# MSCI 2150 Lecture Notes - Price Floor, Economic Equilibrium, Price Ceiling

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7 Feb 2013

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We can analyze Demand and Supply and Market equilibrium with linear equations. These

are equations of the form Y = a + bX where a is the Y-intercept, i.e., the value of Y when X is

zero, and b is the slope (rise/run = ∆Y/∆X) of the function. We know that the function is linear,

i.e., a line, because the slope is constant. The slope is negative the Y falls with an increase in X

and is positive if Y increases with an increase in X.

Example: Suppose that the following equations describe the market Demand for and Supply of a

Economics book.

Demand: PD = 120 – 0.2QDSupply: PS = 30 + 0.1QS (P is in $s and Q is in units)

We don’t need to label these equations Demand and Supply since the negative slope of the

first one and the positive slope of the second one tell us that they are Demand and Supply

respectively. Since equilibrium implies that PD = PS we simply equate the right-hand side of each

equation to find equilibrium.

Equilibrium => PD = PS => 120 – 0.2Q = 30 + 0.1Q

90 = 0.3Q => Q = 300

Q = 300 => P = 120 – 0.2*30 = $60 or P = 30 + 0.2*30 = $60

(P must be the same for Demand and Supply at equilibrium Q)

The following diagram depicts these equations and this equilibrium. Note that 120 is the

vertical (Y) intercept for Demand and that 30 is the vertical intercept for Supply. The horizontal

intercept for Demand is 120/0.2 = 600.

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Demand for and Supply of an Economics Book

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GOVERNMENT IMPACT ON MARKETS

1. Fixed Prices

The government can fix prices to achieve policy objectives but there are economic

ramifications.

a) Price Floors (Minimum Prices)

A government may wish to protect producers against low prices by establishing a minimum

price (price floor) for a commodity. The classic commodities for price floors have been

agricultural products such as eggs, milk, or peanuts, but minimum wages and minimum

exchange rates are also common historically. A price floor is effective only if it is above the

equilibrium price since the market would move to the equilibrium price.

Governments assume or hope that the minimum price is a temporary measure to help

producers in a depressed market but the existence of a price floor above the equilibrium price at

that point results in surplus (unsold) commodities. It is difficult to simply decree minimum

prices since some producers will sell below minimum price on the black market thereby driving

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down the price. Governments usually have to establish the price floor, therefore, by purchasing

surplus commodities.

Example #1. Suppose that the government enacts a minimum price on textbooks by promising to

buy any surplus commodities at $70. The following diagram depicts this situation.

Goverment Price Floor

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Surplus

We can find the specific amount of the surplus and the cost to the government of the price

floor by calculating the surplus as the difference between the quantity demanded and the quantity

supplied in the market at $70

$70 = 120 – 0.2QD=> Qd = (120 – 70)/0.2 = 250

$70 = 30 + 0.1QS => Qs = (70 – 30)/0.1 = 400

=> Surplus = Qd – Qs = 400 – 250 = 150

Cost to the Government in buying this surplus = 150*70 = $10,500

Total Revenue of Firms = 400 * 70 = $28,000

Total Expenditure of Consumers = 250*70 = $17,500

NOTE: Price floors supported by government purchases have two problems:

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