What are 'External Economies Of Scale'?

External economies of scale imply that as the size of an industry grows larger or more clustered, the average costs of doing business within the industry fall. This may occur due to increased specialization or training of workers, faster innovation or shared supplier relationships. These factors are typically referred to as positive externalities; industry-level negative externalities are called external diseconomies.

BREAKING DOWN 'External Economies Of Scale'

External economies of scale also refer to how an industry might experience a downward-sloping supply curve, at least within a given range. Economies of scale, whether external or internal, refer to factors that drive down average production costs as output volume increases. However, there is a limit to the realizable economies of scale based on any given factor. This occurs whenever the added costs of complexity associated with a larger output volume exceed the benefits of greater scaling.

Industry-level Scaling

Unlike internal economies of scale, which occur at the firm level, an external economy of scale manifests at an industry-wide level. The key characteristic of external economies is that individual firms have no direct control over their development, which means they cannot exclude competitors from benefiting also. British economist Alfred Marshall is frequently credited with distinguishing between external and internal economies of scale.

There are many reasons such scaling may occur. For example, one firm might determine that California is a particularly good location for year-round film-making. More firms may then decide to move operations to California to take advantage of the specialized labor and infrastructure already in place thanks to the success of the first firm. As more and more firms succeed in the same area, new entrants can take advantage of even more localized benefits.

Businesses in the same industry tend to cluster in specific regions. For example, new movie producers to locate to Hollywood because there are more camera operators, actors and actresses, costume designers and screenwriters in the area. Successive firms can realize greater cost advantages in such areas.

Scaling Across Industries

If two or more separate industries are incidentally beneficial to one another, there can be external economies of scale across the entire group. This is sometimes called "agglomeration economies," and is similar to the business governance concept of synergy.

Concepts such as external economies of scale or agglomeration economies may help explain why growth does not spread evenly across a country or set of countries. These concepts might also explain why urban areas can grow fast enough to support larger populations. Major innovations, such as the automobile or the internet, result in wide-spread agglomeration benefits.

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