The lower boundary on the price of a commodity in the market Show
What is a Price Floor?A price floor is an established lower boundary on the price of a commodity in the market. Governments usually set up a price floor in order to ensure that the market price of a commodity does not fall below a level that would threaten the financial existence of producers of the commodity.  Types of Price Floors1. Binding Price FloorA binding price floor is one that is greater than the equilibrium market price. Consider the figure below: The equilibrium market price is P* and the equilibrium market quantity is Q*. At the price P*, the consumers’ demand for the commodity equals the producers’ supply of the commodity. The government establishes a price floor of PF. Therefore, prices in the market can’t fall below PF. At price PF, consumer demand is QD (less than Q* due to downward sloping demand curve), and producer supply is QS (more than Q* due to upward-sloping supply curve). After the establishment of the price floor, the market does not clear, and there is an excess supply of QS-QD. Producers are better off as a result of the binding price floor if the higher price (higher than equilibrium price) makes up for the lower quantity sold. Consumers are always worse off as a result of a binding price floor because they must pay more for a lower quantity. 2. Non-Binding Price FloorA non-binding price floor is one that is lower than the equilibrium market price. Consider the figure below: The equilibrium market price is P* and the equilibrium market quantity is Q*. At the price P*, the consumers’ demand for the commodity equals the producers’ supply of the commodity. The government establishes a price floor of PF. At price PF, consumer demand is QD (more than Q* due to downward sloping demand curve), and producers supply is QS (less than Q* due to upward-sloping supply curve). However, the non-binding price floor does not affect the market. The market price remains P* and the quantity demanded and supplied remains Q*. Producers and consumers are not affected by a non-binding price floor. Effect of Price Floors on Producers and Consumers
Reasons for Setting Up Price Floors
Example: Minimum Wage LawsAlmost all economies in the world set up price floors for the labor force market. It is usually a binding price floor in the market for unskilled labor and a non-binding price floor in the market for skilled labor. The price floors are established through minimum wage laws, which set a lower limit for wages. For example, the UK Government set the price floor in the labor market for workers above the age of 25 at £7.83 per hour and for workers between the ages of 21 and 24 at £7.38 per hour. Any employer that pays their employees less than the specified amounts can be prosecuted for a breach of minimum wage laws. Additional ResourcesCFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)® certification program, designed to transform anyone into a world-class financial analyst. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:
What would happen if the price was set at a lower level than the market price?Price ceilings prevent a price from rising above a certain level. When a price ceiling is set below the equilibrium price, quantity demanded will exceed quantity supplied, and excess demand or shortages will result.
What happens when price level is higher than expected?If price levels rise too quickly, central banks or governments look for ways to decrease the money supply or the aggregate demand for goods and services. Although prices change gradually over time during inflationary periods, they can change more than once a day when an economy experiences hyperinflation.
What would happen to the demand of an item if the price is set too high?As we can see on the demand graph, there is an inverse relationship between price and quantity demanded. Economists call this the Law of Demand. If the price goes up, the quantity demanded goes down (but demand itself stays the same). If the price decreases, quantity demanded increases.
What happens if the price is somehow higher than the equilibrium price?When price prevailing in the market is higher than the equilibrium price, demand will be less than supply, i.e. there is excess supply in the market. Excess supply will force the market price to slide down causing expansion of demand and contraction of supply.
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