What Are External Economies of Scale?
External economies of scale occur when the average cost of production falls for all firms in an industry as the industry itself grows or concentrates geographically. Unlike internal economies of scale (cost savings inside a single firm, e.g., from buying larger machines), external economies arise from factors outside any one company but available to many firms at once—better local infrastructure, a deeper pool of skilled workers, shared suppliers, or faster innovation. These are sometimes called positive externalities at the industry level. (Source: Investopedia)
Key Takeaways
– External economies of scale reduce costs across an entire industry as the industry grows or clusters.
– Common drivers include agglomeration (industry clustering), shared supplier networks, improved public infrastructure, and a skilled labor pool.
– Benefits include lower average costs, faster innovation, and easier access to inputs and markets.
– Drawbacks include congestion, rising local costs (rent/wages), environmental pressures, reduced competition, and exposure to local shocks.
– Policymakers, industry associations, and firms can take practical steps to capture benefits while limiting diseconomies.
Fast fact
When many firms in the same industry cluster in one place (e.g., Silicon Valley for tech), they create an environment where suppliers, talent, and complementary services are easier and cheaper to obtain—lowering costs industry-wide and accelerating growth.
The Basics of External Economies of Scale
– What they are: Industry-level cost declines as the scale of the entire industry increases, not merely a single company.
– Why they occur: Shared inputs and services (specialized suppliers, training institutions, logistics), tacit knowledge spillovers (informal learning, poaching of talent), and public goods (transport, ports, telecom) that become more economical per user as usage increases.
– How they differ from internal economies: Internal economies are firm-specific (e.g., a factory installing a larger press), while external economies are available to all local industry participants.
Agglomeration Economies (Industry Clusters)
– Definition: An agglomeration economy occurs when firms in the same or complementary industries locate close together and gain mutual benefits—lower search/transaction costs, knowledge spillovers, and shared infrastructure.
– Examples of benefits: A specialized labor market (actors, camera crews near film studios); dense supplier bases (chip fabs near component suppliers); shared R&D partnerships with nearby universities.
– Synergy across industries: Sometimes different industries clustering together (financial services + law firms + consulting) generate cross-sector advantages.
Pros and Cons of External Economies of Scale
Pros (advantages)
– Lower average production costs across the industry.
– Faster diffusion of innovation and best practices.
– Easier access to specialized labor and suppliers.
– Improved market access (trade shows, distribution).
– Creation of local industry reputation and brand (which attracts more firms and talent).
Cons (disadvantages / external diseconomies)
– Congestion: traffic, overloaded infrastructure, longer lead times.
– Higher local input costs: land and wages can rise, eroding cost advantages.
– Environmental externalities: pollution, resource depletion.
– Reduced competition and potential for collusion if an area becomes dominated by a few large players.
– Geographic vulnerability: localized shocks (natural disasters, regulatory changes) can disrupt entire industry clusters.
Real-Life Example: Route 128 and Silicon Valley
– Route 128 (Greater Boston area, 1960s–1990s): A technology cluster that benefited from proximity to universities, defense contracts, and venture capital.
– Silicon Valley (San Francisco Bay Area): Later eclipsed Route 128 as external economies (venture capital networks, specialized suppliers, entrepreneurial culture) scaled faster, creating a superior ecosystem for startups and tech firms. These regional examples show how clusters can create self-reinforcing advantages.
What Is the Difference Between External and Internal Economies of Scale?
– Internal: Cost savings from growth within a single firm (bulk purchasing, specialized machinery, managerial efficiencies).
– External: Cost savings enjoyed by all firms in an industry because of industry-wide growth or clustering.
Both lower average costs, but they operate at different levels (firm vs. industry/region).
What Are Economies of Scale Internationally?
– International economies of scale appear when industry growth crosses borders—e.g., expanded international air travel creates more routes and reduces per-passenger costs, benefiting consumers and airlines across markets.
– Global value chains: As production/distribution networks expand internationally, firms can source specialized inputs from lower-cost locations, leading to industry-scale cost reductions and wider market access.
– Note: International scale economies depend on trade policies, transport costs, regulatory alignment, and cross-border coordination.
How Do You Achieve External Economies of Scale? Practical Steps
Achieving external economies typically requires coordination among firms, industry groups, and public authorities. Below are concrete, practical steps organized by actor.
For policymakers (municipal, regional, national)
– Invest in targeted infrastructure: improve roads, ports, broadband, public transit that serve industry clusters.
– Support workforce development: subsidize vocational programs, partner with universities to align curricula with industry needs, fund apprenticeships.
– Create innovation hubs and incubators: provide physical space, shared labs, and networking programs to foster knowledge spillovers.
– Use smart incentives: targeted tax credits, matching grants for R&D, or cluster-specific subsidies—time-limited and conditional to avoid deadweight loss.
– Improve regulatory efficiency: streamline permits and zoning for industry-relevant uses (e.g., factories, data centers).
– Preserve competition and resilience: enforce antitrust rules and encourage diversification to reduce vulnerability to industry shocks.
– Environmental and social controls: plan for pollution controls, housing policies, and transport demand management to mitigate diseconomies.
For industry associations and clusters
– Map the value chain: identify critical suppliers, skill gaps, and common infrastructure needs.
– Facilitate shared services: create common logistics hubs, testing facilities, or training centers to lower duplicated costs.
– Organize trade shows and supplier fairs: reduce search costs and match buyers with suppliers.
– Standardize technical norms and certifications: lower transaction costs and speed up supplier onboarding.
– Aggregate demand for inputs: joint procurement can secure lower prices or better service terms.
For individual firms
– Locate strategically: move or expand near existing clusters when supply, talent, or services lower your costs.
– Collaborate locally: share training programs, kiln/lab time, or transport with non-competitor firms.
– Invest in local partnerships: sponsor university chairs, engage in joint R&D, or participate in industry consortia to benefit from knowledge spillovers.
– Focus on specialization: develop core competencies that complement nearby firms rather than duplicate services.
– Monitor risks: diversify suppliers and markets to avoid overexposure to local shocks.
Measuring and Monitoring External Economies
– Track industry metrics over time: average cost per unit, labor productivity (output per worker), number of firms, supplier density, patent filings, and average wages/rents.
– Use surveys and mapping: quantify supplier networks, skills availability, and infrastructure capacity.
– Monitor early warning signs: rising vacancy rates, substantial rent increases, or declining productivity that signal emerging diseconomies.
Balancing Benefits and Risks: Policies to Limit Diseconomies
– Invest in scalable infrastructure before congestion becomes severe.
– Implement zoning and housing policies to prevent runaway rent inflation that displaces workers.
– Design incentives with sunset clauses and performance conditions.
– Encourage industry diversification to reduce systemic risk.
– Adopt environmental regulations and monitoring to limit pollution and resource strain.
The Bottom Line
External economies of scale reduce average costs for an entire industry as it grows or clusters geographically. They are powerful drivers of regional competitiveness and innovation—illustrated by technology clusters such as Route 128 and Silicon Valley—but they are not automatic or unambiguously positive. To capture and sustain the benefits, coordinated action is required by firms, industry bodies, and public authorities: targeted infrastructure and education, shared services, smart incentives, and policies to guard against congestion, inequality, and environmental damage. Properly managed, external economies can produce wide-ranging gains for firms, workers, and local economies.
Source
Primary source: Investopedia — “External Economies of Scale” (https://www.investopedia.com/terms/e/externaleconomiesofscale.asp).