Price floor

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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 in perfectly competitive markets

As indicated in the title of this section, we assume here that for the good on which the price floor is imposed, its market is perfectly competitive.

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).

Surplusabovemarketprice.png

Basic theory in monopsonistic markets

This article or section could be in use of a graph or other visual aid. Relevant discussion may be found on the talk page.

As indicated in the title of this section, we assume here that for the good on which the price floor is imposed, its market is monopsonistic. That is, we assume that there is only one buyer in the market, which is trying to maximize consumer surplus. We also assume that there is no price discrimination in this market; that is, all sellers are paid the same price for the good they are selling.

We also invoke the concept of a marginal revenue cost for the buyer. This is the cost, from the buyer's perspective, of buying another unit of the good. We do not just call it the "marginal cost", because that generally refers to the cost of producing one additional unit of the good in question.

Finally, we refer to the monopsonist's willingness to pay, not a "demand curve". This is because the concept of a demand curve technically relies on the existence of perfect competition.

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

If the price floor is set below the market price (the price at which the good is actually sold, not what the price would be in perfect competition), it has no effect on the market price or quantity traded.

Binding price floors set below the point at which marginal revenue cost equals willingness to pay increase quantity sold

Suppose there is no price floor (or a non-binding price floor) in a monopsonistic market. Then the marginal revenue cost of buying a unit is greater than what sellers would be willing to sell the unit for. The reason why is that not only must the monopsonist pay for the additional unit, they also now have to pay the higher price for all the other units they buy. (As stated above, here we assume that there is no price discrimination.) So if, for example, the supply schedule for a good is $1 for one unit, $2 for two units, $3 for 3 units, et cetera, the marginal revenue cost of buying a third unit is actually $5, not just $3. Instead of spending $4 to buy two units, the monopsonist would be spending $9 to buy three units. The monopsonist will choose to buy units until the marginal revenue cost of buying another unit exceeds their willingness to pay for that unit. Since they have absolute market power, the monopolist can set the price they pay, and so the market price will equal whatever the seller is willing to accept for the last unit described.

However, now suppose a price floor is imposed that is between the prevailing market price and the point at which the monopsonist's marginal revenue cost equals its willingness to pay. The monopsonist's effective marginal revenue cost curve shifts. For the first unit, its marginal revenue cost is equal to the price floor. For units after the first unit, as long as the price floor exceeds the supply curve, the marginal revenue cost still equals the price floor. The reason is that the monopsonist can still buy another unit at a rate equal to the price floor without having to pay a higher price for any other units (because those units would have to be bought at the price floor as well). So the monopolist will still buy units until its marginal revenue cost exceeds its willingness to pay, but its effective marginal revenue cost curve has shifted downwards.

The result is that they will choose to buy more units than they did before the price floor was imposed. The prevailing market price will also increase. The effect on total surplus is positive, as the price floor removes some of the deadweight loss from the monopsony.

Binding price floors set above the point at which marginal revenue cost equals willingness to pay cause excess supply

A binding price floor set above the point at which the original marginal revenue cost curve exceeds willingness to pay will shift the marginal revenue cost curve, but it will shift it upward. Namely, marginal revenue cost will be equal to the price floor until the price floor no longer exceeds what sellers are willing to sell the good for. This causes the monopsonist to buy fewer units as the marginal revenue cost of the good increases. Also, sellers will want to sell more units at this price, creating an excess supply of the good in question. This adds to the deadweight loss from the monopsony.

A binding price floor set at the point where willingness to pay intersects the supply curve maximizes total surplus

If this example were in perfect competition, the willingness to pay curve would be called the demand curve instead. A price floor set at the point described causes the monopsonist to purchase units until the point at which the monopsonist's willingness to pay no longer exceeds what the suppliers will accept for their goods. This is the quantity traded and price which would exist in the case of perfect competition, and so total surplus is maximized. This eliminates all deadweight loss caused by the monopsony.

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).