In economics, an externality is defined as a cost or benefit incurred by a third party as a result of economic activity to which the third party has no relation. Economists use equilibrium models that succinctly measure externalities as a deadweight loss or gain as a result of differences between social and individual marginal cost or benefit curves. However, going from theory to practice creates estimation problems since the effect of externalities is sometimes unknown. To measure externalities in practice, economists use quantitative methods (cost of damages, cost of control), qualitative methods (qualitative treatment) and hybrid methods (weighting and ranking).
In theoretical equilibrium models, economists use marginal benefit (MB) and marginal cost (MC) curves to calculate the externalities. Consider a positive externality where an individual washes his hands twice a day and stops spreading infection. If this person washes his hands more than two times, it is costly to him (time, more soap), but society benefits in terms of less infection. 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 though an equilibrium quantity for the individual. The same measurement technique applies for the negative externality, except that the society MC curve is bigger than the individual MC curve.
Estimating externalities in practice is much harder than in theory since marginal cost and marginal benefit curves are seldom fully observed, and since their estimation process is fraught 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 quantifies 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.
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 impact level a particular event has on the environment, such as no impact, moderate impact or significant impact. Also, 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 utilities companies.
There are advantages and disadvantages to using any method. Quantitative methods, for instance, are convenient since they put an estimated number on externality, but 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 subjectivity of the decision-maker who makes impact assessments. Hybrid methods try to balance the two other categories, inheriting their advantages and disadvantages.