The government has decided that the free market price of cheese is too low. Farmers complain that the price floor has reduced their total revenue. Is this possible? Explain.
Answer (2)
Revenue is the product of price times volume (R = P * V). The problem for the farmers is that because the price of cheese (P) went up, demand for it (V) went down. Essentially, the government raised prices to a level higher than what many people wanted to pay. The farmers made more money with lower prices because they sold a lot of cheese (a high volume, in the terminology of the formula). The potential for these artificial imbalances is why markets are generally more effective than governments at setting prices.
A price floor set above the market equilibrium can lead to lower total revenue for farmers if the quantity sold decreases significantly due to higher prices. When demand is elastic, the reduction in sales can outweigh the benefits of receiving a higher price. This situation exemplifies how government interventions in markets can have unintended consequences.
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