There are situations and circumstances where the market is not Pareto optimal or Pareto efficient. These situations are called market failure. An economist’s suggestion during these situations is government intervention which is necessary through better policy decisions.
Some of the major causes of market failure are:-
1. Imperfect Markets:- Pareto efficiency increases under perfect competition. But it is hard to attain if there are barriers to entry. Imperfect markets are situation where there are many sellers of different products basically monopolies. Monopolist will generally restrict output to raise prices with a view to making profits. Under monopoly, the prices are higher and equilibrium output is lower. Markets with monopolies do not attain Pareto optimality.
2. Incomplete markets :- There are situations where a market fails to provide good or service even though the cost of providing it is not more than what consumers are willing to pay. This situation is called an incomplete market. This situation is encountered usually in financial markets for credit and insurance.
3. Public Goods :- Another cause of market failure is the existence of public goods. A public good is one whose consumption or use by one individual does not reduce the amount available for others. It is non-excludable if it can be consumed by anyone. It is non-rivalrous if no one has an exclusive rights over its consumption. The moment public good displays rivalry and exclusion ability, it will lead to supply in insufficient quantities and that leads to market failure.
4. Externalities :- These are situations where action of one individual or firm affects other individuals or firms by imposing social costs but do not adequately compensates for it. Similarly, an individual or firm can provide benefits but do not reap the rewards. All these situations are called as externalities.
5. Information failure :- Sometimes there is absence of information in markets, and this requires serious government intervention. In the absence of government intervention, the market will provide very little information so that some may get more benefit and some may get less. This situation creates market failure.