What does market failure refer to?

Market failure refers to a situation where the allocation of resources is inefficient, leading to a loss of economic welfare. This inefficiency means that the needs and wants of consumers are not met in the most effective way, resulting in either overproduction or underproduction of goods and services.

When market failure occurs, it often indicates that the market, left on its own, is unable to reach an optimal outcome. For example, in cases of externalities (such as pollution), public goods (like national defense), or information asymmetries (where one party has more information than another), the market fails to provide the right amount of goods and services. Consequently, it can lead to situations where some individuals or groups are worse off than they could be—hence the term "welfare loss."

Understanding market failure is crucial for economic policy because it highlights the limitations of free markets and points to circumstances under which government intervention may be necessary to improve overall economic welfare. This rationale underpins many economic theories and practices regarding regulation and government intervention aimed at correcting these inefficiencies.