Price Floors

Definition

A price floor is a government-imposed minimum price for a good or service that must be charged in the market. It sets a lower limit on the price, preventing the market price from falling below the established floor. Price floors are often implemented to protect producers and ensure a minimum level of income or profitability for specific industries or markets.

5 Must Know Facts For Your Next Test

1. Price floors create a surplus in the market, as the quantity supplied exceeds the quantity demanded at the price floor level.
2. Price floors lead to a deadweight loss, as they prevent the market from reaching the efficient equilibrium price and quantity.
3. Price floors can distort the market's ability to efficiently allocate resources, as they prevent the market from reaching the point where the marginal benefit equals the marginal cost.
4. Examples of price floors include minimum wage laws, agricultural price supports, and the regulation of certain professional services.
5. The effectiveness of a price floor depends on the level at which it is set and the enforcement mechanisms in place to ensure compliance.

Review Questions

• Explain how a price floor affects the market's ability to achieve an efficient equilibrium.
  • A price floor prevents the market from reaching the equilibrium price and quantity where the marginal benefit equals the marginal cost. Instead, the price floor sets a minimum price above the market-clearing price, leading to a surplus of the good or service. This distortion in the market results in a deadweight loss, as some mutually beneficial transactions between buyers and sellers are prevented from occurring. The market's ability to efficiently allocate resources is compromised when a price floor is in place.
• Describe the relationship between a price floor and the concept of a surplus in the market.
  • When a price floor is implemented, the quantity supplied at the price floor level exceeds the quantity demanded, resulting in a surplus. Producers are willing to supply more of the good or service at the higher price floor, but consumers are only willing to purchase the lower quantity demanded at that price. The surplus represents the quantity of the good or service that cannot be sold, as the price floor prevents the market from clearing at the equilibrium price and quantity. This surplus can lead to various economic inefficiencies, such as the storage or disposal of the excess supply.
• Evaluate the role of price floors in the context of the market system as an efficient mechanism for information.
  • Price floors undermine the market system's ability to efficiently allocate resources and transmit information. By preventing the market from reaching the equilibrium price, price floors distort the signals that the market sends to producers and consumers. Producers may receive inflated price signals, leading them to supply more than the efficient quantity, while consumers receive distorted price signals, leading them to demand less than the efficient quantity. This breakdown in the market's information-transmitting function can result in a misallocation of resources and a reduction in overall economic welfare. In the context of the market system as an efficient mechanism for information, price floors represent a significant market distortion that impairs the market's ability to coordinate economic activities effectively.

Related terms

Surplus:

A surplus occurs when the quantity supplied exceeds the quantity demanded at the prevailing market price, resulting in an excess of the good or service.

Deadweight Loss:

Deadweight loss is the reduction in total social welfare or economic efficiency caused by a market distortion, such as a price floor or price ceiling.

Market Equilibrium:

Market equilibrium is the point where the quantity supplied and quantity demanded are equal, and the market-clearing price is established.