How to Measure Externalities

In economics, an externality is defined as a cost or benefit incurred by a third party as a result of economic activity that the third party has no relation to. An economist may use equilibrium models to succinctly measure externalities as a deadweight loss or gain. This occurs as a result of differences between social and individual marginal cost or benefit curves.

However, going from theory to practice creates problems with estimating the effect of externalities since they are sometimes unknown. 

Measuring Externalities in Theory

In theoretical equilibrium models, economists use marginal benefit (MB) and marginal cost (MC) curves to calculate the externalities. Consider a positive externality wherein a person washes his hands twice a day to help prevent the spread of infection. Washing hands more than two times is individually costly (time, more soap), but society benefits in terms of less exposure to viruses and bacteria. In this case, the benefit to the person is less than the benefit to society, and the MB curve (or the demand curve) of the person is less than the MB curve of society.

The positive externality is then measured as the deadweight loss area above the individual MC curve and below the society MB curve constrained by the vertical line going through an equilibrium quantity for the person. For the negative externality, the same measurement technique applies except that the society MC curve is bigger than the individual MC curve.

Measuring Externalities in Reality

For measuring externalities, economists may use quantitative methods (cost of damages, cost of control), qualitative methods (qualitative treatment) or hybrid methods (weighting and ranking).

Quantitative Methods

Estimating externalities in practice is much harder than in theory since marginal cost and marginal benefit curves are not fully observed very often and since the process of estimating can be met with challenging statistical issues. Sometimes, the full extent of the externalities' effect is not known. The two prominent quantitative methods used by economists to assess externalities are cost of damages and cost of control.

For example, in the case of an oil spill, the cost of damages method puts a number to the cost of cleanup necessary to clear the pollution and restore the habitat to its original state. On the other hand, the cost of control method uses the costs of controlling the externality as a proxy for the damages that may result.

Qualitative Methods

The qualitative method of assessing externalities widely used by environmentalists is called qualitative treatment. This method does not put any numbers behind externalities, but rather states the level of impact that a particular event has on the environment, such as no impact, moderate impact, or a significant impact.

Hybrid Methods

A weighting and ranking method has been developed that is a hybrid between qualitative and quantitative methods. This method assigns weights and ranks to externalities to evaluate their impacts and is commonly used by utility companies.

The Bottom Line

There are advantages and disadvantages to using any method. Quantitative methods, for instance, are convenient since they put an estimated number on externality, but a lack of data is the biggest impediment to using quantitative methods. Qualitative methods, on the other hand, are highly flexible and adaptive, but they suffer from the subjectivity of a decision-maker who makes assessments on the impact. Finally, hybrid methods try to balance the other two categories, inheriting both their advantages and disadvantages.

Take the Next Step to Invest
The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.