A price floor is the minimum price that is set by the government for certain services and commodities that are believed to be sold at very low prices in the market, and the producers need aid.
The price floor is set based on the equilibrium. When it is set above the equilibrium price, there could be an oversupply of service or commodity or a surplus.
This prompts the producers to manufacture a huge amount of the goods and without knowing the products will go unsold because of lack of market.
Therefore, an effective price should be above the equilibrium price. Equilibrium price is the price at which the supply and demand are equal.
In the modern market, there is stiff competition for goods and services. Therefore, the supplier will tend to lower price to get market share.
However, this will ruin the overall market and supply of the product simply because the cost of production is higher than the selling price.
Example 1
A salon offering beauty services will not charge $30 for a perm when the other salons in the vicinity are charging $50-80 for the same thing.
If the reduction in prices means that the employees will earn below the minimum wage for the salon to make a profit, then this would be deemed illegal.
The minimum wage is a price floor set by the government in order to prevent exploitation of employees.
It is applied throughout the States of America and currently it is set at $7.25 per hour. It is illegal for companies to pay less than the minimum wage to the employees.
Example 2
In many industrialized nations across the globe, such as the European Union or the United States, price floors are set for the agricultural products.
In this way, the price floors protect farmers, as well as encourage them to increase the production of a variety of produce.
For example, Mr. Bowen produces 1000 kilograms of tomatoes and will sell to the local groceries at $10,000, instead of the $3000 he would have made a decade ago.
As an investor, people will be attracted to the venture in order to make more money.
Impact of Price Floors
When the price floor is set above the market price there is a higher chance of oversupply of different products in the market.
Producers who did not foresee the impact of the price will suffer a loss because the prices will fall. When prices do fall, and the cost of production is high, the firm goes at a loss.
Conversely, producers may decide to cut back on production in response to low prices.
This will increase demand, and people will be forced to pay high prices because of a scarcity of the produce.
The effect of issuing a higher price transfer the consumer surplus to producer surplus this, in turn, creates a dead weight loss.
