What Are the Causes of Market Failure?

Market failure is a situation in which the demand for a given product is not in sync with the supply that manufacturers are currently providing for sale. The failure may be in the form of a glut of available products that consumers are not purchasing at a pace that keeps up with the production, or involve a situation in which suppliers are unable to keep up with the current level of demand from consumers, creating a temporary shortage. There are several causes of market failure, with some having to do with pricing and quality, while others are connected to the current general state of the economy.

One reason for market failure has to do with externalities. These are simple factors that are outside the control of consumers or the companies producing the goods and services offered for sale. Examples of this include negative situations such as natural disasters that temporarily reduce production, or downturns in the economy that prompt consumers to greatly reduce their consumption of certain products. Positive events may also qualify as externalities, such as an economic recovery that increases consumer confidence and motivates increased purchases of non-essential and luxury products. In the former instance, companies may find that the demand for their products drops suddenly, leaving them with high inventories of finished goods that are not wanted at any price. The latter positive example may mean that, until producers can increase production to meet demand, they will not be able to adequately keep up with customer orders.

Other causes of market failure have to do with an imbalance between the price of a product and its perceived level of quality. Price and quality may create a positive or a negative situation, because if consumers think that the price is reasonable in relation to the quality, demand will be high. Unless producers can keep up with that demand, there is a failure to meet market expectations. At the same time, if consumers see the quality of the products as not being worth the purchase price, demand will drop and the producer is left with a large inventory. Depending on the nature of the products, it may be possible to reverse these problems by lowering the price to a level that consumers find more in line with the quality and begin to move the backlog of finished goods.

Markets that are controlled by monopolies can also cause some products to fail. When a particular market is dominated by one or two companies, this can make it extremely difficult for smaller competitors to build client bases and sell enough products to keep their operations viable. Setting production schedules based on unrealistic projections for demand can also lead to market failure.

Since so many different elements can affect the balance between supply and demand, many companies are constantly reviewing customer expectations and buying habits while also attempting to project how the economy will change in the months and years ahead. Doing so can aid in adjusting production accordingly and either prepare the company to meet increased demand or curtail production so that the business is not left with a glut of finished goods for which there is not a great deal of demand.