Price Floor

Article byNanditha Saravanakumar
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Price Floor? 

A price floor in economics refers to the lowest price level at which any product or service can be legally charged. Often, the government has to limit the minimum and maximum prices at which a commodity can be sold. The aim is to prevent the exploitation of weaker sections of society.

Price Floor

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Ideally, the price floor should be higher than the equilibrium price where supply and demand are equal. When the price is capped, it has many macroeconomic effects, such as unemployment, fall in demand, rise in supply, etc. Its converse is the price ceiling, where the upper price limit is fixed.

Key Takeaways

  • The price floor refers to capping the economic price levels of commodities so they cannot fall below a certain limit. The government or private trade organizations mostly fix this limit. 
  • The basic intention is to ensure that no section of society benefits unfairly.
  • But such a restriction on the lower price limit can affect the economy, such as unemployment, oversupply, fall in demand, inflation, and market inefficiency.
  • The price floor on minimum wage is an appropriate example. 

Price Floor Explained 

The price floor in economics can be understood as putting a cap on the price of a commodity. In some situations, the government is forced to restrict the prices from falling below a certain level. This can be done to ensure fair market prices, protect manufacturers from exploitation, etc. However, not just governments but even some trade groups and associations agree on lower price limits.

One of the best examples is the price floor on minimum wage. The government has mandated that the federal minimum wage be paid to employees to ensure a decent economic position. It is beneficial to those who secure employment. However, there is a downside to this. A higher minimum wage implies an increased cost for the firm. This means they will recruit fewer people and pay them more instead of recruiting more people and paying them adequately. This negatively impacts the employment rate.

The labor supply will be high as there are more unemployed people, but the demand will be less since the company cannot hire more people. The same happens with commercial goods. When the government increases the price, the demand falls automatically, but the supply is high. Therefore, the company will only benefit if the price increase offsets the fall in demand. The customers, however, are at a loss.

Here’s a calculation example to understand the idea. A company sells mobile phones for $500. It has an average demand of 100 units per month. 

Revenue = 500 x 100 = $50,000

If the government sets the minimum price to $600, the demand falls to 80 units.

Revenue = 600 x 80 = $48,000 (The company loses).

Alternatively, if the minimum price is $530, the demand falls to 95 units.

Revenue = 530 x 95 = $50,350 (The company gains).

Thus, it is a trade-off between making profits from a price rise and increasing quantity.

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Types 

Price floors are of two types – binding and non-binding. Let’s understand them in detail.

  • Binding – The minimum price is set above the equilibrium price in this model. This is usually disadvantageous to customers as they will pay more than before. For sellers, it depends on the price-demand relation. If the price increase can compensate for the loss of customers (quantity demanded), the businesses will gain. If not, they, too, will be making a loss. Nevertheless, a binding price floor is ideal, as supply matches demand.
  • Non-binding – The minimum price is maintained below the equilibrium price. Though not that common, this model doesn’t affect the market since the buyers can keep selling at the market price. Therefore, they would satisfy the minimum price level criteria anyway, with constant demand and supply.

Refer to the graphs below to understand the mathematical aspects of these two types.

Examples

Let’s discuss a few examples of a price floor.

Example #1

Country X is an agrarian economy. Rice is sold at $20 per pound in the market. However, the intermediaries buy the same quantity at $5 per pound from farmers and sell it at $20. This results in farmers making little to no profits and intermediaries benefitting at the expense of the farmers. Therefore, the government mandated that the minimum purchase price from the farmers should be $10 and the maximum retail price should be decreased to $15.

Example #2

The G7 nations, the 27 European Union countries, and Australia recently imposed a price cap on Russian oil at $60 per barrel. The price cap will be revised every two months to remain at least 5% below the average Russian crude price estimated by the International Energy Agency. In response, Russia has decided to introduce a price floor by setting a fixed price for the barrels or laying down maximum discounts on the oil.

Graph

Here is the diagrammatic representation of the price floor. The graph is plotted with quantity demanded on the X-axis and price on the Y-axis. At the equilibrium price, the supply and demand are equal.

Binding Price Floor

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The minimum price is above the equilibrium in the binding price floor graph below. At this price, the supply is more while the demand is less (note the intersecting points). This creates a surplus in the market. The graph shows the binding floor but is also the general representation, as this is the most common scenario.

Non Binding Price Floor

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The non-binding price floor graph is relatively rare and shows the non-binding floor. The minimum price is set below the equilibrium price. But this doesn’t mean that there is a shortage. Because the supply and demand corresponding to the non-binding price need not apply here. 

Pros And Cons

Here are the major pros and cons of the system of price floor:

ProsCons
The increase in market price may be good for businesses (though only sometimes).It mostly increases the market price, which is not a good sign for customers.
Helpful to alleviate any unfair advantage to a market participant.This can lead to reduced demand and increased supply, thus creating a surplus.
Minimum wages and minimum support prices are good for the economy.Leads to market inefficiency.
Unemployment, oversupply, inflation, etc., are some relevant issues.

Price Floor vs Price Ceiling

Price ceiling and floor are two important but opposing economic related to price control. Let’s distinguish between them:

Price FloorPrice Ceiling
Setting a minimum price on commodities.Setting a maximum price on commodities.
The price should not fall below this lower limit.The price should not exceed this upper limit.
Ideally, it should be above the equilibrium price.Ideally, it should be below the equilibrium price.
It is likely to cause a product surplus in the market.It doesn’t usually affect the market supply or demand.
Example: Minimum wages.Example: Rent control in the U.S.

Frequently Asked Questions (FAQs)

What is a binding price floor?

A binding floor refers to a situation where the price floor is maintained at a value above the equilibrium price (demand meets supply). The price hike leads to a fall in demand and an increase in supply, thus leading to surplus production or availability.

Why are price floors implemented by governments?

Governments introduce price caps – floors and ceilings – for the larger benefit of society. The intention is to prevent economic exploitation of a certain section that might not receive decent monetary compensation for their goods and services (farmers, manufacturers, retailers, etc.).

Do price floors create shortages?

No. If anything, price floors are associated with market surpluses when demand falls and supply rises on a binding floor. But the shortage is an extremely rare situation. Because for this to happen, a non-binding floor should be introduced first, and the sellers should start selling at this minimum price. But both of these are low-probability events.

This has been a guide to what is Price Floor. Here, we explain its examples, compare it with the price ceiling, graph, pros & cons, and types. You can learn more about from the following articles –

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