External Economies of Scale

External Economies of Scale

Table of Contents What Are External Economies of Scale? Scale economies that occur outside of a company, but from which all companies in an industry benefit could include the following: New production methods Transportation modes Government tax breaks Increased tariffs against a foreign competitor New off-label use of a prescription drug or other product External economies of scale have several advantages. As an industry grows larger or becomes clustered in one location — as with, say, the banking and financial services in New York or London — than the average costs of doing business within that industry over the long run become lower, and we have external economies of scale. Interestingly, toward the end of the 20th century, Route 128 was eclipsed as the center of the high-tech industry by Silicon Valley in the San Francisco Bay Area, where the external economies of the scale grew — as things in California tend to do — bigger, faster, and on a grander scale. **Growth**: External economies of scale can drive industry growth in particular regions and can also encourage the rapid economic development of support industries and the entire city or geographic area in general. **Lower costs**:

External economies of scale are business-enhancing factors that occur outside a company but within the same industry.

What Are External Economies of Scale?

External economies of scale occur outside of an individual company but within the same industry. Remember that 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 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.

As an industry grows larger or becomes clustered in one location — as with, say, the banking and financial services in New York or London — than the average costs of doing business within that industry over the long run become lower, and we have external economies of scale. With external economies, costs also may fall because of increased specialization, better training of workers, faster innovation, or shared supplier relationships. These factors are typically referred to as positive externalities; industry-level negative externalities are called external diseconomies.

External economies of scale are business-enhancing factors that occur outside a company but within the same industry.
In addition to lower production and operating costs, external economies of scale may also reduce a company's variable costs per unit because of operational efficiencies and synergies.
On the downside, external economies of scale could dull the competitive edge of a company, as it cannot exclude competitors from benefiting also.

The Basics of External Economies of Scale

Businesses in the same industry tend to cluster in together. For example, a film studio might determine that California is a particularly good location for year-round film-making, so it moves to Hollywood. New movie producers also move to Hollywood because there are more camera operators, actors, costume designers, and screenwriters in the area. Then, more studios might decide to move to Hollywood to take advantage of the specialized labor and infrastructure already in place, thanks to the success of the first firm.

As more and more firms succeed in the same area, new industry entrants can take advantage of even more localized benefits. It makes sense for industries to concentrate in areas where they are already strong.

An agglomeration economy, or synergy, is when businesses in different industries are beneficial to each other and can share resources and opportunities.

Agglomeration Economy

If two or more separate industries are incidentally beneficial to one another, there can be external economies of scale across the entire group. This phenomenon is sometimes called an "agglomeration economy," in which businesses are located close to one another and can share resources and efficiencies. It is similar to the business governance concept of synergy.

Scale economies that occur outside of a company, but from which all companies in an industry benefit could include the following:

Pros and Cons of External Economies of Scale

External economies of scale have several advantages. They include the following:

But external economies of scale are not without drawbacks as well. These disadvantages include:

Real-Life Example of External Economies of Scale

From the late 1960s to the early 1990s, the arguable epicenter of the U.S. high-tech sector was a region just outside of Boston. It was known as Route 128, named for the freeway that ringed the city, and around which a cluster of technology companies grew — including those in the burgeoning computer business.

A variety of factors enticed entrepreneurs there, including proximity to corporations and educational institutions with their research centers and talent, financial services and venture capital firms, and military bases. And the more businesses that came, the more external economies of scale developed, making it easier for more ventures to find facilities, skilled labor, suppliers, sub-contractors, and support services — and to markets themselves, staging conventions and conferences.

Interestingly, toward the end of the 20th century, Route 128 was eclipsed as the center of the high-tech industry by Silicon Valley in the San Francisco Bay Area, where the external economies of the scale grew — as things in California tend to do — bigger, faster, and on a grander scale.

Related terms:

Competitive Advantage

Competitive advantage refers to factors that allow a company to produce goods or services better or more cheaply than its rivals. read more

Diseconomies of Scale

Diseconomies of scale occur when a business expands so much that the costs per unit increase. It takes place when economies of scale no longer function. read more

Economics : Overview, Types, & Indicators

Economics is a branch of social science focused on the production, distribution, and consumption of goods and services. read more

Economies of Scale

Economies of scale are cost advantages reaped by companies when production becomes efficient. read more

Economies of Scope

Economies of scope are economic factors that make it cheaper to manufacture a wider variety of products together instead of on their own. read more

Externality & Examples

An externality is an economic term referring to a cost or benefit incurred or received by a third party who has no control over how that cost or benefit was created. read more

Inflation

Inflation is a decrease in the purchasing power of money, reflected in a general increase in the prices of goods and services in an economy. read more

Monopoly

A monopoly is the domination of an industry by a single company, to the point of excluding all other viable competitors. read more

Operational Efficiency

Operational efficiency is a metric that measures the efficiency of profit earned as a function of operational costs. read more

Price Leadership

Price leadership occurs when a preeminent company determines the price of goods or services within its market and other firms in the sector follow suit. read more