How do externalities affect market efficiency and what is a possible policy solution to address them?

Externalities are effects of a market transaction that impact people who are not directly involved in that transaction. For example, if a factory pollutes the air while producing goods, the surrounding community suffers from health problems, which is a negative externality. This situation reduces market efficiency because the costs of pollution are not reflected in the price of the factory's products, leading to overproduction and harming society. A possible policy solution to address this issue is to impose a tax on the factory based on the amount of pollution it produces. This tax would encourage the factory to reduce its pollution and help ensure that the true costs of production are included in the market, leading to a more efficient outcome for everyone.