5.c The Effects of Price Floors

A price floor is a base price at which an item can be sold. If a price floor is imposed below the natural equilibrium price, it is not binding. A price floor that is not binding has no affect on the current price of a good. On the other hand, if the price floor is set above the equilibrium price, it is said to be binding, resulting in a surplus. Figure 5.c.1 demonstrates this with candy bars.

Figure 5.c.2 The natural market price for labor is $5. A minimum wage of $7 decreases the employer’s surplus (CS-consumer surplus) by the areas B and C. Meanwhile it increases the employees’ surplus (PS-producer surplus) by the area B and decreases it by the area E. Since the labor demanded decreased from 100 to 70, 30 people lost their jobs. There is also a surplus (unemployment) of 50 because the labor supplied exceeds the labor demanded. Figure 5.c.3 illustrates a table on the effects of minimum wage.

5.c Example: Farm Price Supports

In the United States, the government sets a price floor for milk, which causes a surplus. The government then buys the surplus and stores it. It’s as if they bought it and then threw it away. Refer to Figure 5.c.4.

Figure 5.c.4 After the government imposes a $3.75 price ceiling on milk, there is a 10-unit surplus. The government buys the surplus and stores it. The government suffers a loss equivalent to the area BCJE. Refer to Figure 5.c.5.

Figure 5.c.5 This is a table defining consumer surplus (CS) and producer surplus (PS). Consumer surplus decreases by the area HBIG while producer surplus increases by the area HCIG as a result of the price floor.

5.c Example: Price Supports with Reselling

5. C. – The Effects of Price Floors with Reselling

After learning the basic application of a cost-benefit analysis for a price ceiling, we can apply this tool to a more complex situation involving the resale of goods. In previous examples, we have held that the government buys the excess good resulting from the surplus and for purpose of convenience; we assumed they disposed of it. In this assessment, we will see the effects and change caused when the government buys the excess good and decides to sell it at a lower price.

In order to demonstrate this example, we will consider an old policy in India regarding the production of cloth. Indian weavers complained that they were unable to earn enough money selling their hand-woven cloth since new machinery was much more efficient and taking away a significant portion of their previous income. In response, the government placed a price floor on Indian cloth to give the weavers a higher price.

Figure 5.c.i

Figure 5.c.i. The original equilibrium (Q*, P*) was at (20, 7). The price floor is indicated by the horizontal line at P = $10. As a result of the floor, there is a shift in equilibrium and there is now a surplus of 14 units of Indian Cloth.

Because of the surplus of Indian Cloth due to the price floor policy, the government decides to buy the excess cloth and resell them at a lower price than the initial equilibrium point. The consumers are able to enjoy a lower price for Indian Cloth while producers are still able to achieve a higher price for their production of Indian Cloth. However, these benefits remain contingent upon the government being responsible for buying the excess cloth produced.

Figure 5.c.ii

Figure 5.c.ii. The consumers gain areas E, F, G, and H as a result of the government reselling cloth. Consumers no longer have to pay the $10 for Indian Cloth imposed by the price floor but can obtain if for $5 from the government’s resale, illustrated by the horizontal line at P = 5.

Figure 5.c.iii

Figure 5.c.iii. The producers are still able to achieve a price of $10 for their cloth due to the price floor policy. Since the producers still gain such a profit, they are producing at 26 units. The producer surplus increases by areas B, C, and D as a result.

After seeing the consumer and producer surplus changes, we take into account the change in government spending and see what the overall net effect of these two policies are.

Figure 5.c.iv

Figure 5.c.iv. The government initially paid 0 yet due to the price floor and reselling policy implementation, they are now forced to pay areas B, C, D, E, F, G, H, and I. These are all entered as negative values since they were not a previous liability of the government. The net effect of the increases in consumer/ producer surplus as well as the increase in government spending results in a deadweight loss (DWL) of area I, outlined in the red triangle.

Table 5.c.i summarizes all the changes that happen, as well as showing the overall net effect. After doing a cost-benefit analysis, it is clear that these government policies are making the country poorer as a whole, despite the advantages that the consumers and producers obtain. From this analysis, we see it would be most beneficial if the government stopped these policies.

Table 5.c.i

Without Price Floor/ Reselling / With Price Floor/ Reselling / Change
Consumer Surplus / ABC / ABCEFGH / +E+F+G+H
Producer Surplus / EFJ / BCDEFJ / +B+C+D
Government Spending / 0 / BCDEFGHI / -(BCDEFGHI)
Net: - I

Practice Questions:

Using the above graph, answer the following:

  1. By how much does the consumer surplus increase?
  2. $58b. $60c. $65d. $68
  3. What areas represent the consumer surplus after the government price floor and reselling policies?
  4. EFGHb. ABCEFJc. ABCEFGHd. CFGHKLM
  5. What is the increase in producer surplus?
  6. $100b. $130c. $98d. $133
  7. What areas were the producer surplus before the government price floor and reselling policies?
  8. Jb. BCDEFJc. EFJd. BEJ
  9. After the price floor and reselling policies, government spending is increased by:
  10. $81b. $98c. $192d. $160
  11. How much money does it cost government ONLY to on buy the surplus units?
  12. $168b. $288c. $160d. $96
  13. What is the dollar value of the deadweight loss?
  14. $64b. $48c. $24d. $32

Answers:

1. B4. C7. D

2. C5. C

3. A6. A