Final answer:
Market inefficiencies arise from externalities like pollution because they lead to a market failure where output levels exceed socially optimal levels, resulting in environmental harm and deadweight loss.
Step-by-step explanation:
Externalities, such as pollution, cause market inefficiency by not being reflected in the supply curve, leading to a market failure. Companies may not consider all costs, which are private costs, in the case of negative externalities, and they produce more than what is socially optimal. This overproduction results in social costs exceeding social benefits, typically demonstrated through environmental damage, which also leads to a deadweight loss to society. This is because the market equilibrium, where demand meets supply, does not account for these external costs, only private costs. Consequently, the efficient output is not achieved, necessitating government intervention to correct the market failure. Methods of intervention include command-and-control regulations, taxes, or tradable permits to incorporate the externality into the market.