A price floor is a minimum price set by a government or other body with the result that a price is not permitted to fall below a certain minimum level. Where the equilibrium price set by supply and demand would be below this level, the price floor is likely to result in some distortion in the market. The consequence will be a greater supply of the relevant goods or services as firms are attracted by the higher price available, however there will be a reduction in demand as some potential customers or recipients of the services are unwilling or unable to pay the higher price required.
Examples of Price Floors
One modern example of a price floor is a minimum wage. A minimum wage may apply to a particular sector or all across the board. Normally, wages are determined by supply and demand in the labor market. In sectors where the equilibrium price determined by supply and demand of labor is below the minimum wage, the level of the minimum wage acts as a price floor and the effect is to artificially raise the price of labor. This may therefore serve to increase the potential supply of labor, because it will be worthwhile for more people to enter the job market at the minimum wage level. While this may combat exploitation of cheap labor, it can also distort the market and cause employers to reduce the number of people employed. While the potential supply of labor increases, the demand for labor by employers may therefore be reduced.
Certain industrialized countries and trading blocs such as the European Union have at times introduced price floors for agricultural goods, to protect their agricultural sector. Such price floors have had the effect of encouraging existing producers to increase their levels of production and attracting new firms to enter the market for certain agricultural goods. The effect of this policy when used in the EU was to create large stocks of some produce, which were purchased and stored by the EU, often referred to by the use of expressions such as butter mountains and wine lakes.
The problem of over-production resulting from the imposition of price floors for agricultural produce was dealt with in the EU by measures such as payments to farmers to leave some fields fallow, effectively paying farmers not to produce. The introduction of quotas for crops such as potatoes ensured that producers kept their production levels within the required limit to avoid paying a fine imposed by the EU.
An alternative approach is to set an intervention price for a certain good, a level at which a government or trading bloc will intervene in the market to purchase the goods and ensure that the price does not fall below that level. A similar mechanism can be seen on currency markets where a government may intervene to buy its own currency and keep the exchange rate above a certain level.
Another strategy used by governments is a price floor for products such as alcoholic drinks, to ensure that the price does not fall low enough to encourage excess consumption. This may reduce demand but may also encourage an increase in the supply of these goods. Governments may achieve the same effect on the price by the imposition of so-called sin taxes such as alcohol or tobacco duty.
Where a price ceiling is set and is below the equilibrium price set by supply and demand, the effect is to cause the producers to decrease their production while consumers demand more of the product. Existing producers have to accept a lower price than they would otherwise set for their goods or services, and as a result some of the producers are likely to withdraw from the market. Likely consequences of price ceilings are queues for goods, the introduction of rationing or the growth of a black market for the goods.
Another example of current price floors and ceilings in today’s economy would be the control of rents in certain cities. This may be done by local government to ensure that apartments are affordable for citizens who need them and to combat exploitation by landlords. The consequence is, however, that a price may be set that is below the equilibrium price arrived at through supply and demand, thereby increasing the demand for apartments in the city. Landlords will not receive the full amount that they would be able to charge in a free market, and as a result some may decide to withdraw from the market, for example by selling apartments and investing elsewhere. The supply of accommodation may therefore be reduced by the imposition of the price ceiling.
The consequence of a price ceiling on rents may be queues and waiting lists for apartments caused by the increase in demand. Some landlords may impose certain criteria on the tenants they accept, causing discrimination against certain categories of tenant. The withdrawal of some apartments from the market is likely to increase the problems caused by shortages of accommodation.
Price ceilings may also be imposed on the sale price of apartments in a city. This has similar effects in terms of an increase in the demand for apartments and a reduction in the supply because people are reluctant to put their apartments onto the market. The price ceiling may lead to inefficiency in the system because people are reluctant to move from one location to another owing to their inability to obtain a market price for their apartment. Consequently, people may be turning down jobs for which they are the best candidates and the restriction on labor mobility leads to inefficient allocation of resources.
Information on price controls on www.econport.org/content/handbook/Equilibrium/Price-Controls.html