External economies of scale describe factors beyond the control of a company that are present in the same industry and that lead to cost benefits. These factors may be positive or negative industry or economic trends. External economies of scale, therefore, are business-enhancing factors occurring outside a company but within the same industry.
Aspect
Explanation
Definition
External Economies of Scale refer to cost advantages that result from the expansion of an entire industry or cluster of firms within a specific geographical area or market. Unlike internal economies of scale, which benefit individual firms as they grow, external economies of scale benefit multiple firms or participants in a particular industry or location. These cost advantages can manifest as improved infrastructure, a skilled labor pool, access to specialized suppliers, research and development facilities, or a supportive business ecosystem. External economies of scale enhance the competitiveness and efficiency of firms operating in proximity to each other and can stimulate economic growth within a region.
Key Concepts
– Geographical Concentration: External economies of scale are often associated with the geographic clustering of related firms or industries. – Shared Resources: Multiple firms benefit from shared resources, such as skilled labor, research facilities, or industry-specific infrastructure. – Collective Efficiency: These economies result from collective rather than individual efforts, contributing to overall industry efficiency. – Regional Growth: The presence of external economies can attract more firms, fostering regional economic growth. – Network Effects: A positive feedback loop occurs as more firms cluster in an area, leading to increasing benefits for all participants.
Characteristics
– Industry Clusters: External economies often emerge within industry clusters or business ecosystems, where firms in the same sector co-locate. – Cost Reduction: Firms experience cost reduction due to shared resources and efficiencies within the cluster. – Innovation Hubs: External economies can create innovation hubs, fostering collaboration and knowledge exchange. – Regional Development: Regions with strong external economies tend to attract investment and talent, driving economic development. – Positive Feedback Loop: The presence of external economies can attract more firms, reinforcing the benefits for all participants.
Implications
– Competitive Advantage: Firms located within regions with strong external economies gain a competitive advantage due to cost efficiencies and access to resources. – Innovation and Research: Clusters with external economies often become centers of innovation and research, attracting talent and investment. – Economic Growth: External economies can stimulate economic growth within specific regions, benefiting local communities and industries. – Talent Attraction: Regions with strong external economies tend to attract skilled workers, further enhancing competitiveness. – Network Effects: The positive feedback loop created by external economies can lead to continued growth and prosperity for participants.
Advantages
– Cost Efficiency: Firms benefit from cost efficiencies through shared resources and infrastructure. – Innovation: External economies foster innovation and knowledge sharing within industry clusters. – Competitive Cluster: Firms in regions with strong external economies enjoy a competitive advantage over those in less-developed areas. – Talent Magnet: Such regions attract a pool of skilled talent, enhancing workforce quality. – Economic Development: External economies contribute to regional economic growth and prosperity.
Drawbacks
– Dependency: Firms within regions with strong external economies may become overly dependent on shared resources, creating vulnerabilities. – Competition: Intense competition within clusters can lead to price wars and reduced profit margins. – Overcrowding: Overcrowding in popular clusters can strain resources and infrastructure. – Entry Barriers: New entrants may find it challenging to establish themselves in competitive clusters. – Resource Limitations: External economies may saturate, limiting further benefits.
Applications
– Silicon Valley: The technology hub of Silicon Valley in California is a classic example of external economies of scale. It features a concentration of tech firms, research institutions, venture capital, and a skilled workforce, fostering innovation and growth. – Automotive Clusters: Regions like Detroit, Michigan, and Stuttgart, Germany, have become automotive industry clusters with external economies that support research, development, and manufacturing. – Financial Districts: Financial districts in major cities benefit from external economies, with a concentration of financial institutions, expertise, and infrastructure. – Fashion Capitals: Cities like Milan and Paris are known as fashion capitals due to the presence of external economies supporting the fashion industry. – Medical Research Hubs: Cities with renowned medical research institutions attract biotech and pharmaceutical firms, benefiting from external economies.
Use Cases
– Tech Startups in San Francisco: Tech startups in San Francisco often locate in proximity to Silicon Valley to access the external economies of scale offered by the technology ecosystem. – Financial Services in London: Financial firms choose to operate in London’s financial district to leverage the external economies, including access to a skilled workforce and financial infrastructure. – Automotive Manufacturing in Stuttgart: Automakers and suppliers cluster in Stuttgart to benefit from shared research and development resources and specialized suppliers. – Biotech in Boston: The biotech industry in Boston thrives due to external economies of scale, including prestigious research institutions and a talent pool in the life sciences. – Fashion Designers in Milan: Fashion designers choose Milan as a base to access the external economies associated with the city’s fashion ecosystem, including skilled artisans and access to luxury materials.
When a government imposes higher import tariffs on passenger vehicles, for example, this reduces competition for domestic manufacturers. In response, the average cost of production decreases as the production output increases to take advantage of fewer imported vehicles.
In general, a company has external economies of scale if its size results in preferential treatment. Governments often reduce state taxes to attract companies large enough to provide the most jobs. Large companies in turn take advantage of partnerships with universities to reduce their research and development expenditure.
Smaller companies do not have the leverage to enjoy similar benefits, but they can sometimes band together by pooling their resources or locating themselves in the same geographic area.
What causes external economies of scale?
External economies of scale occur for the following reasons:
Cluster effect
Companies located in close proximity make it more efficient for suppliers to do business with a larger customer base. For example, artists, galleries, and restaurants may benefit from being located in the same city art district.
Price transparency
The cluster effect also reduces prices for each business. Since each is purchasing from the same supplier, the supplier cannot charge different prices to different businesses. Transparent pricing ensures no firm pays a higher amount for inputs, which reduces the average cost.
Transport links
When an iron ore company establishes a new venture in a region known for mining, it can take advantage of existing transport infrastructure and obtain lower average costs.
Supportive legislation
As noted in the previous section, governments can introduce subsidies or reduce tariffs for local industries that are politically or economically important. These incentives lead to a lower cost of doing business.
Skilled labor
American universities such as MIT and Harvard have better access to a stronger, smarter workforce. The same can also be said for Silicon Valley, where tech firms spend relatively less recruiting skilled labor.
Advantages and disadvantages of external economies of scale
External economies of scale are sometimes referred to as positive externalities because they result in a positive gain on both the private and societal levels.
Research and development conducted by one company increases the profit potential of similar companies while also benefitting society. For example, the initial investment in smartphone technology by Apple paved the way for subsequent profitable companies and has improved society through more accessible information.
Businesses that emphasize investment in education also create a smarter and more intelligent workforce. These workforces increases external economies of scale because it costs the business less money to train and develop them.
So what are the disadvantages?
For one, the factors responsible for external economies of scale are beyond the control of participating businesses. This means no business receives a competitive advantage and any obtained benefit may disappear at a moment’s notice. The domestic vehicle manufacturer may lose the benefits derived from increased import tariffs when a new government takes office and decides to abolish them.
Secondly, businesses within the same industry that cluster in the same region may find it difficult to move to a new location away from the cluster. That is, the benefits realized from clustering may be canceled out by the costs associated with expanding into new markets.
Examples
Silicon Valley, California, USA:
Industry: Technology
Description: Silicon Valley is a renowned technology hub located in the San Francisco Bay Area of California. It is home to numerous tech giants, startups, venture capital firms, research institutions, and skilled tech professionals.
Case Study: Google, one of the world’s leading technology companies, benefits from the external economies of scale present in Silicon Valley. By being headquartered in this tech hub, Google gains access to a dense network of talent, investors, potential partners, and cutting-edge research facilities. The concentration of tech companies in Silicon Valley fosters collaboration, innovation, and knowledge sharing across the industry. Google leverages these external economies to attract top talent, drive product development, and maintain its competitive edge in the global tech market.
Shenzhen, Guangdong Province, China:
Industry: Electronics Manufacturing
Description: Shenzhen is a major manufacturing and technology hub in southern China, known for its electronics industry, particularly smartphones and consumer electronics.
Case Study: Huawei Technologies, a leading global provider of telecommunications equipment and smartphones, benefits from the external economies of scale in Shenzhen. As one of many electronics manufacturers based in the city, Huawei leverages the dense network of suppliers, skilled workers, and specialized infrastructure available in Shenzhen. The clustering of electronics firms in Shenzhen creates a competitive ecosystem that drives innovation, cost efficiencies, and rapid product development. Huawei capitalizes on these external economies to streamline its supply chain, accelerate product launches, and expand its market share in the global telecommunications industry.
London, United Kingdom:
Industry: Financial Services
Description: London is a prominent global financial center, hosting a concentration of banks, investment firms, hedge funds, and financial institutions in its financial district, known as the City of London.
Case Study: Barclays PLC, a multinational banking and financial services company, benefits from the external economies of scale present in London’s financial district. By maintaining its headquarters and operations in the City of London, Barclays gains access to a deep pool of financial talent, capital markets, regulatory expertise, and institutional infrastructure. The clustering of financial firms in London fosters collaboration, deal flow, and market liquidity, enhancing Barclays’ competitiveness in the global financial industry. Barclays leverages these external economies to offer a wide range of financial products and services, attract investment capital, and sustain its position as a leading player in the banking sector.
Milan, Italy:
Industry: Fashion and Design
Description: Milan is renowned as one of the world’s fashion capitals, known for its luxury fashion brands, haute couture houses, fashion events, and design heritage.
Case Study: Prada Group, a global fashion powerhouse, benefits from the external economies of scale present in Milan’s fashion ecosystem. By being headquartered in Milan, Prada gains access to a vibrant community of fashion designers, artisans, suppliers, and trendsetters. The clustering of fashion houses and luxury brands in Milan creates a dynamic environment for creativity, craftsmanship, and brand prestige. Prada leverages these external economies to innovate in design, production, and marketing, setting trends, and maintaining its status as a leading luxury fashion brand worldwide.
Boston, Massachusetts, USA:
Industry: Biotechnology and Life Sciences
Description: Boston is a prominent biotech hub, home to world-class research institutions, biopharmaceutical companies, startups, and life sciences talent.
Case Study: Biogen Inc., a biotechnology company specializing in neuroscience therapies, benefits from the external economies of scale present in Boston’s biotech cluster. By operating within the city’s vibrant biotech ecosystem, Biogen gains access to cutting-edge research, clinical trials expertise, venture capital funding, and collaborative partnerships. The concentration of biotech firms and research institutions in Boston creates a fertile ground for innovation, drug discovery, and scientific advancements. Biogen leverages these external economies to develop breakthrough treatments, accelerate drug development pipelines, and address unmet medical needs in neurological diseases.
Key takeaways:
External economies of scale are business-enhancing factors occurring outside a company but within the same industry.
External economies of scale occur for several reasons, including the cluster effect, price transparency, transport links, supportive legislation, and a skilled workforce.
External economies of scale can result in positive gains for both the business and society as a whole. Having said that, realized benefits are beyond the control of the receiving entity and may be withdrawn at any time. Businesses who enjoy the benefits of the cluster effect may also find those benefits negated by an ability to expand.
Key Highlights
Definition: External economies of scale refer to factors occurring outside a company but within the same industry that lead to cost benefits. These factors can be positive or negative industry or economic trends.
Causes of External Economies of Scale:
Cluster Effect: Proximity of companies in a particular industry enhances efficiency and reduces costs.
Price Transparency: Cluster effect reduces prices as the same supplier charges consistent prices to all businesses.
Transport Links: Companies benefit from existing infrastructure in a specific region.
Supportive Legislation: Governments provide subsidies or tariff reductions for local industries.
Skilled Labor: Concentration of skilled workers in certain regions benefits businesses.
Advantages and Disadvantages:
Advantages: External economies of scale lead to positive externalities, benefiting both individual businesses and society. Investments in R&D and education create smarter workforces and improve overall industry and society.
Disadvantages: Factors contributing to external economies of scale are beyond a business’s control, making benefits uncertain and subject to change. Companies clustered in specific regions might find it challenging to expand to new markets due to costs.
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An economy of scope means that the production of one good reduces the cost of producing some other related good. This means the unit cost to produce a product will decline as the variety of manufactured products increases. Importantly, the manufactured products must be related in some way.
Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
