultural industry, some countries have enacted laws to reduce volatility in farm prices and by extension, farm income.
During periods of low rainfall and low productivity, farmers are protected by the price floor and receive some surety of a basic income.
This is achieved by the government entering the market and purchasing the product to increase demand and keep prices higher.
The United States government, for example, spends around $20 billion on price support subsidiaries which are distributed to about 39% of the nation’s 2.1 million farms.
Price floor types
There are two types of price floor.
1 – Binding price floor
This is a price floor that is greater than the market equilibrium point where supply equals demand.
In this scenario, the price floor causes an excess of supply in the market but producers will benefit if the higher price they can charge offsets the lower quantity sold.
Consumers, on the other hand, are disadvantaged because they must pay more for a lower quantity of products.
Non-binding price floors are set lower than the market equilibrium point. As a result, they do not impact the market price or the quantity that is demanded or supplied.
We can then conclude that a price floor is only effective when it is set above the point where supply equals demand.
In other words, a price floor that is set below the equilibrium point will be below market value.
Other effects of a price floor on the market
Some of the intended and unintended consequences of a price floor include:
The formation of a black market
When a binding price floor sets prices above the market value, a black market can form since producers are keen to sell their surplus products.
In the NFL, for example, a price floor on season tickets made it difficult for fans to sell them because it was above the price many were prepared to pay.
In response, a black market was created to give ticketholders unrestricted access to buyers.
As we hinted at earlier, consumers often have to pay more for the same product. When a price floor of $10 is set for a $9 pizza, consumers must find an extra $1.
For this reason, price floors are sometimes seen as corporate welfare.
An extension of increased prices is lower demand as consumers seek out substitute goods that are not subject to a price floor.
Another consequence of a price floor above the equilibrium point is overproduction.
Producers are encouraged to supply the market with the promise of higher prices, but this causes the demand to increase and a surplus to form.
In the case of the agricultural industry, producers are further incentivized to oversupply the market because they know the government will purchase excess production.
- A price floor is a control placed on a good, service, or commodity to stop its price from falling below a certain limit.
- There are two types of price floor. In a binding price floor, the control is set above the equilibrium point where supply equals demand. In a non-binding price floor, the control is set below the equilibrium point.
- The creation of a price floor has various consequences, including the formation of a black market, exorbitant consumer prices, lower demand, and excess production.
Read Next: Pricing Strategy.
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