Deadweight loss (DWL) occurs in scenarios of both underproduction and overproduction, leading to inefficiencies in the market. Understanding the concept of the "bowtie of deadweight loss" can help visualize these inefficiencies. When underproduction happens, the price is set below the equilibrium price (P_star), resulting in a shortage. This low price attracts high demand, but suppliers are unwilling to meet this demand, leading to a quantity supplied that is less than the quantity demanded. The area representing deadweight loss in this case is the trades that did not occur due to the incorrect pricing, forming one side of the bowtie.

Conversely, in cases of overproduction, the price exceeds the equilibrium price. This situation creates a surplus, as suppliers produce more than what consumers are willing to buy at that price. The deadweight loss here is represented by the excess production that does not meet demand, forming the other side of the bowtie. Thus, the deadweight loss can be visualized as two triangular areas: one for underproduction on the left and one for overproduction on the right.

Market failure occurs when the market fails to allocate resources efficiently, leading to deadweight loss. Several factors can contribute to market failure. Price or quantity regulations imposed by the government can disrupt equilibrium, causing inefficiencies. Externalities, which are costs or benefits affecting third parties not involved in a transaction, can also lead to market failure. A common example is pollution, where the negative effects of production impact individuals not part of the transaction.

Monopolies represent another cause of market failure, as a single seller can manipulate prices and restrict output, preventing the market from reaching equilibrium. Additionally, high transaction costs can deter trades, leading to inefficiencies. For instance, if transaction fees become prohibitively high, potential trades may not occur, further contributing to market failure.

In summary, understanding deadweight loss and the factors leading to market failure is crucial for recognizing how markets can become inefficient and the implications of such inefficiencies on overall economic welfare.