A market failure results when the price of goods and services do not reflect the true costs of producing and consuming those goods and services. Market failure comes in two varieties. The first type occurs within the framework of neoclassical economic theory, when unregulated markets do not produce the Pareto optimal outcome (in which no agent can improve his or her position without adversely affecting at least one other agent) that the theory asserts will ensue if the requirements of perfect competition, complete information, and an absence of external effects are met. These requirements are very stringent, suggesting that market failure is likely to be quite common. Monopolies arise naturally if there are economies of scale in production or distribution; the informational requirements for fully efficient markets are immense; and the absence of property rights in all the goods and services affecting the well-being of individuals means that not all socially relevant costs and benefits will be taken into account by private economic decision-makers.
The second type of market failure arises because real individuals and organizations do not have the properties of the ideal types that populate economic models. People, business firms, and public institutions are boundedly rational rather than completely rational, they operate under internal and external rules and procedures that necessarily result in less-than-perfect outcomes, and they respond to incentives that, while pushing them in the direction of improved economic performance, nevertheless do not guarantee optimality. While these real-world departures from the neoclassical model are commonly labeled "market failure," they might more properly be described as psychological, institutional, or organizational deviations from the abstractions of neoclassical economics.