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
- What causes external economies of scale?
- Advantages and disadvantages of external economies of scale
- Key takeaways:
- Connected Business Concepts to External Economies of Scale
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:
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.
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.
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.
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.
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.
- 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.
- Diseconomies Of Scale
- Network Effects
- Negative Network Effects
- Platform Business Model
- Amazon Business Model
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