What is a price floor?
A price floor is the lowest legal price that can be charged for goods and services, labor, or financial capital in a given market. An example of a price floor is the federal minimum wage, which Congress periodically raises to reflect market changes that increase the cost of living.
Price floors, also called price supports, prevent costs from falling below a minimum number. Price floors are essential to industries with fluctuating prices as they guarantee a minimum income level for people in those industries.
The government enacts price floors by buying up products in the market, increasing demand, and keeping costs above the price floor. These prices don’t change the demand of a product, but they set a minimum price that can be charged for a product.
Price floors don’t move the demand curve. They create a different choice of quantity demanded along a demand curve. When a price floor is above the equilibrium price, the amount will exceed demand, resulting in a product surplus.
The primary purpose of a price floor is to influence companies to manufacture more products, increasing the overall market supply. The government often sets price floors when economic activity slows and the supply of certain products dips.
Setting a price for an agricultural product, for example, is a way for the government to prevent farmers from abandoning a crop that isn’t profitable and decreasing the supply of that crop in the process. Companies utilize pricing software to track the impact of pricing strategies on sales profitability and analyze the best pricing strategies for their products and services.
Types of price floors
There are two types of price floors: binding and non-binding. The difference between the two lies in how they affect consumers, producers, and the overall market.
- Binding price floors: A price limit greater than the equilibrium market price. Producers benefit from this type when the higher price compensates for the lower quantity sold. However, consumers suffer because they pay more for less.
- Non-binding price floors: A price limit lower than the equilibrium market price. This type doesn’t affect the market. The market price remains the same and so does the quantity demanded and supplied. Therefore, this type of price floor does not affect producers or consumers.
Reasons for setting price floors
Price floors are set for several reasons. Some reasons are economical, while others are put in place to improve consumer habits. Below are three common reasons price floors are set.
- To help producers: Governments typically set price floors to help producers. This occurs when the government wants to encourage the production of a certain product.
- Inelastic demand: Governments also create price floors in markets with inelastic demand and naturally low prices. By doing this, governments can increase the welfare of society because the gain for producers offsets the loss of consumers.
- Public health initiatives: Some countries impose price floors on substances like alcohol to dissuade consumers from developing a drinking problem.
Effects of a price floor
Price floors have both positive and negative effects, and sometimes the results are not what the government intended. Whether a person benefits from or is hurt by a price floor depends on their place in the market. These are some of the effects that result from price floors:
- Black market: When prices are higher than the market value, producers sometimes turn to black markets to sell production surplus.
- Higher prices: Price floors set above equilibrium can lead to higher prices. This hurts the consumer but benefits the producer.
- Lower demand: When prices are higher than when in market equilibrium, customers seek alternative goods which results in reduced demand.
- Overproduction: Suppliers sometimes produce more than the demand when prices are set above equilibrium. This overproduction results in a surplus of products, where demand decreases as supply increases.
- Price support: Governments support the price floor by purchasing the resulting spare capacity. This market stabilization tactic is the government’s way of aiding businesses that are hurt by the resulting changes.
Martha Kendall Custard
Martha Kendall Custard is a former freelance writer for G2. She creates specialized, industry specific content for SaaS and software companies. When she isn't freelance writing for various organizations, she is working on her middle grade WIP or playing with her two kitties, Verbena and Baby Cat.
