Question

How does a price floor set above the equilibrium level affect quantity demanded and quantity supplied?

Short answer

A price floor set above the equilibrium level leads to a decrease in quantity demanded and an increase in quantity supplied, resulting in a market surplus and potential inefficiencies. This occurs as consumers reduce their demand due to higher prices, while producers increase their supply in response to the increased price.

Step-by-step solution

1. Understand equilibrium price and quantity

: The equilibrium price and quantity are determined in a perfectly competitive market where the demand and supply curves intersect. This intersection point represents the market balance of supply and demand, where the quantity demanded equals the quantity supplied. In this situation, consumers and producers have no incentive to change their current actions.

2. Define price floor and its purpose

: A price floor is a government-imposed minimum price that can be charged for a particular good or service. It is designed to protect producers and ensure adequate compensation for their production. Price floors are typically set above the equilibrium price in order to have an impact on the market. If a price floor is set below the equilibrium price, it won't affect market dynamics because the market price is already above the floor.

3. Impact of price floor on quantity demanded

: When a price floor is set above the equilibrium price, the market price will be higher than what consumers were willing to pay at the equilibrium point. As a result, consumers will reduce their quantity demanded for the good or service. This can be explained by the law of demand, which states that as the price of a good or service increases, the quantity demanded will decrease, holding all else constant.

4. Impact of price floor on quantity supplied

: With a price floor set above the equilibrium price, producers will observe an increase in the market price for their goods or services. This encourages them to supply more than what was supplied at the equilibrium point. According to the law of supply, as the price of a good or service increases, the quantity supplied will increase, assuming all other factors remain constant.

5. Effect of price floor on market balance

: Since the price floor causes the quantity supplied to increase and the quantity demanded to decrease, a surplus of the good or service occurs in the market. This surplus is the excess supply that remains unsold, as consumers aren't willing to buy as much as producers are willing to supply at the higher price. This can lead to inefficiencies, potential waste, and a misallocation of resources in the economy. In conclusion, setting a price floor above the equilibrium level in a market results in a decrease in the quantity demanded and an increase in the quantity supplied. This ultimately leads to a surplus of the good or service and potential inefficiencies within the market.