1. When the game originally came out, video games were hard, very hard. If a bad guy hit your platform-jumping character, that was it. Start the level over until you ran out of lives. If you’re just learning the game, that really doesn’t encourage you if you’re still trying to get better at it. Being able to get hit without starting over is big, since you can still realize you screwed up without being wholly penalized. It’s kind of like having a save game point, except there are still consequences to getting hit. (Two hits and you really are dead.)
2. It’s a simple way for a character to have health without getting meta and having a “health bar” or “meter”. It keeps the game within it’s own strange fiction and makes the mechanical rewards part of the universe that Mario lives in. Yep, immersion.