If the government imposes a binding price floor in a competitive market, what will be the immediate effect on the market price and the quantity traded?

Solution

A price floor is a government-mandated minimum price that can be charged for a good or service. For a price floor to be "binding" (meaning it actually has an effect on the market), it must be set above the natural equilibrium price.   Why "B" is Correct

• Price Increase: Since the floor is binding (set above equilibrium), the market price is legally forced upward. Sellers cannot charge the lower equilibrium price.
• Creation of a Surplus: At this higher price, two things happen simultaneously:
1. Law of Demand: Consumers are less willing to buy the product at a higher price, so the Quantity Demanded (Q_D) decreases.
2. Law of Supply: Producers are more willing to sell the product at a higher price to increase profits, so the Quantity Supplied (Q_S) increases.
• Result: Because Q_S > Q_D, a surplus or "excess supply" is created.

• A is incorrect: The price cannot decrease to clear the supply because the law forbids the price from falling below the floor.
• C is incorrect: Shortages are caused by price ceilings (maximum prices set below equilibrium), not price floors.
• D is incorrect: If a floor is binding, it forces the price away from equilibrium. A floor only has no effect (and stays at equilibrium) if it is "non-binding" (set below the equilibrium price).