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Price Floors and Ceilings

How governments can protect buyers and suppliers

What are Price Floors and Ceilings?

Price floors and price ceilings are government-imposed minimums and maximums on the price of certain goods or services. It is usually done to protect buyers and suppliers or manage scarce resources during difficult economic times. Price and ceilings are inherently inefficient and lead to sub-optimal consumer and producer surplus but are nonetheless necessary for certain situations. Before proceeding, a sound understanding of the laws of supply and demand is recommended.

 

Price Floors and Ceilings

 

Price Floors

Price floors impose a minimum price on certain goods and services. They are usually put in place to protect vulnerable suppliers. A good example of this is the farming industry; small farmers are very sensitive to changes in the price of farmed products due to thin margins. The graph below illustrates how price floors work:

 

Price Floor

 

When a price floor is put in place, the price of a good will likely be set above equilibrium. Price floors can also be set below equilibrium as a preventative measure in case prices are expected to decrease dramatically. In such situations, the quantity supplied of a good will exceed the quantity demanded, resulting in a surplus.

If a farmed good faces inelastic demand, a price floor will boost the supplier’s profits since the increase in price will cause a disproportionately smaller decrease in demand. Thus, the additional prices will offset the lost sales volume and allow the supplier to increase profitability. If the good faces elastic demand, the rise in price will cause a disproportionately large decrease in demand, leading to smaller profits. Thus, it is important for governments to be mindful of a good’s price elasticity when setting price floors when trying to protect vulnerable suppliers.

 

Price Ceilings

Price ceilings impose a maximum price on certain goods and services. They are usually put in place to protect vulnerable buyers, or in industries where there are few suppliers. A good example of this is the oil industry, where buyers can be victimized by price manipulation. The graph below illustrates how price floors work:

 

Price Ceiling

 

When a price ceiling is put in place, the price of a good will likely be set below equilibrium. Price ceilings can also be set above equilibrium as a preventative measure in case prices are expected to increase dramatically. In situations like these, the quantity demanded of a good will exceed the quantity supplied, resulting in a shortage.

If a good faces inelastic demand, a price ceiling will lower the supplier’s profits since the decrease in price will cause a disproportionately smaller increase in demand. Thus, the lower prices will offset the increase in sales volume and suppliers will see profitability decrease. If the good faces elastic demand, the drop in price will cause a disproportionately large decrease in demand, leading to even smaller profits. Thus, it is important for governments to be mindful of the good’s price elasticity when setting price ceilings when trying to protect vulnerable buyers.

 

More Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

  • Macrofinance
  • Price Elasticity
  • Utility Theory
  • Economic Exposure

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