What Is A Price Floor? Price Floor In A Nutshell

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.

2 – Non-binding price floor

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.

Exorbitant prices

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.

Lower demand

An extension of increased prices is lower demand as consumers seek out substitute goods that are not subject to a price floor.

Excess production

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.

Key takeaways:

  • 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.

Main Free Guides:

Connected Business Concepts

Price Sensitivity

Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.

Price Ceiling

A price ceiling is a price control or limit on how high a price can be charged for a product, service, or commodity. Price ceilings are limits imposed on the price of a product, service, or commodity to protect consumers from prohibitively expensive items. These limits are usually imposed by the government but can also be set in the resale price maintenance (RPM) agreement between a product manufacturer and its distributors. 

Price Elasticity

Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It can be described as elastic, where consumers are responsive to price changes, or inelastic, where consumers are less responsive to price changes. Price elasticity, therefore, is a measure of how consumers react to the price of products and services.

Economies of Scale

In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Network Effects

network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.

Negative Network Effects

In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

Creative Destruction

Creative destruction was first described by Austrian economist Joseph Schumpeter in 1942, who suggested that capital was never stationary and constantly evolving. To describe this process, Schumpeter defined creative destruction as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Therefore, creative destruction is the replacing of long-standing practices or procedures with more innovative, disruptive practices in capitalist markets.

Happiness Economics

Happiness economics seeks to relate economic decisions to wider measures of individual welfare than traditional measures which focus on income and wealth. Happiness economics, therefore, is the formal study of the relationship between individual satisfaction, employment, and wealth.

Command Economy

In a command economy, the government controls the economy through various commands, laws, and national goals which are used to coordinate complex social and economic systems. In other words, a social or political hierarchy determines what is produced, how it is produced, and how it is distributed. Therefore, the command economy is one in which the government controls all major aspects of the economy and economic production.

Animal Spirits

The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage.  Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.

State Capitalism

State capitalism is an economic system where business and commercial activity is controlled by the state through state-owned enterprises. In a state capitalist environment, the government is the principal actor. It takes an active role in the formation, regulation, and subsidization of businesses to divert capital to state-appointed bureaucrats. In effect, the government uses capital to further its political ambitions or strengthen its leverage on the international stage.

Boom And Bust Cycle

The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.
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