Key Terms
Minimum Prices: A price floor below which the price of a good or service is not allowed to decrease.
Theory
What is a Minimum Price Floor?
A minimum price floor is a form of government intervention that prevents the price of a good or service from falling to low thus being unfair. A real world example a minimum price floor is the national minimum wage introduced by Labour party during 1997 election campaign, taking effect 1999.
How does it work?
Minimum price floors are set above free market equilibrium. Since the price is set above equilibrium this creates an extension of supply (Q2) and a contraction of demand (Q3). Excess supply is created and disequilibrium sets in.
Advantages of Minimum Price Floors
1) Higher income for producers
Assuming demand for the good is relatively price inelastic, higher prices should result in higher income for producers. This could lead to reinvestment and a better quality product in the long-run as income is reinvested.
2) Reduces demand if implemented on demerit good
If a minimum price floor is levied on a demerit good, quantity demanded should fall. The extent to which demand falls depends on the elasticity of the good. If demand is inelastic, quantity demanded will be largely unchanged.
Assuming demand for the good is relatively price inelastic, higher prices should result in higher income for producers. This could lead to reinvestment and a better quality product in the long-run as income is reinvested.
2) Reduces demand if implemented on demerit good
If a minimum price floor is levied on a demerit good, quantity demanded should fall. The extent to which demand falls depends on the elasticity of the good. If demand is inelastic, quantity demanded will be largely unchanged.
Disadvantages of Minimum Price Floors
1) Inequitable
Higher prices for consumers hits the lowest earners hardest. Minimum price floors may therefore contribute to higher income inequality which is a source of market failure.
2) May encourage import of goods
Consumers may feel that the minimum price is too high, therefore they will switch their demand from domestic goods to foreign goods.
3) Encourages black market behaviour
Instead of turning to the foreign market through importing, consumers may find it more convinent to buy from the black market.
Higher prices for consumers hits the lowest earners hardest. Minimum price floors may therefore contribute to higher income inequality which is a source of market failure.
2) May encourage import of goods
Consumers may feel that the minimum price is too high, therefore they will switch their demand from domestic goods to foreign goods.
3) Encourages black market behaviour
Instead of turning to the foreign market through importing, consumers may find it more convinent to buy from the black market.
Evaluation
In the long-run minimum price floor may be beneficial E.g. If producers choose to reinvest.
Existence of black markets could lead to government failure.
Existence of black markets could lead to government failure.