What is meant by the term “market failure” in economics?

The term "market failure" in economics refers specifically to a situation where the allocation of goods and services is not efficient, leading to a loss of economic and social welfare. In a perfectly functioning market, resources are allocated in a way that maximizes the potential benefits to society—called optimal allocation. However, when market failures occur, it typically means that either too much or too little of a good or service is produced or consumed, which can result from various factors such as externalities, public goods, monopoly power, or information asymmetries.

For example, when there are negative externalities, such as pollution from a factory, the costs imposed on society are not reflected in the market price of the product being made, leading to overproduction and ultimately harming public welfare. This inefficient allocation of resources can result in both economic inefficiency and an adverse impact on social well-being, making this choice the definition of market failure.