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 Floors
1. Binding Price Floor
A 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 Floor
A 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
The effect of a price floor on producers is ambiguous. Producers may be better off, no different, or worse off as a result of the measure.
The effect of a price floor on consumers is more straightforward. Consumers never gain from the measure; they may be worse off or no different.
Reasons for Setting Up Price Floors
Governments usually set up price floors to assist producers. For instance, if a government wants to encourage the production of coffee beans, it may establish one in the coffee bean market.
Governments put in place price floors in markets with inelastic demand and very low prices naturally. The practice allows the government to increase overall welfare in the society as the gain for producers more than offsets the loss of consumers.
Example: Minimum Wage Laws
Almost 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.