What Are External Economies of Scale? External Economies of Scale In A Nutshell

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.

Understanding external economies of scale

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.

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. 

Main Free Guides:

Connected Business Concepts to External Economies of Scale

Economies of Scale

In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Network Effects

In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

Negative Network Effects

In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

Creative Destruction

Creative destruction was first described by Austrian economist Joseph Schumpeter in 1942, who suggested that capital was never stationary and constantly evolving. To describe this process, Schumpeter defined creative destruction as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Therefore, creative destruction is the replacing of long-standing practices or procedures with more innovative, disruptive practices in capitalist markets.

Happiness Economics

Happiness economics seeks to relate economic decisions to wider measures of individual welfare than traditional measures which focus on income and wealth. Happiness economics, therefore, is the formal study of the relationship between individual satisfaction, employment, and wealth.

Command Economy

In a command economy, the government controls the economy through various commands, laws, and national goals which are used to coordinate complex social and economic systems. In other words, a social or political hierarchy determines what is produced, how it is produced, and how it is distributed. Therefore, the command economy is one in which the government controls all major aspects of the economy and economic production.

Animal Spirits

The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage.  Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.

State Capitalism

State capitalism is an economic system where business and commercial activity is controlled by the state through state-owned enterprises. In a state capitalist environment, the government is the principal actor. It takes an active role in the formation, regulation, and subsidization of businesses to divert capital to state-appointed bureaucrats. In effect, the government uses capital to further its political ambitions or strengthen its leverage on the international stage.

Boom And Bust Cycle

The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.
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