Final answer:
Externalities such as pollution result in market failure because the market does not account for external costs, leading to overproduction and social inefficiency. Tradable permits are one solution to this problem by creating a market for pollution rights, aligning private incentives with social costs.
Step-by-step explanation:
Externalities lead to market failure because the market does not take into account the external costs, leading to an outcome that does not achieve the social optimum. In essence, externalities such as pollution cause the supply curve to no longer represent all social costs, only accounting for private costs. This discrepancy means that, without intervention, firms will produce more than is socially optimal, imposing costs on third parties who are not involved in the market transaction.
The concept of a marketable permit program is one approach to address this issue. This program allows firms to be issued permits to emit a certain amount of pollution, where firms with excess permits can sell them to others, potentially leading to a more efficient and reduced overall level of pollution.
Negative externalities, like pollution, are a classic example of market failure because they result in social costs that exceed social benefits at market output levels. The private market alone, without any form of intervention such as taxation or regulation, fails to achieve an efficient allocation of resources, which is one of the essential conditions for a well-functioning market economy.