External Economies of Scale

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

1. 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.
2. 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.
3. 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)

Related Finance Terms

• Decreasing Costs-per-Unit
• Growth of Industry
• Specialized Suppliers
• Regional Specialization
• Market Size

Sources for More Information

• • Investopedia
  • Corporate Finance Institute
  • Indeed
  • WallStreetPrep