Definition
External Economies of Scale refer to the cost benefits that an entire industry or sector can experience as it expands, not just a single company. This can be due to factors like increased specialization, technological advancements, network effects, or improved transportation and logistics. Essentially, it describes a decrease in costs per unit that arises from the growth of the industry as a whole.
Phonetic
The phonetics of “External Economies of Scale” would be: Ex-ter-nal: /ɛksˈtɝːnəl/Economies: /iˈkɑːnəmiz/of: /ʌv/ Scale: /skeɪl/
Key Takeaways
- Cost advantages: External economies of scale refer to the decrease in costs per unit that businesses experience due to an increase in the size of an entire industry, not just the company itself. They provide cost advantages to all companies within the industry.
- Industry growth: They are typically related to the growth and expansion of an industry. If the industry grows and expands, companies within it enjoy various economies such as access to better and more resources, better technology, and improved transportation or logistics.
- Dependence on external factors: Unlike internal economies of scale which a company can control, external economies of scale depend on external factors such as suppliers, infrastructure, government policies, or the availability of skilled workforce, over which single companies have little control. This can also lead to external diseconomies of scale if those factors turn unfavorable.
Importance
The concept of External Economies of Scale is important in business/finance because it relates to factors that lead to a decrease in a firm’s average costs as the entire industry expands. These factors are external to the firm but beneficial to its cost-effectiveness and competitiveness. They may include improved supply chain networks, knowledge spillovers, skill labor pools, infrastructural developments, and governmental or institutional support. By understanding external economies of scale, firms can strategically position themselves within certain industries or regions to take advantage of these shared benefits and increase their own efficiency and profitability. It also provides insights into industrial clustering and the importance of geographic location in a firm’s operational strategy.
Explanation
External Economies of Scale pertain to the benefits or competitive advantages that a company experiences as an overarching consequence of industry growth or expansion, rather than the result of a specific company’s individual efforts or outputs. These types of economies of scale come from external factors beyond the control of a single business, and are typically associated with geographic concentration or industry clustering. This is important as industries seek to maximize efficiency and profitability, by capitalizing on shared resources such as a skilled labor pool, logistics and transportation systems, or familiarity with a specific technology.
Large industries, particularly in market sectors like technology and manufacturing, can bring about significant cost reductions and grant companies within their sphere a critical competitive edge. For example, a business located in a region with robust technology-centered industries may benefit from a pre-existing skilled labor pool, technological infrastructure and ecosystem. Furthermore, companies can benefit because they can share the costs of overheads and access resources more easily. Thus, external economies of scale serve as a driving force and incentive for companies to strategically locate or partner within larger industry clusters or regions, which in the long run can lead to beneficial collaborations and overall industry growth.
Examples
1. Global Shipping Industry: A global shipping company like FedEx or DHL benefits from external economies of scale because as more businesses participate in global commerce, infrastructure like roads, airports, and seaports are improved and expanded to accommodate the increased activity. This reduces FedEx’s or DHL’s costs of shipping goods, as they can take advantage of this improved infrastructure without bearing the cost of these improvements themselves.
2. Tech Hubs & Silicon Valley: Many tech companies cluster around places like Silicon Valley primarily to take advantage of knowledge spill-overs. Having closely located talented engineers, innovators, and entrepreneurs leads to more idea exchanges and collaborations, resulting in reduced overall costs in creating new technology or services. Moreover, these businesses have access to a large pool of specialized workers, which can reduce recruitment and training costs.
3. Wineries in Napa Valley: This California region is known for its wineries. Each individual winery benefits from the region’s reputation and shared resources, such as tourism infrastructure, expertise in viticulture, and favorable climate conditions. As more wineries enter into this region, the cost per winery to maintain the shared resources decreases, thereby experiencing external economies of scale.
Frequently Asked Questions(FAQ)
What are External Economies of Scale in business?
External Economies of Scale occur when the cost per unit of output decreases due to the growth in the size of an entire industry, rather than due to the firm’s operations. These savings are external as they are beyond the control of a single firm.
What are some examples of External Economies of Scale?
Examples include improved infrastructure, accumulation of knowledge and skills within the industry, advancements in technology, and access to more suppliers and resources at cheaper costs.
How does technology contribute to External Economies of Scale?
When an industry grows, technological advancements often follow. This can lead to improved manufacturing processes, better software solutions, and other advancements that benefit every firm within that industry.
How does External Economies of Scale differ from Internal Economies of Scale?
While Internal Economies of Scale comes from the expansion of the company itself, External Economies of Scale is an advantage gained due to the growth of the industry as a whole.
How does External Economies of Scale contribute to industry growth?
It encourages growth by providing cost advantages which attracts more firms to the industry, increasing competition and innovation.
What are the drawbacks or limitations of External Economies of Scale?
If an industry contracts, firms may experience dis-economies of scale, the opposite effect where costs per unit increase. Also, not all firms in an industry may benefit equally due to variations in their operations and business strategies.
Can a firm control benefits gained from External Economies of Scale?
No, a single firm cannot control external economies as they occur outside of any one firm’s control, depending on factors related to the wider industry or economy.
How do External Economies of Scale impact pricing?
As costs per unit decrease due to external economies of scale, firms might be able to reduce their prices, stimulating demand and potentially leading to increased market share.
Related Finance Terms
- Decreasing Costs-per-Unit
- Growth of Industry
- Specialized Suppliers
- Regional Specialization
- Market Size
