How governments can protect buyers and suppliers
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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 floors and ceilings are inherently inefficient and lead to suboptimal consumer and producer surpluses but are necessary for certain situations. Before proceeding, a sound understanding of the laws of supply and demand is recommended.
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 farm products due to thin margins. The graph below illustrates how price floors work:
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 expectedto decrease dramatically. In such situations, the quantity supplied of a good will exceed the quantity demanded, resulting in a surplus.
If a farm 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 higher prices will offset 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 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 ceilings work:
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 expectedto 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 decrease in sales volume.
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 trying to protect vulnerable buyers.
More Resources
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