Price Floor

Used to create a minimum price for a commodity in the market

Rohan Arora

Reviewed by

Rohan Arora

Expertise: Investment Banking | Private Equity


November 14, 2023

What is a Price Floor?

It is a concept in economics that describes a commodity’s absolute minimum price level in a market. Usually, an authoritative force, like the government, is the entity that sets the price levels of the floor. 

The government wants to ensure that the price of a good or service doesn’t drop below a certain level, threatening producers’ ability to stay in the market.

They are also referred to as “price supports” as they actively support a price from falling below an assigned level.

Price controls are used to create a fair market accessible to all. However, sometimes the government tries to step in and correct inequality in the market. They can do this by implementing price controls. 

There are two types of price controls: price ceilings and price floors. 

A price floor is used to create a minimum price for a commodity in the market. It sets a lower limit on the price of a commodity. A common example seen in everyday life is the minimum wage.

Types of Price Floors

A few of the types are:

1. Binding Price Floor

Binding price support occurs when the minimum price level set is above the market’s equilibrium price. 

The term “binding” means that it affects the market. A binding price support results in a surplus of goods in the market. It implies that the quantity supplied in a market is greater than the quantity demanded

There is no longer an equilibrium in the market. 

The example above is a binding price floor. 

At the price P* (the equilibrium price), the market is at equilibrium as the number of goods produced in the market equals the number of goods demanded. 

The government then decides to establish a price floor at PF. This means that the price in the market can’t fall below this level. 

Due to a downward-sloping demand curve, the quantity demanded at PF (QD) is less than the quantity demanded at the market equilibrium price (Q*).

On the other hand, since the supply curve is upward-sloping, the quantity supplied at PF (QD) is greater than the quantity supplied at the equilibrium price (Q*).

Since the quantity demanded and quantity supplied are no longer equal, there is an imbalance in the market. As a result, more people are willing to sell a product than people are willing to buy it, and a surplus is created in the market. 

2. Non-Binding Price Floor

A non-binding price floor occurs when the minimum price level set is below or equal to the market’s equilibrium price. The term “non-binding” refers to price support that does not affect the market. 

Above is an example of a non-binding price floor. 

As we can see, the PF in this market is below the equilibrium price (P*). Since PF is below the equilibrium price, there is nothing to keep the market from remaining at equilibrium. The market will act as if the price floor doesn’t exist. 

Effect of Price Floors on Producers and Consumers

Price supports are ambiguous for the producers of the market. While it is possible that price support could help a business, there is also a chance it could hurt a business. In some cases, it may not even affect the producers. 

On the other hand, price supports never help consumers. Instead, they either make the consumers worse or may not affect them. 

Price supports don’t necessarily affect the quantity demanded or supplied in the market. They only affect the price at which the goods are sold.

This means they never shift the supply or demand curves in the market; they only cause a movement along the two curves. 

Usually, the goal of implementing price support is to protect producers and consumers or manage scarce resources in hard economic times. But unfortunately, the result isn’t as positive; price supports lead to inefficiency and suboptimal consumer and producer surpluses. 

This is because price supports restrict markets from operating at equilibrium. As a result, net benefit (consumer and producer surplus) is maximized when markets operate at equilibrium. 

Inefficiency arises because the number of people who demand and supply the product isn’t equal. Some people will not find buyers, and some people will not find sellers, given the specific price support implemented. 

While they are necessary for some situations, they usually result in a negative impact rather than what they’re intended to produce. 

Reasons for Setting Up Price Floors

The government generally sets price supports to aid producers. However, if the government wants to stimulate the production of an industry, it may elect to enforce price support for that industry. 

This example of price control can be seen in many countries' agricultural industries. 

Many governments worldwide have elected to set price supports in their agricultural markets. The prices in farming constantly fluctuate, meaning that farmers’ incomes are very unstable. Bad years are incredibly hard on farmers due to the volatility of their income. 

Governments try to avoid this from happening to them by creating price support, which ends up preventing these swings and stabilizing their income. 

Governments may also decide to set a price level in markets with inelastic demand and markets that naturally have lower prices. Again, this will increase the overall utility of society due to the gain for producers outweighing the loss that consumers experience. 

Reasons for not Setting Up Price Floors

The surplus that results from price support creates missed opportunities within the market. These inefficiencies are similar to the ones caused by price ceilings. 

Binding price support can cause a deadweight loss because of inefficiently low quantity. A deadweight loss is the loss of economic efficiency regarding utility for consumers or producers when allocative efficiency is not achieved. 

In other words, it’s like money thrown away that benefits no one. 

Another inefficiency caused by price support is sellers’ inefficient allocation of sales. Producers willing to sell the product at the lowest price are not always the ones who manage to do it. 

Due to a surplus, goods will sit on the shelf and are never bought. As a result, the material making these goods and the goods themselves are wasted. The materials could’ve been used for something else that is more productive.

There will also be goods of inefficiently high quality. Sellers may offer high-quality goods at a high price, but the consumers in the market don’t want to pay for these high-quality goods. They would rather buy lower-quality goods at a lower price. 

An example would be the pen market.

Sellers may be offering pens that are $20 each but write smoothly and sharply. The pens that the firms in the market are selling are of the highest quality, but most customers are general-use.

These customers aren’t penned collectors and aren’t interested in pens will all the extra qualities and features. Instead, they want a pen that can write. So they would rather buy a cheap pen than a more expensive pen.

Another reason why price support may not be a good idea is that it can promote illegal activity. Sellers want to eliminate their surplus, so they may sell the product below the price supported on the black market to get more sales. 

Price floors Vs. Price Ceilings

The opposite of a price floor is a price ceiling, which sets the maximum price for a good or service. This is another form of price control that the government uses. There are two types of price ceilings: binding and non-binding. 

Price ceilings and price floors are considered binding in different ways. A price ceiling is considered binding when the price ceiling is set below the equilibrium price. This will cause the market to have more demand than supply, resulting in a shortage.

Price support is binding when it is set above the equilibrium price. This creates a surplus in the market.

Price ceilings can allow goods and services to be affordable, but many other problems may arise from price ceilings. For example, because there is a shortage of goods, sellers must ration the goods demanded by the consumers. This can result in some unfair and inefficient practices. 

For example, there will be long lines to get products due to scarcity, leading to market inefficiency. There will also be discrimination according to the sellers’ biases, which creates unfairness. 

The goods don’t necessarily go to the individuals who value them the most. 

How does elasticity affect it?

Elasticity is the economic measure of the responsiveness of quantity demanded or supplied in a market to a change in one of its determinants. 

Elasticity affects profitability for suppliers in the market when price support is enacted. Therefore, the government must be mindful of the elasticity of a good when setting a price floor (or any price control, for that matter). 

If the good face elastic demand, the price increase will cause a disproportionately large decrease in demand, resulting in smaller profits for producers. 

On the other hand, if the good face inelastic demand, the price support will help increase the supplier’s profits as the increase in price will disproportionately cause a smaller decrease in the demand. 

The increased prices will outweigh the lower sales volume, increasing the supplier’s profitability. 

An example of a price ceiling is rent control. It occurs when the government enacts a maximum price that people can pay for rent. This creates a shortage of apartments since landlords don’t think it’s worth selling their apartments for a lower price. 

Since everyone needs a place to live, rent control makes it so some people can’t rent an apartment. 

Also, some landlords won’t feel the need to upgrade their buildings and amenities because of the low price being paid. This can lead to a lower quality of apartments on the market.

Rent controls usually result in more negatives than positives. This is because the purpose of rent control is to make rent affordable for lower-income families. 

Due to the nature of rent control, many people who would benefit fromaren’tower rent aren’t the people who end up getting the apartments because of the limited supply.

Minimum Wage Laws

The most prevalent use in our economy is the minimum wage.  It is a concept the government uses to set a minimum amount of money that companies have to pay their workers. 

This is exactly how price support is defined —the minimum wage is a price below which you cannot sell labor. 

It results in a surplus of labor as the providers of labor exceed the buyers. 

It usually affects workers with low productivity. These individuals are generally the least experienced and least educated/trained. Teenagers are a prime group that is affected by the minimum wage. 

Many companies don’t value the work of teenagers as much as a recent college graduate. If minimum wage laws weren’t in place, these employers would pay teenagers less than what they’re required to pay them. This shows that the minimum wage for teenagers is binding.

The price support (the minimum wage laws) for recent college graduates is usually not binding. Recent graduates generally get paid way more than the minimum wage rate, meaning that the price support is below their equilibrium wage. 

Raising the minimum wage is a highly debated topic in the United States for many reasons. 

This is because 

  • A modest increase in the minimum wage will affect a small percentage of the working population.
  • At best, raising the minimum wage will raise the wages of some low-skill and young workers. However, this may not have a significant impact as wages would have increased just by gaining more skills over time for these young and unskilled workers.
  • At worst, the increase will cause the price of some commodities, lead to unemployment, or keep teenagers in school for a little longer. 

A more significant increase in the minimum wage will result in serious unemployment. It could also cause an increase in inflation.

It can also promote illegal activity. For example, labor workers may sell their labor for less than the price of the minimum wage to find a job. This would be illegal in countries that have a set minimum wage. 

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Researched & Authored by Alexander

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