Question

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

Short answer

In summary, 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. This occurs because the higher price floor makes the product more expensive for consumers, reducing their demand, while simultaneously making it more attractive for sellers to supply the product.

Step-by-step solution

Define the key terms

Before diving into the exercise, it's essential to understand the basic terms related to the problem. The two key terms are: 1. Price floor: A price floor is a minimum price set by a government or regulatory body, below which the good or service cannot legally be sold. It is designed to protect the interests of producers or sellers, ensuring that they receive a minimum income. 2. Equilibrium level: In economics, the equilibrium level is defined as the point at which the quantity demanded of a good or service equals the quantity supplied. At this level, there is no shortage or surplus of the good or service, and the market clears.

Illustrate the market equilibrium

Let's consider a hypothetical market with an upward-sloping supply curve and a downward-sloping demand curve. According to the law of supply, an increase in the price will lead to an increase in the quantity supplied, and according to the law of demand, an increase in the price will lead to a decrease in the quantity demanded. In this market, the equilibrium level is achieved when both the supply and demand curves intersect (let's call this point E, at price \(P_E\) and quantity \(Q_E\)).

Introduce the price floor

Suppose the government or a regulatory body sets a price floor higher than the equilibrium price (let's call this price \(P_F\)). The price floor doesn't allow the good or service to be sold below the minimum price of \(P_F\), and therefore, the market will adjust to this new restriction.

Analyze the effects on quantity demanded and supplied

Since the price floor is set above the equilibrium price, the buyers (consumers) must now pay a higher price than before. At this higher price, they might decide to decrease their consumption, which will lead to a decrease in the quantity demanded. For sellers, the higher price floor is more appealing because they can receive a better income from their goods or services. Therefore, the quantity supplied will tend to increase. Now, the higher price floor has led to a decrease in the quantity demanded and an increase in the quantity supplied. This situation creates a surplus of the good or service in the market, as the quantity supplied exceeds the quantity demanded.

Conclusion

In conclusion, when a price floor is set above the equilibrium level, it results in a higher price for the good or service in the market. This leads to a decrease in the quantity demanded and an increase in the quantity supplied, causing a surplus in the market.