Hi everyone, a minimum price is an example of a price control. It's a fixed price or a price flaw enacted by the government usually set above the equilibrium market price. So what the government is saying is that the equilibrium price in the market is simply too low.
We want to raise it by implementing a minimum price and legally therefore prices cannot fall below that level. Hence, it's a floor price, the price floor. Legally that is the lowest price. that can exist in the market, nothing below. Hence we call it a price floor.
So the question is why? Why would governments use minimum prices set above the equilibrium market price? Well the main reason why we see these globally is to protect producers from price volatility, especially farmers, so those that produce agricultural goods, but also producers of primary commodities.
Now we know prices of primary commodities, of agricultural goods, are highly volatile. When prices go up that's good news. for those producers because demand is price inelastic, their revenues rise, their living standards can rise, but it's when prices fall that these farmers, these primary commodity producers see a huge problem.
Their revenues fall, their living standards collapse, they may even go out of business as a result of price falls. So a minimum price protects producers from price falls in particular and hopefully keeps an industry going. In that sense, providing producers a guaranteed minimum income.
That's the most common reason, but equally, minimum prices can be used to solve market failures by raising price in the market, discouraging consumption, discouraging production of goods and services that do a lot of harm to society. So minimum prices on alcohol are good examples of that. But in this video, we're going to focus on this core purpose, and we're going to look at the key impacts diagrammatically of a minimum price. So here we have the market for a commodity, let's say the market for wheat.
And we are at P1Q1 initially, that's equilibrium. But now the government comes in and says, no, we want to enact a minimum price, a price floor above the equilibrium market price. And there it is at P min. At that price, we can draw a line across because that is the price floor. Legally, prices cannot go below that.
So the price, the minimum price dominates in the market. There it is. Now at that minimum price, let's see what's happened in the market. Well, clearly the price has gone up. That's impact number one from P1 to P min.
But look what's happened now to demand and supply. Go to demand first. We can see that there has been a contraction of demand, a movement up the demand curve.
Demand has fallen, therefore, from Q1 to QD because of this higher price. What about supply? Well, we can see there has been an expansion or an extension of supply from Q1 to QS. Supplies are responding to the incentive of higher prices by producing more output.
But that creates a big issue in the market supply is now much greater than demand an excess supply is created of that quantity difference between QD and QS we can label it as such on the diagram that quantity difference there is the excess supply also known as a surplus and that is a big issue that's actually a very inefficient allocation of scarce resources But it's a massive burden on producers because producers have put a lot of cost into making all of that output but they're only selling QD. That's going to impact on their profit margins. At the same time, what are they going to do with this surplus?
Are they going to destroy it? What a waste of resources that would be, a big cost involved there. Are they going to store it?
Well, there is a huge cost of storage, right? So this is a massive burden on producers and very much not what the government wants to achieve when they use a minimum price. So often what you will see as long as the government can afford it, is the government will come in and they will buy up the excess supply, a process known as intervention buying.
And what we can see on the diagram is exactly what the cost to the government will be of intervention buying. So the government would come in, the excess supply of QDQS is what they're buying up, and they're buying it up at the price of pmin. So pmin multiplied by QDQS gives us the area QDQSBC.
That is the cost of intervention buying to the government. So QD, QS, B, C. Okay. What are the implications now for producer revenue?
Well, the impact on producer revenue very much depends on whether there is intervention buying or not. If there is intervention buying, producers are actually selling QS at the price of PMIN. Partly they're selling to consumers, that's up to QD, but the rest from QD to QS is being sold to the government. So overall, producer revenue is p min multiplied by qs that gives the area p min c q s zero so p min c q s zero but if there is an intervention buying maybe it's a developing country government they can't afford to intervention buy producer revenue will only be p min multiplied by whatever they're selling to consumers which is qd so p min b q do qd zero which is a much smaller area Okay, but also by intervening like this, the government is actually creating a deadweight loss.
Overall, the quantity in the market is much lower, and that's why there is a deadweight loss. If I put the label here D, we can say the deadweight welfare loss is the triangle A, B, D. At this point, guys, I will say that if you click on this link over here, you'll see a video where I explain why there is a deadweight welfare loss and what the implications of that are. So feel free to click on that if you want to understand this in more detail. But let's now finish by looking at the key impact. of a minimum price on stakeholders, consumers, producers, and the government.
Well, it's clear from the diagram that consumers are not fans of minimum prices because they're paying higher prices, their consumer surplus is being eroded, quantity is lower, choice is lower. At the same time, if you're a low-income household, affordability is much lower now. In that sense, we can argue minimum prices take a greater proportion of the income of the poor than they do of the rich.
In that sense, their effect is regressive. So all of this is not good at all, but even worse, over time consumers suffer because they have to bear the cost of intervention buying. Taxes will be higher to fund this. There might be cuts to other areas of government spending in the economy to fund this. The government might be borrowing money and thus paying debt interest on that borrowing, which has a large opportunity cost.
And hey, the opportunity cost overall of intervention buying is huge. That money could have been used more productively elsewhere in the economy that could have given consumers a... greater benefit. So consumers are suffering in so many different ways. Yes, you might argue some consumers might like the fact that maybe an industry survives, you know, producers continue producing in this market, but overall the net effect on consumers is very negative.
What about for producers? Well, their effect depends heavily on whether there is intervention buying or not. If there is, we can see producers are loving it. They're getting a huge increase in revenue, an increase in producer surplus, but also they survive. In the market, if there is price volatility and prices fall, producers are completely protected by this minimum price, which is good for them, their livelihoods, their living standards.
But if there is an intervention buying, it's hard to say overall if they're winning or not, whether their revenues rise or not. So very dependent on whether there is intervention buying or not. What about the government?
Well, in theory, we can say, yeah, you know, the governments would like minimum prices if their core goals are being reached. If they're protecting producers, they're keeping an industry going. If they're solving key market failures, like we said, great, but they will be very concerned about the impact on consumers, especially the regressive impact.
They'll be concerned of unintended consequences like black markets forming because of higher prices. They'll also be concerned about the intervention buying cost. And we've already talked about the funding issues with that.
But also they are bearing that excess supply. What are they going to do with it? Are they going to store it?
Well, that's costly. Are they going to destroy it? What a waste of resources and cost there. Maybe they dump it at a price below cost of production overseas, which they're not really allowed to do.
That will create international relations issues. So they've got that problem as well, as well as bear in mind, creating a deadweight welfare law. So the governments have to be very mindful of all of those unintended impacts before they're going to be fully happy with a minimum price. But there you go, guys.
Noble intention, you might say, the minimum price, but very distortionary impacts on the diagram. You can see that now. Thank you very much for watching. I'll see you all in the next video where we go to a maximum.