Market Failure and the Implementation of Price Floor

When a market is not in equilibrium, market failure will occur. Before we go into what market failure is, let us first look into some assumptions. The first assumption made is we assume the market has many buyers and many sellers, which means no single buyer or seller can be able to influence the market price as each individual firms or household are considered relatively small compared to the market size. The next thing will be complete freedom of entry into and exit from the market. Besides that, buyers and sellers are well aware of the market price and production cost. Products sold in this market are also homogenous as they are all of the same quality and are identical in the eyes of consumers. The last one will be the assumption that factors of production can be switched from one industry to another easily, making them perfectly substitutable.

Market failure will prompt government into taking actions such as controlling the price or designing price policies to hold the actual price at some disequilibrium value. So let us look at why market failure happens before going more in depth into the price policy we are going to discuss. Market failure occurs when the price mechanism fails to allocate resources efficiently when they are left to be decided by demand and supply forces. A few reasons initiating market failures are non-provision of public goods and externalities. In a free market which is also called the perfect market, public goods are not provided due to two characteristics which are non-excludability and non-rivalry. Non-excludability means when a good or service is provided, it will be free to all. Therefore, no one will be willing to pay for it as they will be hoping for others to do the payment so they can enjoy free services. As for non-rivalry, it basically means the consumption of a good or service will not reduce the consumption possibilities of others. One clear example for this is streetlamp where people will still be able to benefit from it even if it is used or shared by others. Another reason for market failure to occur is due to externalities where it is further divided into positive and negative externalities. Positive externality affects market equilibrium in a sense that producers always produce lesser than what the society wants which causes inefficiency to occur. As for negative externality, it is just the other way round where products are produced way more than what the society want leading to disequilibrium.

Now that we know why government intervene in the economy, we will go more into one of the policy we are going to discuss, price floor. Price floor is also known as minimum price and is basically set to guarantee a certain amount of price is there for that particular good. This regulation makes it illegal for trading to take place at any price below the indicated level.

Price here actually means the wage rate of labor while quantity is the amount of labor available in the market. Price floor has to be set above the equilibrium point (P1) to ensure it can work effectively. If it were to be set below the equilibrium point (P2), it will bring no effect as buyers and sellers will continue to consume and produce at the original equilibrium with equilibrium price of P0 and equilibrium quantity of Q0.

From the article ( http://www.themalaysianinsider.com/malaysia/article/minimum-wage-gazette-on-july-1-takes-effect-in-january-2013/ ), we know that a floor wage or the minimum wage has been announced by our very own Prime Minister Datuk Seri Najib Razak on the eve of Labour Day. This implementation is introduced to secure a minimum wage rate for the workers. As mentioned above, the minimum wage has to be above the equilibrium point to be truly effective. This price policy has brought up a certain amount of debates between economists as well as politicians. Therefore, we shall look at some of the effects when a successful minimum wage is introduced.

From the diagram, we can see that the quantity of labor available in the market is at Q2 while the demand for the service of labor is at Q1 when the price is set at P1. This eventually causes a surplus of labor because the amount of labor willing to work exceeds the number of labor the firms want to employ. This will continue because the firms are not allowed to hire workers with a wage rate below the wage floor. However, firms always hope to minimize their cost of production so this action actually results in unemployment. Besides that, minimum wage also causes market disequilibrium where both consumer and producer surplus are reduced. Original consumer surplus is represented by the area A, B and C but is now reduced to only area A. Original producer surplus which is area D, E and F is left with only area F. So what really happens to area C and E is described as a deadweight loss which is also the social loss. This is because the amount of goods produced when a labor is employed now reduces. As for area B and D, it now represents the opportunity costs where lots of bargaining and negotiating actually takes place. Producers are searching for people willing to work below the price floor (P1) while workers are searching for a wage rate of P1 or even higher. This time used for negotiations will incur opportunity costs as they can actually use this time to get another job and earn extra income.

So, is this action of government fair? No doubt it has angered many employers especially small-medium enterprises (SME) where we can find from the article. According to the article, 59 percent of labor forces are employed by small-medium enterprises and when this policy starts, unemployment will definitely occur as they will not want to increase their production costs. Another effect from this implementation is that illegal employment of workers might occur. When unemployment is common in an economy, some workers who desperately need a job will agree upon a wage rate lower than the minimum price and some even below the original equilibrium price. This exploitation of labor occurs because unemployment makes it hard for workers to get a job and when their life is depending on it, they will no longer have the bargaining power to ask for a better pay.

However, introducing this policy will also provide some benefits in some area such as reducing the income gap between the rich and the poor. Although there is still a significant difference, wage floor can at least prevent them from growing wider. Workers can also avoid from being abused by their employer as law stated that employers are not allowed to bargain and get a desperate worker at a rather unsatisfying wage rate.

In summary, a price floor policy just like this minimum wage can bring both advantages and disadvantages depending on how people react to it. Therefore, it is really important to have a study on the situation before deciding on anything. If the unemployment rate is not too high compared to the benefits the society can benefit from. It will be wise to have it implemented but if it is the other way round, government will have to come up with a new policy to help increase and protect the workers welfare.