Question:
Why do producers overproduce if there’s a price floor, I understand it had to do with the law of supply, but I don’t get why one would over-allocate resources knowing they won’t sell a large portion of their stock.Answer:
To start, I’ll clarify a couple pieces of the question. First, from Lacy et al. (2019): A binding price floor is a legal minimum price, set by the government, at which a good can be sold. Second, while we often think of producers as the suppliers in a market, this is not always the case. Think about retailers such as Walmart. They don’t produce the products on the shelves, but they do sell them. This is a subtle but important distinction. For the sake of simplicity, let’s assume that sellers and producers are one and the same in this context.
Now, let’s review how price floors work in the standard Econ 101 context. Suppose that we have a market in equilibrium. This means that the quantity demanded and quantity supplied agree at the market price. For a price floor to be effective, it must be higher than this equilibrium price. What this means is that the market price is now higher than the equilibrium price, so buyers demand less and sellers supply more. In other words, there is now a surplus in the market. Producers sell where the quantity demanded intersects the new market price. The effect of this price floor on producer surplus depends on the characteristics of the demand and supply curves in the market (Lacy et al., 2019). Importantly, the market supply curve is the horizontal sum of individual sellers’ supply curves. Even if producer surplus increases in the market, some producers may be excluded from selling now. The important caveat here, however, is that all this activity takes place for a defined period of time.
So, what happens when these decisions are made over time? Without getting into detailed economic models, the simple answer is that producers adjust their behaviors as new information becomes available (Boudreaux, 2022). Some may exit the market. Others may change the quality of the product. How long this takes is uncertain, but even the most naïve producers will make adjustments. In the standard context, where we are considering a single period of time, producers may have imperfect information. Perhaps, alternatively, producers do not think the price floor is credible. In that case, producers may “wait it out” until the government ends the price floor. Entering and exiting the market are often costly, and producers make rational decisions based on the information they have. Perhaps goods are storable but resources are perishable. Perhaps the government mandates and enforces the higher level of production.
From this, I want to emphasize the complexity of price floors and market distortions more broadly: there are a countable infinitude of ways in which producers may be incentivized to change their behavior. In the standard context, we deal with a simplistic model of the world with all else equal—ceteris paribus. In the real world, however, it is difficult to say what will happen. This is what makes economics such a unique and exciting field!
References
Boudreaux, D. J. (2022). On the Negative Consequences of Price Floors. American Institute for Economic Research. https://www.aier.org/article/on-the-negative-consequences-of-price-floors/.
Lacy, K., Sørensen, T., & Gibbons, E. (2019). Government Cheese: A Case Study of Price Supports [Case Study]. Applied Economics Teaching Resources. https://dx.doi.org/10.22004/ag.econ.301862.
