External economies of scale

What Is External Economies of Scale?

External economies of scale refer to the cost advantages that accrue to a firm or industry due to factors outside its direct control but within its operating environment, often stemming from the growth of the entire industry or geographic region. These benefits are external to the individual company but internal to the broader industry or location, falling under the realm of Microeconomics and Production costs. They manifest as a reduction in the average cost of production for individual firms as the overall scale of the industry expands. This phenomenon differs from Economies of scale that a single firm achieves through its own increased output.

When an entire industry grows, it can create a more skilled Labor market, better Infrastructure, and more specialized supplier industries, all of which reduce costs for individual firms operating within that industry or region. This shared benefit enhances Productivity across the board.

History and Origin

The concept of external economies of scale was prominently developed by the influential English economist Alfred Marshall in his seminal work, Principles of Economics, first published in 1890. Marshall observed that industries concentrated in specific localities, which he termed "industrial districts," gained significant advantages from their proximity. He noted that when many small businesses of a similar character gathered in a particular area, they could secure benefits dependent on the general development of the industry.¹³, ¹⁴, ¹⁵, ¹⁶

Marshall's observations from 19th-century industrial regions, such as the textile mills in Lancashire and Yorkshire, highlighted how the "mysteries of the trade become no mysteries; but are as it were in the air," leading to easy diffusion of knowledge and skills.¹¹, ¹² This shared pool of expertise, alongside the development of specialized suppliers and improved public infrastructure, were key examples of the external economies of scale he identified.⁹, ¹⁰ This concept provided an explanation for how localized industries, often composed of small, specialized firms, could achieve collective efficiency, offering an alternative to the growing importance of large, corporate structures.⁷, ⁸

Key Takeaways

• External economies of scale provide cost advantages to firms due to the growth and development of the entire industry or region, not just the firm's own output.
• These benefits arise from shared resources, specialized labor pools, improved infrastructure, and knowledge spillovers within an Industry clusters.
• They lead to lower average Production costs for individual companies as the industry expands.
• The concept is foundational to understanding the benefits of geographical concentration of industries and Agglomeration economies.
• Firms can achieve a Competitive advantage by locating in areas with strong external economies of scale.

Interpreting the External Economies of Scale

External economies of scale are interpreted as positive externalities that reduce the average cost curves of firms operating within a growing industry or geographical area. When an industry experiences external economies of scale, it implies that the collective prosperity and efficiency of the industry improve as it expands. For example, if a region becomes a hub for a particular technology, the entire ecosystem—from component suppliers and skilled labor to research institutions and specialized services—becomes more efficient.

This leads to a downward shift in the long-run average cost curve for individual firms, even if their individual output remains constant. It signifies that the environment outside a firm's direct operations is becoming more conducive to production, leading to lower per-unit costs and potentially higher profitability. Businesses evaluating new locations or considering expanding their operations often assess the potential for such external benefits. They look for existing or developing industrial concentrations that can provide access to a skilled Human capital base or specialized Supply chain partners.

Hypothetical Example

Consider the development of a hypothetical "Green Energy Vehicle Manufacturing Hub" in the fictional city of Electrovill. Initially, a few small electric vehicle (EV) component manufacturers set up shop. As demand for green energy vehicles grows globally, more EV manufacturers, battery producers, and charging station developers are attracted to Electrovill.

This influx of companies creates significant external economies of scale for all firms in the hub. For instance:

1. Specialized Labor Pool: The concentration of EV companies draws engineers, technicians, and skilled factory workers to Electrovill, creating a deep pool of specialized talent. Individual companies spend less on recruitment and training because skilled labor is readily available.
2. Shared Infrastructure: The local government and private investors build advanced testing facilities, specialized transportation networks for oversized components, and robust power grids specifically tailored for EV production needs. These improvements in Infrastructure benefit all companies without each needing to build them individually.
3. Ancillary Industries: New businesses emerge to support the EV industry, such as specialized software developers for vehicle control systems, advanced material suppliers, and even niche repair services for robotic assembly lines. This allows the EV manufacturers to further enhance their Specialization and focus on core competencies.

As the Electrovill hub grows, the average Production costs for an EV manufacturer within the hub decrease, not because that specific manufacturer increased its output, but because the entire industry ecosystem around it became more efficient and supportive.

Practical Applications

External economies of scale are highly relevant in various aspects of finance, economics, and business strategy:

• Regional Economic Development: Governments and policymakers often actively promote the formation of Industry clusters to harness external economies of scale. By concentrating related industries, they aim to foster Economic growth, job creation, and Innovation. For example, efforts to establish "tech hubs" or "manufacturing corridors" are direct attempts to leverage these benefits. In a recent example, the U.S. Commerce Department has been involved in funding manufacturing tech hubs, though such initiatives can face challenges.
• ⁶ Location Strategy for Businesses: Companies deciding where to establish or expand operations often prioritize locations with existing or potential external economies of scale. Access to a specialized Labor market, a network of suppliers, and shared infrastructure can significantly reduce a firm's long-term Production costs and enhance its Competitive advantage. Michael Porter's work on clusters highlights how geographic concentrations of interconnected companies and institutions can lead to unusual competitive success.
• ⁵ Venture Capital and Investment: Investors in specific sectors, such as biotechnology or software, often look for companies located within established industry clusters (e.g., Silicon Valley for tech, Boston for biotech). The presence of external economies of scale can signal a more favorable operating environment and a higher likelihood of success due to shared knowledge, talent, and resources.

Limitations and Criticisms

While external economies of scale offer significant benefits, there are also limitations and potential criticisms associated with unchecked industrial concentration.

One major drawback is the risk of "lock-in," where excessive reliance on local networks and ideas can hinder external Innovation and lead to a lack of diversification. An industry or region that becomes too specialized might struggle to adapt if its core sector faces disruption or decline. For instance, a region heavily reliant on a single manufacturing type could experience severe economic downturns if that industry shifts globally.

Furthermore, intense clustering can lead to negative externalities or "diseconomies," such as:

• Increased Competition for Inputs: A high concentration of similar firms can drive up the cost of local labor, specialized raw materials, or real estate.
• ⁴ Congestion and Pollution: Increased industrial activity in a small area can lead to overcrowding, traffic congestion, and environmental degradation, imposing costs on both businesses and residents.
• ², ³ Homogeneous Thinking: A dense cluster might foster a "groupthink" mentality, where firms become less open to outside ideas or less likely to challenge established practices, potentially stifling long-term Innovation.

Research has identified several negative effects of industrial clustering on regional social and economic development, including overconcentration and increased competition within the cluster area, which can threaten the survival of small and medium-sized firms.

##¹ External Economies of Scale vs. Internal Economies of Scale

The primary distinction between external economies of scale and Internal economies of scale lies in their origin and the way they affect a firm's costs.

Essentially, internal economies are about a firm getting bigger to get cheaper, while external economies are about an entire industry getting bigger and making it cheaper for all firms within that industry, regardless of their individual size.

FAQs

What causes external economies of scale?

External economies of scale are typically caused by factors such as the growth of a specialized Labor market in a region, the development of specialized suppliers and service providers, improvements in shared Infrastructure, and the free flow of knowledge and Innovation among firms in an Industry clusters.

How do external economies of scale affect a firm's average cost curve?

When external economies of scale occur, the long-run average cost curve of an individual firm shifts downward. This means that a firm can produce its goods or services at a lower average cost for any given level of output, simply because the external environment has become more efficient or supportive.

Are external economies of scale always positive?

While often beneficial, external economies of scale are not always positive. They can lead to negative externalities, also known as external diseconomies of scale, such as increased competition for limited local resources, higher labor costs, urban congestion, and a potential "lock-in" effect that hinders adaptation to new market conditions.

Can external economies of scale lead to monopolies?

External economies of scale themselves do not directly lead to monopolies. They primarily benefit all firms within a concentrated industry, regardless of size. However, if these benefits lead to significant overall Economic growth and success for a few dominant players, it could indirectly contribute to market concentration, especially if those few firms also achieve substantial Internal economies of scale.

What is an example of external economies of scale in the modern economy?

A common modern example is the clustering of technology companies in areas like Silicon Valley. The concentration of software developers, venture capitalists, specialized legal services, and universities with strong computer science programs creates a rich ecosystem. This allows new tech startups to find talent, funding, and support services more easily and at lower relative cost, benefitting from the overall growth and sophistication of the tech Industry clusters.