What is an externality, and how can it lead to market failure?

An externality is a situation where the actions of one person or business affect others who are not directly involved in that action, often without compensation. For example, if a factory produces goods but also pollutes the air, nearby residents may suffer from health problems due to the pollution, even though they are not part of the factory's operations. This can lead to market failure because the factory does not take into account the negative effects it has on the community, resulting in too much pollution and not enough clean air. When externalities occur, the market does not allocate resources efficiently, meaning that the overall welfare of society is reduced. To correct this, governments might step in with regulations or taxes to help balance the costs and benefits involved.