What are External Economies of Scale?
External economies of scale are a phenomenon where the growth of an entire industry leads to lower long-run average costs for all firms operating within that industry. This happens because as more firms enter an industry or as existing firms expand, certain efficiencies and cost reductions become available to all participants.
For instance, consider Silicon Valley in the tech industry. The concentration of tech companies in this region has created a hub where suppliers, skilled workers, and innovative culture are readily available. This setup reduces costs for individual tech firms because they can tap into these shared resources more efficiently than if they were operating in isolation.
Similarly, Hollywood is a prime example for the film industry. The presence of numerous film studios, skilled professionals, and financing options makes it easier and cheaper for any film production company to operate there compared to other locations.
Factors Contributing to External Economies of Scale
Several factors contribute to the emergence and sustenance of external economies of scale.
Cluster Effect
When firms locate in the same area, it creates what is known as the cluster effect. This clustering leads to efficiencies for suppliers and transport links. For example, if multiple tech companies are located in Silicon Valley, suppliers of components and services can set up shop nearby, reducing transportation costs and delivery times for all firms in the cluster.
Skilled Labour
The concentration of similar firms in a region attracts skilled workers who are drawn by job opportunities and career growth prospects. This reduces recruitment costs for individual firms because they can tap into a local talent pool rather than having to search nationally or internationally.
Transport Links
The development of better transport infrastructure is another significant factor. As industries grow in specific regions, there is often an investment in improving roads, airports, and other transportation systems. This benefits all firms in the industry by reducing logistics costs and improving supply chain efficiency.
Supportive Legislation
Growing industries can also gain political bargaining power, leading to favorable legislation such as subsidies, tax breaks, or tariffs that benefit all firms within the industry. For instance, governments may offer incentives to attract more businesses to a particular region or sector.
Implications of External Economies of Scale
The implications of external economies of scale are far-reaching and significant.
Industry Growth
By reducing average costs through shared efficiencies, external economies of scale drive industry growth. Firms can expand their operations more efficiently and invest in innovation without being burdened by high overhead costs. This collective growth fosters a competitive environment where firms can innovate and expand rapidly.
Regional Specialization
These economies also lead to regional specialization, where countries or regions focus on specific industries due to historical and scale-related advantages. For example, Switzerland is known for its watchmaking industry due to centuries of expertise and infrastructure development.
Urban Growth
External economies of scale can contribute to the rapid growth of cities as industries concentrate in specific areas. Cities like San Francisco (thanks to Silicon Valley) or Los Angeles (due to Hollywood) have seen significant urban growth driven by the concentration of industries.
Comparative Analysis with Internal Economies of Scale
It’s important to distinguish between internal and external economies of scale.
Internal vs. External
Internal economies of scale are firm-specific and arise from a company’s own expansion. These could include benefits like bulk purchasing discounts or spreading fixed costs over larger output volumes. In contrast, external economies of scale benefit the entire industry rather than just individual firms.
Competitive Advantage
While internal economies offer greater competitive advantages since they are unique to each firm, external economies are shared among competitors. However, this shared benefit can still provide a significant edge over industries that do not enjoy such external efficiencies.
Examples of Industries Benefiting from External Economies of Scale
Several industries have significantly benefited from external economies of scale.
Silicon Valley
Silicon Valley’s tech industry is a quintessential example. The region offers access to skilled workers, capital, and a culture of innovation that fosters rapid development and cost savings for tech firms operating there.
Hollywood
The film industry in Hollywood benefits from access to skilled professionals, studios, and financing options that make film production more efficient and cost-effective compared to other locations.
London’s Financial District
London’s financial sector enjoys a skilled workforce, access to capital, and favorable regulatory environments that make it an attractive hub for financial services companies.
Additional Considerations: External Diseconomies of Scale
While external economies of scale bring numerous benefits, it’s also important to consider external diseconomies of scale.
Definition
External diseconomies occur when industry growth leads to negative externalities such as increased competition for resources or environmental degradation. These negative effects can result in rising costs for firms within the industry.
Examples
For example, traffic congestion in areas with high industry concentration can increase commuting times and logistics costs. Similarly, increased competition for resources such as water or land can drive up prices and reduce availability.
Understanding both the positive and negative aspects of industry growth helps in making informed decisions about how to manage and leverage external economies of scale effectively.
