The market forces of supply and demand determine prices and equilibrium quantities, but sometimes those amounts are not acceptable to society and policymakers. When people feel that prices are unfairly low, the government establishes a price floor above the free market levels. When market changes are made, imbalances inevitably appear. Whether your small business benefits or not depends on where you fit in the marketplace.

How Markets Function

The forces of supply and demand interact in all markets to establish equilibrium price -- even if government controls override the market. If the price of a product is high, consumers refrain from buying. As the price falls, they buy more. Suppliers will produce more at higher prices, cutting back production with falling prices. Conversely, if the price is low, consumers will want to purchase more than suppliers produce. The excess demand bids up the market price. An equilibrium is reached when the quantity supplied equals the quantity demanded and there is neither surplus nor shortage.

Implementing a Price Floor

When society or the government feels that the price of a commodity is too low, policymakers impose a price floor, establishing a minimum price above the market equilibrium. When the price is above the equilibrium, the quantity supplied will be greater than the quantity demanded and there will be a surplus. Producers are willing and able to supply more than consumers are willing to buy. The normal free market reaction would be to lower prices, but that is not possible because the price floor prohibits that from happening.

Market Distortions

Surplus product is just one visible effect of a price floor. Price floors distort markets in a number of ways. For example, they promote inefficiency. Some suppliers that could not compete at a lower market equilibrium price can survive and prosper at the higher government-mandated price level. Consumers pay more for the product, and in doing so, subsidize the inefficiencies. Because of the higher price, consumers purchase less, so some would-be buyers cannot afford the product or simply elect not to purchase it.

Price Floor Examples

When the minimum wage is raised above the equilibrium that would occur in a free market, the effect may be to create unemployment. Some workers who would not work at the lower equilibrium wage go looking for jobs at the higher wage. At the same time, business owners are faced with higher labor costs and look for ways to cut back on the number of employees they hire. The result is more workers chasing fewer jobs. Agriculture experiences similar market distortions when the government institutes price floors for crops. Artificial higher prices create a surplus, subsidizing farmers at the expense of consumers. If the government purchases the surplus crop, it is at taxpayer expense. And if the excess production is done on marginal farmland, the result could be environmental damage.