Test Your Understanding 4.3 Vansh Patel, IBDP 1, Economics HL 1. Define a price floor, and providing examples, explain some reasons why governments impose them. A price floor is defined as the minimum price determined by the government for a particular good, meaning that the price that can be charged by the producers for the product cannot be lower than this. To have effect, they are always set ‘above’ the market equilibrium price. Governments may set them for different reasons including: - to protect producers of a certain good or service by limiting how low a price can be charged for a good or service. For example, it is set to ensure farmers get sufficient price for their crops. - to protect low-skilled and low-wage workers by offering them wages that are above the market equilibrium, commonly known as ‘national minimum wages’ - to limit the consumption of demerit goods, as increase in prices will likely reduce the consumption according to the assumption underlying the law of demand. 2. Draw a diagram illustrating a price floor that is imposed in a product market, and analyse its effects on market outcomes (price, quantity demanded, quantity supplied, market disequilibrium, excess supply, firm inefficiency, allocative inefficiency, welfare loss). Figure 1: Consequences of Price Floor Figure 2: Welfare Loss of Price Floor In Figure 1, the guaranteed minimum price offered to agricultural farmers gives an incentive for producers to supply more (S1) than is demanded (D1) at the higher price (P2). This results in excess supply at all prices above P1, as shown by the shaded area. This surplus is either stored as excess inventory by producers, who bear the costs of storing it, or is more likely to be bought by the government at a price of P2 to support the farmers. In this case, the surplus is released onto the market during times of bad harvests thereby stabilizing food prices. Moreover, minimum prices also distort market forces so can result in an inefficient allocation of scarce resources. In Figure 10.13, the price floor reduces the quantity demanded to D1 (as consumers need to pay higher prices), creating a surplus (excess supply). This reduces both consumer and producer surplus as shown by the shaded area, so there is a decrease in social surplus. In other words, there is a deadweight loss to society. Vansh Patel IBDP 1 Economic HL 3. Identify some measures governments can take to dispose of surpluses that results from the imposition of a price floor in an agricultural product market. Comment on the problems associated with these measures. - Governments can provide direct provision of these agricultural products or provide them to the low-income families at subsidized rates to further decrease income inequality in the country. However, this will greatly increase consumer expenditure while having negligible effects on the revenue. - Governments can store the additional surplus of agricultural products and sell it at times when the supply for the agricultural products is low to prevent increase in prices due to the shortage by supplying sufficient quantity of the agricultural products. However, a major concern with this measure is that it is very expensive to store such large quantities of agricultural products. - Governments can also export the agricultural products to other countries, also known as ‘dumping’, to gain fair revenue for its agricultural products, but at the same time also ensuring the government receives revenues from the proceeds of the sale. However, this can upset foreign governments as they might claim the products are being dumped in their markets and harming their domestic industries. 4. Assuming a price floor is imposed in a market for an agricultural product, and that the government purchases the entire excess supply that results in order to maintain the price: a. Draw a diagram illustrating welfare loss The total welfare loss to the society is E – D b. Comment on the relationship between marginal benefits and marginal costs in the new equilibrium and what it reveals about allocative efficiency (or inefficiency). Initially, at Q0,P0 , S=D, i.e. Marginal Costs = Marginal Benefits. But after a Price floor was imposed, S=MC exceeded D=MB, indicating that the firm is facing allocative inefficiency as the output produced by the firm is inefficiently high and that currently surplus resources are being dedicated to product the product whose demand is comparatively less. Vansh Patel IBDP 1 Economic HL 5. Examine the consequences for different stakeholders of a price floor for an agricultural product whose excess supply is purchased by the government. - Consumers do not benefit at all as the new equilibrium price is increased, so they will have to pay a higher price for the product. Moreover, since agricultural products are usually a necessity, it will greatly impact the poor more than the rich, as more proportion of income is spent on the necessities by the poor. - Producers benefit greatly as they are receiving higher prices for their goods without any change in costs, leading to higher revenues and thus higher profits. - Workers might possibly benefit too as increased revenues might lead to increase in salaries too. However, if their salaries do not increase more than the increase in the prices of agricultural product, their real income might actually fall. - Governments have to face high opportunity costs of purchasing the surplus. This puts a huge pressure on the budget as this leads to lower spending on other areas.
