Price floor

Minimum price controls (price floor)

Now, the situation is the opposite than for maximum prices. In this case the government sets a
minimum price above the equilibrium price, preventing producers to sell their product below it. This is
done to protect producers. This is usually done in the case of commodities and in the labour
market.
The aims of this policy for the government are usually:
1. To increase the income of producers of goods and services that the government considers
important, such as agricultural products, which are subject to large price fluctuations, or great
foreign competition.
2. To protect workers by setting a wage that would ensure them an earning that would allow
them to have a reasonable standard of living.

Figure 1.
Minimum price on corn.
Figure 1 shows the example of corn. With no government intervention, the market would be trading
at a price of Pe and a quantity Qe.

If the government would set a minimum price on corn, it would be set above the equilibrium price at
Pmin as shown in the diagram.
At the higher price, producers would now be willing and able to supply a greater amount Q 2 , while
consumers, on the other hand, would be willing and able to buy less, Q 1. This would create an
excess of supply from Q1 to Q2.
If the government does not intervene further, then the original policy objective of protecting producers
of corn by increasing their revenue might not be achieved. The price has been increased but only for
those that will still be willing and able to consume the good at the higher price so the quantity sold
has fallen. The extent to which this will imply an increase in total revenues for producers will depend
on which of the two effects has been stronger (this depends on the relative elasticity of PED).

Be Aware
Again, this case is tricky for our brain, as the word "minimum" is usually associated with the word
"below" and with the concept "low"; however, minimum price means 'high price' for producers, and
it is set above the equilibrium price of the market and not below.

Possible consequences of a minimum price

A price floor may produce several consequences. Let's analyse some of its possible outcomes and
effects:

It produces surpluses.

It promotes the creation of black markets.

The government needs to dispose of the surplus.

It might create firm inefficiency.

It eliminates allocative efficiency and generates welfare loss.

Effects on market stake holders.

It produces surpluses

At the price floor Pmin the quantity supplied (Q2) is much higher than the quantity demanded (Q1), thus
not all of the produced crop will be bought by consumers. Consumers will purchase less in response
to the higher price, and a surplus of Q2 - Q1 is created.
If the price is kept at Pmin there will be many consumers that previously at Pe would have purchased
the good (Qe), plus all of the new entrants to the market attracted by the low price, who will not have
access to it now.

It promotes the creation of informal (black) markets

If producers cannot sell all of their production at the regulated price Pmin, they may try to do so at a
lower price in the informal market. This practice is illegal and will go against the original objective of
the policy, selling the good at a lower price nearer to the previous equilibrium price.

The government needs to dispose of the surplus

Figure 2. Further government

intervention to sustain the
minimum price.
As not all of the product will be sold to consumers, the problem of what to do with the surplus comes
into the scene. One option is that the government purchases the excess supply, shifting the demand
curve outwards, as shown in Figure 2, up to Q2. This will imply a cost for the government.
Once it has bought the surplus, it needs to decide what to do with it:
a) It can store the good, which will generate additional costs.

b) It can sell it abroad (export), but it would be difficult to do at the higher imposed Pmin. The
government would have to subsidize the good to be able to compete internationally, and this has a
cost too.
c) It can send it as aid to developing countries, but this usually brings problems to these countries
(issue that will be explored in the Development Topic further on).
d) It could burn it, but burning food (in this case) is not well seen, nor ethically correct, as so many
people in the world are starving.
Almost any action done by the government to get rid of the surplus has costs and disadvantages.

Important
To avoid the problem of what to do with the surplus and still protect producers by assuring them a
higher price for their total production, many countries decide to pay producers not to produce the
excess, and the available land is used to produce something else.

It might create firm inefficiency

If firms know they will receive a higher price no matter how efficient they are in their production
process, they will not be motivated to reduce costs and use more efficient methods of production.
Higher prices than the equilibrium price may lead to production inefficiency, because the high prices
protect them from lower-cost competitors.

It eliminates allocative efficiency and generates

welfare loss

Figure 3. Welfare
loss because of minimum price.
As a greater amount of the good is produced (Q2) than the socially optimum amount determined by
the market equilibrium (Qe), therefore there is an over allocation of resources to the production of the
good from the society's point of view. Society is therefore worse off resulting from
the allocativeinefficiency.
As shown in Figure 2, with no price control, the market equilibrium determined by the price Pe and
the quantity Qe. Consumer surplus is equal to area 'a + b + c', and producer surplus is equal to 'd +
e'.
When the price ceiling is set, consumers only consume the quantity Q 1, therefore the consumer
surplus is area 'a' (all of the area below the demand curve and above the price paid by consumers
Pmin, for the units consumed).
If government buys the excess supply, producer surplus is now 'b + c + d + e + f' (all of the area
above the supply curve and below the price received by producers, P min, for the units sold).
This means that the consumer plus producer surplus increases after the price control. This
happens because producers gain the area 'b + c' lost by consumers in addition of 'f'.
Government has a cost of Pmin (Q2 - Q1), which is a loss of social welfare. As part of this loss is
compensated by the gain in producer surplus represented by 'f', the net deadweight loss for
society is the shaded area shown in the diagram.

Consequences on market stakeholders

Let's analyse the individual consequences on: consumers, producers, workers, and government.
Consumers: Consumers of the good are worse off, after the price ceiling, as they end up consuming
a smaller amount of the good at a higher price.
Producers: Producer now sell a greater amount of the good than before (Q2 < Qe), and receive a
higher price for it. Their total revenue increases after the price floor is imposed, therefore they are
better off.
Workers: As the size of the market increases, it is probable that more workers will be hired in this
market, and employment will rise. Thus, workers will be better off.
Government: If government buys the surplus, it will incur in a cost and will have less funds to spend
on other public goods and services, therefore an opportunity cost. Additionally, if it has to store the
product, or subsidise it to export it to other countries, the cost will be even higher.

Try for yourself!

Suppose the government sets a minimum wage in the labour market, with the intention of ensuring a
decent standard of living to workers and increasing the amount of people employed.
1) What will be the effect on the people willing to work at the minimum wage set by the government?
2) What will be the reaction of firms who demand workers and will have to pay a higher wage rate?
3) What will be the combined effect of the answers to questions 1 and 2?
4) Propose two solutions that could be implemented to solve the problem and achieve both
objectives of the policy?
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