External Economies of Scale: Definition and Examples

What Are External Economies of Scale?

In economics, economies of scale dictate that the more units a business produces, the less it costs to produce each unit.

External economies of scale describe the same phenomenon, except as applied to an entire industry rather than within a single 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. This is an example of external economies of scale.

With external economies of scale, 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.

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.

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:

• 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

Pros and Cons of External Economies of Scale

External economies of scale have several advantages. They include:

• Egalitarian: All of the businesses in an industry enjoy these economies of scale equally.
• 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: In addition to lower production and operating costs, economies of scale may also reduce variable costs per unit because of operational efficiencies and synergies.

But external economies of scale are not without drawbacks. Disadvantages include:

• Lack of control: Individual firms have no direct control over what happens externally. In particular, this means that a company would not have a competitive edge, as it cannot exclude its competitors from benefiting from an external economy of scale.
• Limited locations: External economies of scale may develop so strongly in one geographic region that it becomes difficult for companies in a certain industry to locate anywhere else.
• Company instability: A business might not be able to exploit existing external economies because of its internal shortcomings, such as poor management, or other circumstances.

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. 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 bigger and faster.

The Bottom Line

External economies of scale refer to the phenomenon in which production costs fall for all firms in a certain sector. This is different from economies of scale as the idea is commonly understood, in which production costs decline for a single company. External economies of scale can encourage widespread and egalitarian economic growth, but they can also be geographically limited and dull competition among firms.