External Economies of Scale

Article byKosha Mehta
Reviewed byDheeraj Vaidya, CFA, FRM

What Are External Economies of Scale?

External economies of scale refer to the cost advantages that a group of firms or an entire industry can achieve due to their collective actions and the industry’s growth. Its purpose is to benefit from factors beyond the control of any single company. These factors include a skilled labor force, specialized suppliers, infrastructure, and a knowledge-sharing environment.

External Economies of Scale

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It enables firms within an industry to operate more efficiently and cost-effectively by sharing resources and benefiting from the growth and development of the industry as a whole. This leads to improved productivity, reduced costs, and increased competitiveness. The importance of external economies lies in their potential to enhance overall economic performance, foster innovation, and attract investments.

Key Takeaways

  • External economies of scale stem from collective advantages within an industry or region, fostering cost reductions and innovation through shared resources and knowledge exchange.
  • Industry clusters promote collaboration and knowledge spillovers, increasing efficiency and competitiveness among firms.
  • Proximity to specialized suppliers, skilled labor, and supportive infrastructure enhances productivity, reducing production costs for all participants.
  • External economies of scale showcase how interconnections and collaboration within a geographic area can create a mutually beneficial environment, driving economic growth and shared benefits.

External Economies Of Scale Explained

External economies of scale occur when a group of firms or an entire industry benefits from cost advantages due to shared resources and industry growth. Unlike internal economies of scale resulting from efficiencies within a single firm, external economies stem from factors like skilled labor, specialized suppliers, and a collaborative environment. These factors enhance productivity and competitiveness.

The benefits arising from external economies have the capacity to contribute to regional and national growth. As industry expands, firms can tap into these benefits, reducing costs and improving efficiency. External economies encourage knowledge exchange and infrastructure development, fostering a mutually beneficial environment for all participants.

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Sources

External economies of scale can arise from various sources, contributing to the cost advantages and efficiencies enjoyed by industries or groups of firms. Some sources of external economies of scale include:

#1 – Skilled Labor And Knowledge Sharing

  • The concentration of firms in an industry cluster can attract a skilled labor force, leading to knowledge sharing and a more educated workforce.
  • Proximity to universities and research institutions enables easier collaboration and technology transfer.

#2 – Specialized Suppliers And Inputs

  • Agglomeration of firms can attract suppliers of specialized inputs, leading to reduced procurement costs and improved quality.
  • Shared access to reliable and cost-effective suppliers can lower production costs.

#3 – Infrastructure And Transportation

  • Proximity to transportation hubs, ports, and logistics centers can reduce shipping costs and improve supply chain efficiency.
  • Efficient transportation networks lower distribution costs and enhance market access.

#4 – Knowledge Spillovers And Innovation

  • Proximity to other firms and research centers facilitates knowledge spillovers, leading to technological advancements and innovation.
  • Interaction with other innovative firms can stimulate creativity and problem-solving.

Examples

Let us have a look at the examples to understand the concept better.

Example #1

Consider that a growing tourism industry in the coastal city of Tourismland triggers external economies of scale. A skilled workforce attracted by cultural attractions and beautiful beaches fuels knowledge sharing, fostering a dynamic exchange of ideas. Concentrated tourism businesses lead to specialized suppliers offering tailored products and services, reducing costs and enhancing quality.

Infrastructure investments, such as improved transportation and cultural centers, benefit all firms by making the city more accessible and appealing to visitors. Collaborative marketing campaigns and a Tourism Academy further strengthen the industry, driving competitiveness and sustained economic growth for the city of Tourismland.

Example #2

Consider a hypothetical TechHaven, which is a cluster of technology companies that have flourished. Their proximity has sparked external economies of scale. With a shared labor pool, TechHaven attracts skilled workers and encourages knowledge sharing, leading to innovation and reduced recruitment costs. Additionally, the concentration of tech suppliers reduces procurement expenses for all firms involved.

TechHaven’s infrastructure, including research facilities and transportation networks, lowers overheads. As firms interact, knowledge spillovers drive collective advancement, promoting overall growth. Government incentives support this hub, offering tax breaks that benefit the entire cluster. In this way, TechHaven exemplifies how external economies of scale arise from shared resources, knowledge exchange, and collaborative infrastructure, fostering a thriving technological ecosystem.

Diagram

Let us have a look at the Diagram to understand the concept better.

External economies of scale graph

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The horizontal axis represents the quantity of output produced by firms in an industry, and the vertical axis represents the average cost of production. The graph shows a downward-sloping average cost curve (AC) that starts relatively high at lower output levels and then gradually slopes downward as output increases. As the quantity of output produced (Q) increases, the average cost of production (AC) decreases. This represents the economies of scale zone, where firms benefit from external economies of scale.

Advantages And Disadvantages

Let us have a look at the advantages:

  1. Cost Reduction: External economies of scale can lead to significant cost reductions for firms within an industry. Shared resources, knowledge, and infrastructure contribute to lower production costs, improving overall profitability.
  2. Competitiveness: Firms operating in an environment with external economies of scale can become more competitive on a global scale. Reduced costs and improved productivity enhance their ability to offer competitive prices and quality products.
  3. Skilled Labor Pool: Concentrated industries can attract a skilled workforce, creating a talent pool that benefits all firms in the cluster. This can lead to a more educated and specialized labor force.

Let us have a look at the disadvantages:

  1. Dependency: Overreliance on external economies of scale can create a dependency among firms. If these advantages diminish or disappear, firms may struggle to maintain their competitiveness.
  2. Limited Flexibility: The collaborative nature of external economies might restrict firms’ ability to make independent decisions. Decisions may need to align with the cluster’s interests, limiting individual autonomy.

External Economies Of Scale vs Internal Economies Of Scale

Let us have a look at the differences between external economies of scale and internal economies of scale.

ParametersExternal Economies of ScaleInternal Economies of Scale
DefinitionCost advantages resulting from industry-wide or regional factorsCost advantages achieved within a single firm due to its operations
Source of BenefitShared resources, infrastructure, knowledge, and industry growthFirm-specific factors like specialization, technology, and size
ScopeBenefit multiple firms within an industry or geographic areaBenefit a single firm
CollaborationRequires collaboration and interaction among firmsRelies on efficient internal processes and management
DependencyFirms depend on the industry cluster or region for advantagesThe firm’s performance and advantages are self-contained
Knowledge ExchangeKnowledge spillovers and innovation often result from proximityKnowledge is developed and retained within the firm
Risk DistributionShared risks and uncertainties among firms in the clusterFocused risk management based on firm-specific strategies

Frequently Asked Questions (FAQs)

1. What role does collaboration play in external economies of scale? 

Collaboration is a fundamental element of external economies of scale. Firms within a cluster or region collaborate to share resources, knowledge, and experiences. This interaction leads to knowledge spillovers, innovation, and the efficient utilization of shared infrastructure. Through collaboration, firms can collectively overcome challenges, benefit from each other’s expertise, and create a supportive ecosystem that fosters growth and competitiveness.

2. How do external economies of scale impact regional economic development? 

External economies of scale play a significant role in regional economic development by attracting investments, fostering innovation, and promoting industry growth. Concentrated clusters of firms create a magnet for skilled labor, research institutions, and specialized suppliers, enhancing the region’s economic attractiveness. As the industry thrives, it generates employment opportunities and contributes to the local economy through increased production and exports.

3. How do external economies of scale influence small businesses?

External economies of scale can benefit small businesses by enabling them to access resources and opportunities that might otherwise be challenging to attain individually. Small businesses in industry clusters or regions with external economies can tap into shared resources, skilled labor, and knowledge spillovers, allowing them to compete more effectively with larger competitors.

This has been a guide to what are External Economies of Scale. We explain its examples, advantages, sources, and comparison with internal economies of scale. You can learn more about it from the following articles –

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