A minimum price is the lowest price that can be charged for a product. The government fixes this in order to intervene in the market when it thinks the equilibrium or market price is too low. The minimum price has to be set above the equilibrium price in order to be effective. It is also called a price floor as the price is not allowed to fall below it but it can rise above it. For example, the government may believe that the price of alcohol is too low because it has negative effects on third parties. And it will fix the minimum price for it. This means that it cannot be sold below the fixed price but it can be sold above it. A minimum price can also be used to protect the producers so that they get a high price for their products, e.g. farmers.
Figure 1: Minimum price
Because it is above the market price, the quantity demanded will decrease (the Law of Demand) while the quantity supplied will increase (the Law of Supply). Therefore, the quantity supplied will outstrip the quantity demanded and produce a surplus (excess supply). In Figure 1 above, the quantity demanded is Qd which is less than the quantity supplied Qs, resulting in a surplus of from Qd to Qs. The quantity traded in the market is Qd as producers cannot sell more than the quantity consumers demand. Unless the government buys the excess supplied or restricts supply by setting production quotas, firms would want to clear their excess stocks by illegally selling below the stipulated price. This will defeat the purpose of the price control.
One other drawback of this policy is that firms would not strive to achieve efficiency because they are protected by the high price fixed by the government. They would not reduce their costs (productive inefficiency) or produce alternative products that consumers want more (allocative inefficiency).
Effect of minimum price on welfare
Figure 2: Minimum price and welfare
Minimum price and consumers’ welfare
The price paid by the consumer P1 (minimum price) is higher than the equilibrium price P and the quantity purchased Qd is less than the equilibrium quantity Q. Thus, the welfare of the consumer has worsened. This can be buttressed by a decline in consumer surplus which is a measure of the welfare of the consumers. The initial consumer surplus at equilibrium is the area of triangle APC; the new consumer surplus after minimum price P1 was fixed is the area of triangle AP1B. The consumer surplus (welfare) lost is the area of trapezium P1BPC.
Minimum price and producers’ welfare
The producer receives price P1 which is higher than the equilibrium price P. The initial producer surplus at equilibrium is the area of the triangle PFC. The consumer surplus at the minimum price is the area of trapezium P1BFE. The producer benefits by obtaining a greater producer surplus (welfare).
Minimum price and economic welfare
The economic welfare arising from the imposition of minimum price is the addition of consumer surplus and producer surplus. The overall effect on the society is a welfare loss represented by the triangle BEC. The consumer surplus lost area is represented by trapezium P1BPC. The producer surplus lost triangle DCE but gained part of the lost consumer surplus ( rectangle P1BPD). The economic welfare loss (triangle BEC) is also referred to as deadweight loss. The quantity traded Qd is below the equilibrium quantity Q. It is at equilibrium that welfare is maximised and inefficiency is eliminated. In other words, both consumer surplus and producer surplus are at the highest level when there is equilibrium.