How does a price floor work and affect a market?

In different countries, there are different policies set by the governments in order to intervene the market of any goods correctly when it is necessary. Government might control prices by setting price ceiling and price floor, impose tax and provide subsidies and etc. To be precise, few policies are designed to intervene the market and are used very commonly, fiscal policy and monetary policy.

            When there is no government intervention, the market is said to be efficient. Efficiency in this field means that the market has achieved both allocative and productive efficiency. Market is productively efficient when firms are producing at its lowest average cost while market is allocatively efficient when the right amount of goods and services needed by the consumers are produced. In the case of market being efficient, the marginal social benefit (MSB) is equal to the marginal social cost (MSC). Marginal social benefit is defined as the sum of the additional benefit enjoyed by the entire society by consuming one good or services. Whereas, marginal social cost means the extra cost viewed by the whole society when one additional unit of good and service is produces. The graph below illustrates an efficient market.

        The diagram above shows that the market is in efficiency whereby MSB equals to MSC. In this situation, the total surplus (sum of consumer and producer surplus) is maximized. This happens when government does not do anything to the market in order to achieve certain goals.

            According to the article, Scottish government has an incentive to set a minimum price of 50p per unit of alcohol (Philip, 2012). This may be rooted by the unreasonably low price that has been determined by the market force in that country. Market forces simply mean the demand and supply in the market that can determine the price of alcohol when the two curves intersect. In my opinion, the relatively low price may be due to the supply is very much more than the demand in the alcohol market.

            According to the Independent UK, Ms Sturgeon said that: "Cheap alcohol comes at a price and now is the time to tackle the toll that Scotland's unhealthy relationship with alcohol is taking on our society. Too many Scots are drinking themselves to death. The problem affects people of all walks of life. It's no coincidence that as affordability has increased, alcohol-related hospital admissions have quadrupled, and it is shocking that half of our prisoners now say they were drunk when they committed the offence. It's time for this to stop. Introducing a minimum price per unit will enable us to tackle these problems, given the clear link between affordability and consumption." With this announcement, it is pretty true that this government action is actually mainly to maximize social welfare, letting people in Scotland know how harmful alcohol is, and eventually cut down the consumption of alcohol by the whole society.

            In order for a price floor to work, it must be set above the equilibrium price. Otherwise, the market price and quantity traded will only stick to the initial ones determined by the invisible hand (market forces). Diagram 3 below will tell us how the minimum price should be set in order to achieve what the government wants.

             In diagram 2, the market equilibrium is initially associated with the market price P_e and the quantity traded Q_e. Yet, the government is not satisfied with the combination and hence has decided to intervene the market by setting a minimum price of P_min. In Scotland, the minimum price is set to be 50p per unit of alcohol. Back to the diagram, the minimum price causes a fall in quantity demanded in the alcohol market and hence, the quantity traded is reduced to Q₁, government’s main purpose of setting a price ceiling is achieved. Moreover, the minimum price will cause a surplus of Q₁Q₂ in the market due to the excess supply. Scottish government will have to buy in the market surplus of Q₁Q₂ or else the excess stock will be wasted in the market itself, no one is going to “clean” it. The government can actually export the excess supply of alcohol to other countries to boost economic growth.

            Other that setting minimum price, Scottish government can also impose a tax on alcohol, either on buyer or on seller because taxing both sides will get the same effect of reducing the quantity traded of alcohol, which is also the goal that government wants to attain. The following diagram will show how does tax work to control the consumption and production of alcohol.

            Two of the diagrams above have clearly shown that how an imposition of tax can cause a decrease in quantity traded of one good. In diagram 3, tax is charged on producers and this pushes up the price that consumer will react by stop purchasing the good, quantity demanded fall. With that, quantity traded definitely fall, too. In diagram 4, tax is imposed on buyers. This causes a shift leftward of the demand curve, followed by a fall in quantity supplied due to lower price, quantity traded falls, too. Obviously, tax imposition is also one of the effective ways of controlling the consumption of demerit goods, for example alcohol. Other than achieving government’s goal to maximize society welfare, tax revenue is also a form of income for the government.

            Overall, the effect of setting a minimum price may not be as strong as imposing taxes. It is because taxes can tackle both of the supply and demand side, where the price floor will only make people to consume less, but encourage the suppliers to produce even more since they can earn more. In addition, the party that enjoys the most benefit would definitely be the society itself. This is because they are able to live a healthier lifestyle when the government actions actually work. There would be less crime, less disease and less accidents happening in the country. However, those who are seriously addicted to alcohol would be the ones who suffer from paying a higher price to satisfy their needs.

Original article link: http://www.independent.co.uk/news/uk/home-news/scottish-government-announces-minimum-50p-alcohol-pricing-7745694.html

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