The government has set a price floor on bread

WRITTEN BY PAUL BOYCE | Updated 8 January 2021

What is a Price Floor

A price floor is a minimum price set on goods and services usually determined by the government. This makes it illegal for any company or individual to sell its goods or services below the set minimum price. In turn, it can provide a boost to the suppliers and sellers, who may achieve a higher income as a result.

The aim of price floors is to ensure suppliers achieve a minimum price which ensures the firm stays in business. Or, in the case of the minimum wage (an example of a price floor), to improve living standards.

Price floors are most effective when they are set above the equilibrium point whereby supply and demand meets. This is because if the price floor is set below the equilibrium, then the price floor is set below the market value. In other words, the firm is able to sell at a higher price than the minimum price set. For example, the iPhone sells for around $699. Yet if the price floor was set at $500 (below the equilibrium), it would have no effect.

If the price floor was set at $800 instead, it would benefit Apple as it would be selling at a higher price. However, fewer customers will purchase the iPhone as a result – meaning the actual profit it receives may in fact be lower. This results in an economic surplus, whereby more goods are supplied than demanded.

As the price is higher than it would be normally, this incentivizes greater production. However, demand falls, thereby creating a surplus of goods. What governments often do to counteract this is actually purchase the remaining surplus. For example, the European Union’s Common Agricultural Policy (CAP) sets a price floor and agriculture products which guarantee farmers an income. So even if production is doubled or trebled, the EU will purchase the surplus.

Effects of a Price Floor

1. Black Market

When prices are set artificially above the market value, it can lead to black markets as producers seek to sell their production surplus. For instance, the NFL used to operate a price floor that set a minimum price on resold tickets. This meant season ticket holders and other resellers had to sell for a minimum price. However, this made it more difficult for them to sell as the price was in excess of what many were willing to pay. In turn, a black market was created to allow those who wanted to sell tickets to find buyers.

2. Higher Prices

When price floors are set above the equilibrium point, it can lead to higher prices. For instance, doughnuts sell for $2 each. If the price floor is set at $2.50, this means that the customer must now pay the extra 50 cents for each doughnut. So whilst the baker may potentially benefit, the customer does not, which is why price floors are often seen as corporate welfare.

3. Lower Demand

With prices higher than they would be under a market equilibrium, customers will look to purchase substitute goods instead. For instance, if a price floor for a loaf of bread increases its price from $1.50 to $2, consumers may start to switch to cereal’s that are also $2 for a box.

4. Over-Production

When the price is over and above the equilibrium, suppliers are willing to supply well in excess of the demand. As we can see from the graph below, when the price floor is set above the equilibrium, suppliers are willing to supply more, but the demand falls as the prices are higher. In turn, a surplus is created.

As part of implementing a price floor, the government may agree to purchase any excess production in order to help keep firms in business. As we have seen from the EU’s Common Agricultural Policy (CAP), this can lead to overproduction as farmers have a direct incentive to increase production – because there will always be demand for their output.

5. Price Support

As already discussed, governments may look to support the price floor by purchasing any spare capacity that may result. This is to help support businesses that may in fact be made worse as a result of the higher prices. For instance, they may actually lose enough business that in fact, it makes them worse off despite the higher prices. So the government steps in to ensure that the market is stabilized and those businesses are secure.

Price Floor Examples

Alcohol

In 2018, Scotland became the first country in the world to set a price floor on alcoholic beverages. The minimum price was set at 50 pence (70 cents) per unit of alcohol, targeting cheap, but strong alcoholic beverages. The aim was to reduce the consumption of cheap but highly toxic alcoholic beverages and thereby limit the side effects. For instance, it is said that alcoholic misuse costs Scotland £3.6 billion ($4.9 billion US) each year. Not only does it have to pay for healthcare, but also policing, public disorder, and any criminal damage that is committed.

Usually, price floors are designed to provide a boost in income to the producers on the supply side, but in this case, it is to actually limit consumption from the demand side.

EU Common Agricultural Policy (CAP)

The Common Agricultural Policy was introduced to Europe in 1957 under the Treaty of Rome. Its aim was to create stability in the agriculture markets where farmers were prone to fluctuations in supply due to droughts and other weather conditions. The policy supports the price of goods such as wheat, rice, beef, butter, and other dairy products – by purchasing them at a price floor. In other words, if the farmers can’t sell them, then the European government will buy them, thereby acting as a price floor.

Minimum Wage

The minimum wage is one of the most prevalent price floors across the world – nearly every country has one. Its level varies from country to country, and its effect equally differs. Some are set above the equilibrium level, so result in lower demand for workers, whilst others are set below and therefore have little impact. At the same time, there are many other outcomes of setting the price floor of labour above the equilibrium point. This may in fact lead to higher levels of employment despite the higher cost. However, this may be subsidized by existing benefits. Benefits that range from pension contributions to bonuses, and overtime pay. So whilst the usual supply and demand mechanism may not come into play, it may be costed in a different way.

Imports

In 2016, India set a price floor on steel imports – largely to deter foreign competitors such as China from dumping cheap steel into the market. With the country facing cheap steel from China, its domestic steel manufacturers came under significant pressure. Customers were opting for the cheaper Chinese option, which threatened the existence of Indian manufacturers. The government, therefore, stepped in to artificially inflate the price of Chinese steel and essentially make it uncompetitive. This protected its domestic steel industry as it saw demand return as Indian steel became comparatively cheap.

Price Ceiling vs Price Floor

A price floor is where a minimum price is set for a good or service. In other words, suppliers cannot sell below that price. It is usually determined by the government, but public entities such as the NFL have been known to organize a private price floor. This is generally to protect the income and survival of the producer.

By contrast, a price ceiling is a maximum price set for a good or service. Examples include rent controls and pay caps. These aim at reducing prices to the consumer and restricting inequality.

Related Topics

• Fiscal Policy
• Law of Demand
• Law of Supply
• Price Ceiling
• Substitute Goods

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