What Are External Economies of Scale? A Complete Guide

External economies of scale are cost savings that occur when an entire industry expands, benefiting all firms in that sector As more businesses emerge in a particular field and location, they can share resources, lower expenses, and boost efficiencies across the industry

Understanding external economies of scale and how they promote growth provides valuable insight into key economic principles. This comprehensive guide examines what external economies of scale are, how they work, major benefits and downsides and real-world examples.

What Are External Economies of Scale?

External economies of scale describe beneficial cost factors that arise outside of a company but within an industry. They occur when an entire sector expands in a particular region, allowing firms to lower average costs.

For example, as more technology firms open in a city, supporting businesses and infrastructure develop, lowering costs for all technology companies. External economies of scale apply across an industry, unlike internal economies of scale that occur within a single firm.

Key drivers of external economies of scale include:

Industry concentration in a geographic area – Clustering allows sharing of resources.
Specialized labor forces – Workers with niche skills are available locally.
Improved infrastructure – Common transportation and networks reduce expenses.
Industry growth – Expansion creates economies of scale and shared efficiencies.
Supporting and related industries – Supply chains and partnerships emerge.

Examples of External Economies of Scale

There are various examples of how external economies of scale emerge and offer industry-wide benefits:

A new railway built to transport coal lowers transportation costs for all mining companies in the region.
Biotech firms in a city hire from the same pool of specialized scientists and engineers.
Tech manufacturers share common component suppliers located in the same industrial park.
Policy changes like tax incentives apply across renewable energy companies.
As more banks open offices, financial infrastructure like ATMs proliferate in an area.

In each case, the combined growth and concentration of an industry in one place generate positive externalities that reduce expenses. Firms gain cost advantages that are external to their individual companies.

Why Do External Economies of Scale Occur?

There are various mechanisms through which external economies of scale arise as an industry develops:

Clustering Effects

When firms in the same sector locate near one another, suppliers and related services emerge locally to support them. For example, as more tech companies open in Silicon Valley, an ecosystem of vendors, lawyers, and talent develops that all tech firms can leverage.

Labor Pools

Industry clusters attract workers with specialized skills. As sectors like healthcare or finance grow in a region, relevant talent flocks there. Companies can tap into these labor pools rather than building them internally.

Infrastructure

Localized industry expansion allows certain transportation networks, utilities, communications links and other infrastructure to be built. These benefit all participants in the sector versus just one firm.

Shared Suppliers

With sector concentration in one place, suppliers that cater to those companies often emerge. Firms can share suppliers and achieve lower costs through combined economies of scale.

Knowledge Spillovers

Knowledge transfers more easily between companies in close proximity, accelerating innovation and efficiencies. Being located near competitors fosters faster idea sharing.

Benefits of External Economies of Scale

External economies of scale offer numerous advantages, including:

Lower operating costs – Sharing of resources and suppliers reduces expenses.
** Increased productivity** – Innovation and operational efficiencies spread rapidly.
Access to skilled labor – Specialized local workforces reduce hiring and training costs.
Development of infrastructure – Common regional infrastructure drives down costs.
Business expansion – Emerging ecosystems allow companies to scale faster.
Reduced barriers to entry – It becomes easier for new firms to enter and establish operations.
Jobs and economic growth – These factors all spur job creation and overall economic expansion.

Essentially, external economies of scale enable entire industries to reap the benefits of greater scale and concentration in one place.

Disadvantages of External Economies of Scale

However, there are also some risks and downsides to external economies of scale:

Industry concentration in one area can leave firms overexposed to local economic and labor disruptions.
Companies have less control over external economies of scale versus internal cost efficiencies.
Competitors benefit equally, reducing a firm’s competitive advantage from scale.
Dominant regions become almost monopolistic, limiting locations for new operations.
Rapid local growth can spark negative externalities like higher living costs and pollution.
Initial capital costs to establish infrastructure can be high.

Companies have to balance the broad efficiencies of external economies with potential drawbacks around competition and regional risk.

Examples of Industries Benefiting From External Economies of Scale

Certain industries have flourished due to robust external economies of scale in key regions:

Entertainment in Hollywood – Film, TV, and music companies leverage specialized labor, suppliers, and expertise concentrated there.
High tech in Silicon Valley – Tech firms capitalize on the supportive ecosystem and workforce.
Financial services in New York – Banks and related sectors thrive via dense financial infrastructure and labor pools.
Automotive in Detroit – Carmakers and suppliers prosper from industry clustering.
Energy in Houston – Oil, gas and renewable companies tap into specialized services and infrastructure.

Each region has developed particular external economies that benefit all embedded companies and foster ongoing sector expansion.

External Economies vs. Internal Economies

External economies of scale are distinct from internal economies. Internal economies arise from factors solely within one firm that allow it to lower costs through operational efficiencies as it grows. External economies accrue at the industry-level versus company-specific factors.

For example, an auto firm that offers on-site childcare services has an internal economy of scale. Meanwhile, an entire local automotive industry that shares a common components supplier illustrates external economies. The key difference is the broader industry focus.

Are External Diseconomies of Scale Possible?

External diseconomies of scale can arise if an industry’s rapid expansion creates negative consequences like:

Severe congestion
Overburdened infrastructure
Scarcity of resources like labor and real estate
Excessive local pollution or waste

These can ultimately increase business costs and offset the benefits of clustering in a region. Firms need to assess if diseconomies emerge that could affect long-term viability.

The Importance of External Economies of Scale

External economies of scale are a pivotal economic force that commonly explain:

The emergence of industry epicenters like Silicon Valley.
Rapid sector growth in specific regions.
The decline of certain areas losing key industries.
New trade patterns as industries cluster based on initial historical accidents.
How nations develop distinct industrial specializations.

Leveraging External Economies of Scale

Companies seeking to capitalize on external economies of scale should:

Consider industry concentration patterns when choosing locations.
Seek areas with specialized labor, suppliers, and infrastructure.
Align with related and supporting businesses where possible.
Weigh external economies against potential local risks like higher costs or congestion.
Factor in competitor presence and the potential loss of proprietary advantages.

Overall though, most industries benefit enormously from the positive externalities and knowledge spillovers of a vibrant local ecosystem. Firms that tap into these external economies gain an edge.

Understanding Industry-Level Scale Benefits

In conclusion, external economies of scale are crucial drivers of sector-wide growth and cost efficiencies. They allow industries to reap synergies from concentration in certain regions. By leveraging shared labor, suppliers, infrastructure and knowledge, companies can achieve scales that benefit entire markets versus just individual firms. Evaluating external economies provides vital perspective on macroeconomic geography, trade, and growth.

what are external economies of scale

External Economies of Scale

External economies of scale are generally described as having an effect on the whole industry. So when the industry grows, the average costs of business drop. External economies of scale can happen because of positive and negative externalities.

Positive externalities include a trained or specialized workforce, relationships between suppliers, and/or more innovation. Negative ones happen at the industry levels and are often called external diseconomies.

There are several contributing factors behind external economies of scale. When competing companies set up shop in one area, specialized workers will seek employment. An example of this would be the IT industry in Silicon Valley, which has attracted a special set of skilled workers.

Secondly, certain industries may become so important that they can develop bargaining power with politicians and local governments. This, in turn, can lead to more favorable treatment in the form of subsidies or other concessions. The oil industry has a long history of subsidies in the United States, which were historically given to continue a steady flow of domestic supply.

What Are the Main Types of Economies of Scale?

The different types of economies of scale include technical, managerial, advertising, financial, and networking. These are different economies of scale that allow for increased output with a reduction in costs.

External economies of scale

What is the difference between internal and external economies of scale?

Internal and external economies of scale both refer to downward pressure on production costs. The central difference between the two concepts is that internal economies of scale are specific to a single company, whereas external economies of scale apply across an industry. What Are Economies of Scale Internationally?

What are economies of scale?

Economies of scale can be both internal and external. Internal economies of scale are based on management decisions, while external ones have to do with outside factors. Internal functions include accounting, information technology, and marketing, which are also considered operational efficiencies and synergies.

Why is external economies of scale important?

External economies of scale can be very important for driving industry grows in particular regions. It can also explain the rapid growth of cities. External economies of scale are generally beyond the scope of individual firms. It depends on whether other firms grow and the industry concentrates in the same geographical area.

What is an example of external economies of scale?

For example, if a city creates a better transportation network to service a particular industry, then all companies in that industry will benefit from the new transportation network and experience decreased production costs. External economies of scale are business-enhancing factors that occur outside a company but within the same industry.