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.
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.
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.
Revenue model patterns are a way for companies to monetize their business models. A revenuemodel pattern is a crucial building block of a business model because it informs how the company will generate short-term financial resources to invest back into the business. Thus, the way a company makes money will also influence its overall businessmodel.
A pricingstrategy or model helps companies find the pricing formula in fit with their business models. Thus aligning the customer needs with the product type while trying to enable profitability for the company. A good pricingstrategy aligns the customer with the company’s long term financial sustainability to build a solid businessmodel.
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 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.
Price skimming is primarily used to maximize profits when a new product or service is released. Price skimming is a productpricingstrategy where a company charges the highest initial price a customer is willing to pay and then lowers the price over time.
Productized services are services that are sold with clearly defined parameters and pricing. In short, that is about taking any product and transforming it into a service. This trend has been strong as the subscription-based economy developed.
Menu costs describe any cost that a business must absorb when it decides to change its prices. The term itself references restaurants that must incur the cost of reprinting their menus every time they want to increase the price of an item. In an economic context, menu costs are expenses that are incurred whenever a business decides to change its prices.
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.
Predatory pricing is the act of setting prices low to eliminate competition. Industry dominant firms use predatory pricing to undercut the prices of their competitors to the point where they are making a loss in the short term. Predatory prices help incumbents keep a monopolistic position, by forcing new entrants out of the market.
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.
The bye-now effect describes the tendency for consumers to think of the word “buy” when they read the word “bye”. In a study that tracked diners at a name-your-own-price restaurant, each diner was asked to read one of two phrases before ordering their meal. The first phrase, “so long”, resulted in diners paying an average of $32 per meal. But when diners recited the phrase “bye bye” before ordering, the average price per meal rose to $45.
The anchoring effect describes the human tendency to rely on an initial piece of information (the “anchor”) to make subsequent judgments or decisions. Price anchoring, then, is the process of establishing a price point that customers can reference when making a buying decision.
A price maker is a player who sets the price, independently from what the market does. The price setter is the firm with the influence, market power, and differentiation to be able to set the price for the whole market, thus charging more and yet still driving substantial sales without losing market shares.
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 organizationscale further.
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.
A 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.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
