Final answer:
Externalities cause market failure as they lead to a situation where the market does not account for all social costs or benefits, such as with pollution, resulting in an inefficient allocation of resources and overproduction of harmful goods.
Step-by-step explanation:
Externalities are considered a cause of market failure because they represent situations where markets do not fully account for all social costs or benefits. Specifically, a negative externality like pollution means that the supply curve fails to reflect all the social costs associated with production. This leads to inefficient market outcomes, where private markets produce and consume quantities that do not align with social optimum levels. For instance, with pollution as a negative externality, firms may not bear all the costs of the damages their production causes the environment, leading to overproduction. This imbalance results in an overallocation of resources to the production of goods that generate negative externalities, such as pollution, and underproduction of goods with positive externalities.
A marketable permit program can help correct externalities by allowing firms to trade permits for emissions, ensuring that those who can reduce pollution most cheaply do so, whilst still providing economic incentives to reduce overall pollution levels. Without such correction mechanisms, negative externalities can cause harm to third parties and result in a market outcome where social costs of production exceed the private costs imposed on the market.