A Price Floor or a minimum price is defined as an intervention to raise market prices if the government feels the price is too low. In this case, since the new price is higher, the producers benefit. For a price floor to be effective, the minimum price has to be higher than the equilibrium price.
For example, many governments intervene by establishing price floors to ensure that farmers make enough money by guaranteeing a minimum price that their goods can be sold for. The most common example of a price floor is the minimum wage. This is the minimum price that employers can pay workers for their labor.
The opposite of a price floor is a price ceiling.
A Price Floor Diagram
For a price floor to be effective, it must be set above the equilibrium price. If it’s not above equilibrium, then the market won’t sell below equilibrium and the price floor will be irrelevant. In the diagram below, the minimum price (P2) is below the equilibrium price at P1. Since the equilibrium price is higher, this price floor will be ignored.
In the diagram below, the government establishes the price floor at Price Pmin, which is above the market equilibrium. The result is that the Quantity Supplied (Qs) far exceeds the Quantity Demanded (Qd) which leads to a surplus of the product in the market.
Real-World Example of Price Floor
Minimum wage laws set legal minimums for the hourly wages paid to certain groups of workers. In the United States, amendments to the Fair Labor Standards Act have increased the federal minimum wage from $.25 per hour in 1938 to $5.15 in 1997.1 Minimum wage laws were invented in Australia and New Zealand with the purpose of guaranteeing a minimum standard of living for unskilled workers. Most noneconomists believe that minimum wage laws protect workers from exploitation by employers and reduce poverty. Most economists believe that minimum wage laws cause unnecessary hardship for the very people they are supposed to help.
The reason is that although minimum wage laws can set wages, they cannot guarantee jobs. In practice, minimum wage laws often price low-skilled workers out of the labor market. Employers typically are not willing to pay a worker more than the value of the additional product that he produces. This reality means that an unskilled youth who produces $4.00 worth of goods in an hour will have a tough time finding a job if he must, by law, be paid $5.15 an hour.
Effects of a Price Floor
In the end, even with good intentions, a price floor hurts society more than it helps. It may help farmers or the few workers that get to work for minimum wage, but it only helps those people by hurting everyone else. Price floors cause a deadweight welfare loss. A deadweight loss is a loss in economic efficiency.
Consumers must now pay a higher price for the exact same good. Therefore, they reduce their demand or drop out of the market entirely. Meanwhile, suppliers find they are guaranteed a new, higher price than they were charging before. As a result, they increase their production. The problem is that this creates excessive supply, which usually the government ends up buying and stockpiling the extra quantity. Often the government destroys the surplus or allows it to spoil.
The government also has the option to subsidize consumption to encourage more demand. If the government sells the surplus in the market, then the price would drop below the equilibrium. A price floor also leads to a market failure (where markets don’t efficiently allocate scarce resources).