Price floor

Definition

A price floor or minimum price is a lower limit placed by a government or regulatory authority on the price (per unit) of a commodity.

A price floor is a form of price control. Another form of price control is a price ceiling.

There are two types of price floors:

• Non-binding price floor: This is a price floor that is less than the current market price.
• Binding price floor: This is a price floor that is greater than the current market price.

There are two extreme forms of price floors:

• A price floor of infinity can be thought of as analogous to making the exchange or selling of the commodity illegal.
• A price floor of zero (non-inclusive) can be thought of as a requirement that the good cannot be given away for free.

Basic theory

Non-binding price floor: price floors set below the market price have no effect

If the price floor is set below the market price, it has no effect on the market price.

Binding price floors: price floors set above the market price cause excess supply

A price floor set above the market price causes excess supply, or a surplus, of the good, because suppliers, tempted by the higher prices, increase production, while buyers, put off by the high prices, decide to buy less. This leads to a deadweight loss. The picture below illustrates this. Here, the distance AB measures the surplus when the price floor is set at the price level of the line AB, which is higher than the equilibrium price (i.e., the market price).

Effects of price floors

Regulatory agency may buy up the surplus

The regulatory agency setting the price floor may agree to purchase all excess inventory.

Non-price competition among sellers

Lower effective prices by means of additional services (a form of non-price competition) or special discounts and rebates on related products.

Black market

A black market, where the goods are sold for less than the price floor (typically, though, black markets are used to handle shortages or scarcity due to price ceilings).