Price Floors

In the next two videos, we'll turn our attention to price floors and their effects. In this video, we'll look at the first two effects and cover one of the most well-known price floors: the minimum wage. Let's get started.

A price floor is a minimum price allowed by law. That is, it is a price below which it is illegal to buy or sell, called a price floor because you cannot go below the floor. We're going to show that price floors create four significant effects: surpluses, lost gains from trade, wasteful increases in quality, and a misallocation of resources. We're going to go through these each in turn.

Before we do so, however, it's worthwhile asking this question: price floors are less common than price ceilings -- why is this? That is, it's more common to see a price being held below the market price, than it is to see a price being held above the market price. Why? One reason may be political. That is, there are typically more buyers of goods than there are sellers of goods. So when you hold a price below the market price, you may benefit, or at least appear to benefit, more buyers, more people, more voters than when you hold a price above the market price, which would appear to harm buyers.

Now interestingly, the paradigmatic, the classic case of a price floor is the exception which proves the rule. Because the classic case of a price floor is a good for which there are more sellers than there are buyers. So here's the case where the price is kept above the market price, and it make sense politically because there are lots of sellers compared to buyers. So, what is this good, for which price floor is common and for which sellers exceed buyers? We'll get to that in just a moment. Think about it.

So one of the things which a price floor does is it creates surpluses. Okay. Have you thought of the good which a price floor is common, and it's a good for which the number of suppliers exceeds the number of buyers? Well, the minimum wage is a price floor. The minimum wage is a price below which you cannot sell labor, and the suppliers of labor exceed the buyers of labor. So it's not surprising that a minimum wage is often politically successful.

Now, who will the minimum wage affect? Workers with very high productivity who are already earning more than the minimum wage – they are not going to be affected by the minimum wage perhaps at all. Instead, it will affect the least experienced, least educated, least trained workers. Low-skilled teenagers, for example, are most likely to be affected by the minimum wage. Now, I said that a price floor creates surpluses. The minimum wage is a price floor, so it's going to create a surplus. A surplus of labor, we call what? We say a gaggle of geese? Say pride of lions? A surplus of labor is called unemployment.

So let's look with our model to understand how a minimum wage can create unemployment, particularly among the least skilled workers. Okay. Here's our standard diagram, except we're going to put the quantity of labor, especially unskilled labor, on the horizontal axis. The wage or the price of labor on the vertical axis -- there's our supply curve. There's our demand curve with the market wage and the market employment level. Now we're going to add the minimum wage. This is a price floor below which it is illegal to buy or sell this good: labor.

Now we just read the consequences of the price floor of the diagram. So we read, for example, that at the minimum wage, the quantity of labor demanded is read off the demand curve. Remember, this is the demand for labor. So this is the quantity of labor demanded, and at the minimum wage, the quantity of labor supplied is read off the supply curve. Let's put that point on, that's "Qs." So we have Qs units of labor supplied, "Qd" units of labor demanded. Qs is bigger than Qd, so the difference between them is a surplus of labor, also known as unemployment.

Now the minimum wage is a controversial and hotly debated issue. Some academic results indicate that the unemployment effect of a modest increase in the minimum wage would not be substantial. At the same time, however, we also have to recognize that a modest increase in the minimum wage would not have big benefits either. First, only a small percentage of workers are going to be affected by the minimum wage. 97% or so of workers already earn more than the minimum wage. In fact, even among young workers, 94% or so less than 25 years of age, they already earn more than the minimum wage. At best, the minimum wage will raise the wages of some low-skilled and young workers, most of whose wages would have increased anyway as they became more skilled. At worst, the minimum wage will increase the price of a hamburger, create some unemployment, and/or keep some teenagers in school for a bit longer -- not all necessarily bad things.

What, however, about a larger increase in the minimum wage? Few economists doubt that a large increase in the minimum wage would cause serious unemployment. After all, we could not create prosperity by raising the minimum wage higher and higher. If a minimum wage of $10 an hour is a good idea, what about 15? What about 20, 25, $100? $500 an hour? Would we all be rich at that point? Would we all be receiving wages of $500 an hour? Of course not. Most of us would be unemployed.

So a large increase in the minimum wage is going to cause serious unemployment, and the good example of this is Puerto Rico in 1938. Congress actually set the first minimum wage at this time at 25 cents an hour. Now that may seem low, but that's at a time when the average wage in the United States was still less than a dollar an hour, was 62 and a half cents an hour. Congress, however, forgot to exempt Puerto Rico, when the average wages in Puerto Rico at that time were much lower than in the rest of the United States, only three cents to four cents an hour.

So this modest increase in the minimum wage for the continental United States was a huge increase in the minimum wage for Puerto Rico. And lots of Puerto Rican firms went bankrupt, it created devastating unemployment. In fact, Puerto Rican politicians came to Washington to beg for an exemption to get them out of the minimum wage. So, a large increase in the minimum wage would certainly cause substantial and serious unemployment.

We do see higher minimum wages in other countries. The minimum wage in France is higher than the U.S., relative to average wages in those two countries. In addition, labor laws in France make it very difficult to fire workers once they have been hired. As a result, firms in France are very reluctant to hire new workers.

Younger workers are especially affected because they are less productive, and also they are less known commodities. So, the risk of hiring them is greater. As a result, unemployment among young workers is very high in France. It was 23% in 2005, and that was long before the economic crisis, the financial crisis affecting the entire world. So even during good times, unemployment in France among young workers is very high, because the minimum wage is high, and because firms don't want to hire, given how difficult it is to fire workers.

Okay. Let's also show that the minimum wage creates lost gains from trade -- this ought to be fairly familiar by now. At the minimum wage, the quantity of labor demanded is given by Qd. That is less than the quantity of labor which would be traded, given the market wage, this market employment. Key point is that there are buyers of labor who are willing to buy labor at a price below the minimum wage, and there are suppliers of labor, workers who are willing to work below the minimum wage. These deals would be mutually profitable, but they are illegal. So there are buyers of labor who are willing to buy below the minimum wage, there are sellers willing to sell. These deals would be mutually profitable, but they are illegal, they are not made. Because of that, there are lost gains from trade, or a deadweight loss.

Okay. So, we have covered the first two effects of price floors, namely surpluses and lost gains from trade. In the next lecture, we will use a slightly different example to look at wasteful increases in quality and a misallocation of resources.