Why price floors reduce social surplus

Price floors are a mandated minimum price that firms are allowed to charge for a product. It ensures that all producers of a good receive the mandated price for a good and stops firms from undercutting their competition.

price_floor

Examples of price floors could be:

  • Minimum wage laws*

Minimum wage laws practiced by most developed nations set the minimum price of labor above the equilibrium wage. This makes it more expensive for employers to hire workers, so they are likely to hire less workers. This means that some workers miss out on a job and become unemployed.

  • Milk prices in USA

In the United States, the USDA maintains a price floor for milk farmers. This makes milk prices more expensive for American consumers whilst trying to increase the profit earned by milk producers.

Effects of price floors:

  • Raises the price of good to the mandated price
  • Reduces the quantity produced and consumed
  • Consumers are made worse off
  • Typically, Producers are better off
  • Creates a dead weight loss

To understand how the price floors work, you should have an understanding of the following:

  • Supply and Demand analysis
  • Consumer and Producer surplus

Price floors set the price above the equilibrium level. This reduces the demand from equilibrium level (Q1) to a lower level at (Q2). The increase in supply means that producers want to produce at level Q3, however, cannot because there is insufficient demand. This causes a surplus of Q3-Q1.

If the price floor was a minimum wage, the area Q3-Q1 would be called "unemployment".

in terms of what happens to welfare (which essentially just means surplus for the respective agent e.g consumer surplus for consumers and producer surplus for producers) the following happens:

  • Consumer surplus decreases by the triangle "D".
  • Dead weight loss becomes areas "D" and "E" - this represents the overall loss in surplus to consumers and producers
  • Producer surplus increases by "C" but decreases by "E"

As long as C is larger than E, the producers will do better out of this policy. This is likely as these type policies are typically implemented to benefit producers of a good.

 

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