Answer to Question #132843 in Microeconomics for Amanda

Question

With the aid of a diagram reference use the model of demand and supply to explain what happens when government imposes price floors?

Answer 1

A price floor is a statutory minimum price legislation instituted above the market equilibrium. The government implement price floors when it feels that the market equilibrium price is too low to enhance productivity and to safeguard welfare of producers/suppliers.

A price floor results in surplus supplies in the market. High prices constricts quantity demanded whilst they motivate suppliers to supply more and increase quantity supplied. As a result, quantity supplied exceeds quantity demanded resulting in excess stocks on the market. This situation can be illustrated by the graph below.

On the graph, the initial equilibrium market position is labelled, e, where Pe is the equilibrium price and Qe is the equilibrium quantity. Pf is the price floor set by the government. At the price floor, quantity demanded falls from Qe to Qd whereas quantity supplied increased from Qe to Qs. As a result, Qs exceeds Qd resulting in excess supplies indicated on the diagram.

In the labour market, the surplus represents unemployment whereas in markets such as agricultural markets they represent excess stocks. Producers are faced with huge stock piling and losses emanating from pilferage, warehousing, and obsolescence of their goods. Eventually, producers will start offering their goods and services at a discount in order to clear the excess stocks and prevent further loses. In the long run, the price will, as a result, fall from the set Pf until it reaches the equilibrium; the government will lose credibility.

However, for the price floor to be effective, the government must purchase the excess supplies. It must employ the excess labour in the public sector, and stock the excess supplies in its warehouses such as silos. If the government purchase the surplus, supply is augmented and increase until an equilibrium is established at the point where Pf is the new market equilibrium.