What Are External Economies of Scale?
External economies of scale occur outside of an individual company but within the same industry. In economics, economies of scale mean that the more units a business produces, the less it costs to produce each unit.
External economies of scale describe similar conditions, only for an entire industry instead of a company. For example, if a city creates an improved transportation network specifically for an industry, then all companies within that industry will benefit from this enhancement and experience decreased production costs.
As an industry grows larger or becomes clustered in one location—take the banking and financial services in New York or London, for instance—the average costs of doing business within that industry over the long run become lower, characterizing external economies of scale. With external economies, costs may also fall due to increased specialization, better worker training, faster innovation, or shared supplier relationships. These factors are generally referred to as positive externalities; industry-level negative externalities are known as external diseconomies.
Key Takeaways
- External economies of scale are industry-level advantages that enhance business operations outside an individual company.
- Besides reducing production and operating costs, external economies of scale can also minimize a company’s variable costs per unit through operational efficiencies and synergies.
- A potential downside includes less competitive edge for individual companies, as competitors also benefit from these external improvements.
Let’s Dive Deeper Into External Economies of Scale
Businesses in the same industry often cluster together. For instance, a film studio might move to Hollywood due to favorable filming conditions. This attracts other movie producers to the area, thanks to an abundance of specialized labor like camera operators, actors, costume designers, and screenwriters. This clustering leads to more studios relocating to Hollywood to leverage the specialized infrastructure and workforce already established by earlier firms.
As more firms succeed in the area, new industry entrants can reap localized benefits, consolidating the area’s industry strength. An agglomeration economy or synergy represents when different industries benefit each other by sharing resources and opportunities.
Discovering Agglomeration Economy
When industries, incidentally or purposefully, benefit from one another, we call this an agglomeration economy. Businesses positioned close to each other can share resources and efficiencies, driving external economies of scale for the entire group. This resembles the business governance concept of synergy.
Scale economies that benefit the entire industry include the following:
- New production methods
- Transportation advancements
- Government tax incentives
- Increased tariffs on foreign competitors
- Novel off-label uses for specific products
Evaluating the Pros and Cons of External Economies of Scale
Pros
- Egalitarian: Benefits are distributed equally among all businesses in the industry.
- Growth: External economies of scale can spur industry growth and drive economic development in specific regions.
- Lower Costs: Reduced production and operational costs may also decrease variable costs per unit, owing to operational efficiencies and synergies.
Cons
- Lack of Control: Individual firms have limited control over external factors and cannot solely benefit from the advantages created.
- Location Constraints: Strong development of external economies in certain regions may limit where companies in the industry can situate.
- Company Instability: Firms might fail to leverage external economies due to internal problems, such as poor management.
Real-World Glance: External Economies of Scale in Action
From the late 1960s to the early 1990s, the U.S. high-tech sector centered around Route 128 in Boston. Clusters of technology companies—including those in the budding computer industry—grew due to proximity to corporate and educational research hubs, financial services, and military bases. This agglomeration led to increased external economies of scale, aiding subsequent ventures with access to experienced labor, suppliers, subcontractors, and support services.
Toward the end of the 20th century, Route 128 was eclipsed by Silicon Valley in California, where external economies grew significantly larger, illustrating the massive potential of leveraging external economies of scale.
Related Terms: Economies of Scale, Externalities, Operational Efficiency, Synergy, Variable Costs, Competitive Advantage.
