What is a negative externality and how does it lead to market failure?

A negative externality occurs when a person's actions cause harm to others, but the person does not have to pay for that harm. This often happens in situations like pollution, where a factory might release smoke into the air, affecting the health of nearby residents. Because the factory does not bear the full cost of the pollution, it may produce more goods than is socially optimal, leading to overproduction. This imbalance can result in market failure because the true costs of production are not reflected in the market price, causing resources to be wasted. For example, if the factory's pollution makes people sick, the healthcare costs increase, but the factory does not account for these extra costs in its pricing, leading to inefficiency in the market.