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Price Floor

The lower boundary on the price of a commodity in the market

What is a Price Floor?

A price floor is the 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 pre-set lower boundary.

 

Price Floor

 

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:

 

Binding Price Floor

 

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 amount 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:

 

Non-Binding Price Floor

 

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

  1. 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.
  2. 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

  1. 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.
  2. 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 of Price Floors: 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 up 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 said amounts can be prosecuted for a breach of minimum wage laws.

 

Additional Resources

CFI 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 resources below:

  • Consumer Price Index (CPI)
  • Fiscal Policy
  • Inflation
  • Market Economy

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