When a government intervention (indirect tax, subsidy or regulation) fails to correct a market failure and would create a net welfare loss compared to the free market solution.
Below is a diagram to illustrate how government intervention can sometimes fail to solve market failure and in some cases worsen the welfare belonging to society. In this instance, there is a presence of a negative externality that causes a divergence between the marginal social cost and the marginal private cost curves. Therefore the only way this externality can be removed is if the government introduces a tax equidistant to the distance between the marginal social and marginal private cost curves. However if the government imposes too high a tax then this causes the firm to have a lack of incentive to produce many goods and as a result the dead-weight loss triangle may be even greater than previously. This is normally caused by the government having insufficient information to correct market failure or the government is bowing to electorate pressures and not choosing a socially optimal policy.
