The Effects of Price Floor in the Economics. Overview and Explanation

Understanding Market

Let's take the market for wheat for example and so I've got a downward-sloping demand curve and an upward-sloping supply curve and we see that before the effect of any kind of price floor we see that the consumer surplus is this blue area, that blue triangle that's the consumer surplus and this yellow triangle here is the producer surplus. So that's before the effect of a price floor and so the equilibrium price is $133. Let's say per ton of wheat is $133 and then we have 58 million tons of wheat for example that are produced and consumed in the U.S. or something like that.

Now the price floor is gonna happen, the government is gonna come in and set a price floor of $200. So the government is gonna come in and set this price floor. So the government is saying "It is illegal to sell wheat below the price of $200." Now technically the government could say "If there's any surplus left over we will buy it." I'm not gonna talk about that in this article that's actually called price support. When the government not only says "The floor is gonna be  $200 but we're also gonna buy up in the extra wheat" that's price support, I will write a different article on that. 

The Effects of Price Floor

In this article, the government is saying that the price of wheat is gonna be $200 suppliers cannot come below this floor. So when the government does this what are the effects? Well if we see at a price of $200 if we were to look at that how much wheat is going to be demanded and how much is gonna be supplied then we can find the effects. At the price of $200, The amount supplied is higher than the amount demanded by consumers. Let's say for example that 100 million that the wheat farmers are willing to supply but the demand is 25 million. 

We see that at a price of $200 a ton farmers are like saying "We will supply 100 million tons of wheat we think that's a great price" but the consumers are saying "For that amount of money that's higher than what we're expecting to pay, we'll only demand 25 million tons." So that difference between the 25 and 100 million that's the 75 million difference and that is a surplus. There's gonna be some extra wheat that is leftover and that's why I talked about this idea of price support and again price support is basically a price floor plus a guarantee from the government that they'll buy this surplus. I don't have that topic here I just want to give you a basic example. 

Let's just say the government is not going to buy that surplus so we just have this surplus. Now not only do we have this surplus we're also going to have a change in our consumer surplus and our producer surplus. Now when I say surplus here it's actually pretty confusing, maybe I shouldn't use the word surplus just so we don't get confused let's say that excess supply. The reason I don't want to use surplus is that we've got our consumer surplus and our producer surplus and we could think about the two of those added together as our total surplus and that excess supply is not a part of total surplus. 

Now we look and we say hey we're not at the equilibrium anymore, people are only demanding 25 million tonnes of wheat so what is gonna happen is we are gonna have our old friend the deadweight loss, we're gonna have it right here in the red area.

So this is all going to be lost. This Red spot is not going to be consumer surplus or producer surplus any longer this is our deadweight loss which is a reduction or our lost total surplus, when I say surplus again I'm talking about the consumer surplus and a producer surplus when we add them together that was the total surplus for society and it used to be that whole triangle but now a part of the triangle is gone so our total surplus our consumer and producer surplus has been reduced. 

Now because we've got this price floor is higher, producers are going to get a part from consumer surplus. So there's actually a transfer of this amount used to be for consumers but consumers don't get that anymore they're having to pay a higher price. The people who are consuming wheat still and there are a lot of people who are not because the price is too high. So all of this Yellow part is now producer surplus. That tiny blue triangle is our consumer surplus, which has shrunk a lot, and then there's Red area that belongs to nobody that's a deadweight loss. 

So the effect of this price floor in the wheat even though we might have had good intentions maybe the government said we're gonna help farmers out, we're gonna guarantee a price of $200 and say it's illegal to sell wheat below them. So what has happened though is that the total surplus has been reduced and we have an excess supply of this extra wheat laying around.