What it is:
A market failure occurs when the supply of a good or service is insufficient to meet demand. This results in an inefficient distribution of resources among market participants.
How it works (Example):
Under free market conditions, prices are determined almost exclusively by the forces of supply and demand. Any shift in one of these results in a price change that signals a corresponding shift in the other. Then, the prices return to an equilibrium level. A market failure results when prices cannot achieve equilibrium because of market distortions (for example, minimum wage requirements or price limits on specific goods and services) that restrict economic output. In other words, government regulations implemented to promote social wellbeing inevitably result in a degree of market failure.
Why it Matters:
Economic and social policymakers try to consider the market failures that will result from specific legislation, and, in most cases, they ultimately attempt to minimize market failure by finding a balance between protecting social (or political) interests and maintaining efficient markets.