What Are External Economies of Scale?

What Are External Economies of Scale?

In economics, you know that economies of scale mean the more units a business produces, the less it costs per unit. I want to explain external economies of scale, which apply this idea to an entire industry instead of just one company.

For instance, if a city builds a better transportation network for a specific industry, every company in that industry gets lower production costs from it. That's external economies of scale in action.

Key Takeaways

These are business-enhancing factors happening outside a company but within the same industry. Besides cutting production and operating costs, they can lower variable costs per unit through efficiencies and synergies.

On the flip side, they might weaken a company's competitive edge because competitors can't be excluded from the benefits. As an industry grows or clusters in one spot—like banking in New York or London—average long-run costs drop for everyone involved.

The Basics of External Economies of Scale

Costs can fall due to specialization, better worker training, faster innovation, or shared suppliers. These are positive externalities, while negative ones at the industry level are external diseconomies.

Businesses in the same industry often cluster together. Take a film studio moving to California for year-round filming; it attracts others because of the available talent like camera operators, actors, and screenwriters. More firms join to tap into that specialized labor and infrastructure, making it logical for industries to concentrate where they're strong.

Agglomeration Economy

If separate industries benefit each other incidentally, you get external economies of scale across the group. This is an agglomeration economy, where businesses locate near one another to share resources and efficiencies—much like synergy in business governance.

Examples include new production methods, transportation modes, government tax breaks, increased tariffs on foreign competitors, or new off-label uses for products like prescription drugs.

Pros and Cons of External Economies of Scale

They have advantages: they're egalitarian, with all businesses in the industry benefiting equally; they drive growth in regions, supporting industries and entire areas; and they lower costs beyond production, including variable costs from efficiencies.

But there are downsides: firms lack control over external factors, so no competitive edge from excluding rivals; they're often limited to specific locations, making it hard to operate elsewhere; and a company might not fully exploit them due to internal issues like poor management.

Real-Life Example of External Economies of Scale

From the late 1960s to early 1990s, Route 128 outside Boston was the U.S. high-tech epicenter, with tech companies clustering around the freeway. Factors like proximity to research centers, talent from universities, venture capital, and military bases drew entrepreneurs.

As more businesses arrived, external economies grew, easing access to facilities, skilled labor, suppliers, and markets. But by the late 20th century, Silicon Valley in the San Francisco Bay Area overtook it, with even larger and faster economies of scale.

What Is the Difference Between External and Internal Economies of Scale?

Both put downward pressure on production costs, but internal ones are specific to one company, while external ones apply across the industry.

What Are Economies of Scale Internationally?

They can occur on municipal, state, national, or international levels. With rising international air travel, new routes and options emerge, creating revenue for airlines while competition might lower costs on some itineraries, benefiting consumers and firms globally.

How Do You Achieve External Economies of Scale?

They come from technological advancements cutting industry-wide costs, or government support like infrastructure or tax subsidies.

The Bottom Line

External economies of scale mean falling production costs for all firms in a sector, unlike internal ones for a single company. They promote widespread growth but can be geographically limited and reduce competition among firms.