Market failure is a situation that occurs when resources are not allocated effectively or efficiently. This economic concept can take a number of forms and appear in a variety of situations, and it is often viewed as something that needs to be corrected through intervention, usually on the part of the government, when it appears in the real world. For example, when fisheries experience market failure, the government is expected to step in with policy decisions that will resolve the issue.
When failure occurs, it means that the system is not Pareto efficient. Pareto efficiency refers to a situation in which any improvement to one area would cause a corresponding harm to someone else. For example, if a fried potato franchise lowers the price on its product, bringing about an improvement for consumers, it would also have to lower the price it pays to potato farmers, thereby causing harm. When a system reaches Pareto efficiency, it means that it is operating at optimum level, with everything in balance.
There are a number of factors which can contribute to market failure. Monopolies are a common cause, as the lack of competition over the market for a particular good or service is eliminated when a company holds a monopoly. Externalities can also become a contributing issue, as the end cost of goods and services may fail to take outside factors, such as wages and impact on the environment, into account. Some public goods are also viewed as a form of market failure. Gross inequalities in society can also lead to this situation, as can a variety of other factors.
In all cases, the failure is characterized by the fact that there is a better and more efficient way of doing things, but that this method is not being used. When public goods are used as an example, for example, people may argue that privately funded firefighting might be more effective than services paid for by the government.
Governments can intervene to address this issue in a variety of ways, including through bailouts, legislation, policy changes, controls on wages, and taxation. One of the issues with government intervention is that it can also contribute directly to the failure and make the problem worse by failing to allocate resources appropriately. Knowing how and when to intervene is a difficult decision that can be complicated by political and social issues that may influence people and institutions involved in decision making.