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What are External Economies of Scale?

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  • Originally Written By: K.A. Francis
  • Revised By: C. Mitchell
  • Edited By: A. Joseph
  • Last Modified Date: 04 December 2016
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External economies of scale are events that happen in society that benefit certain corporations or industry sectors, but that these same corporations and sectors have basically no power to control. “Economies of scale” is a business term used most often in the study of economics, and it deals with business productivity and profitability as related to different fixed variables. Sometimes companies can control these variables; this is the case for things like production numbers and advertising placements. Other times, though, companies have little to no power to influence the changes. Examples include things that change in the local or regional economy: advances in transportation, for instance, or changes in the telecommunications landscape. These are generally known as external economies of scale. Companies can’t cause them, but in many cases they can anticipate them and leverage them in advantageous ways. Leaders usually need to capitalize on changed times and circumstances to keep up, and failure to adapt often leads to problems with competitiveness.

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Understanding Economies of Scale Generally

Economies of scale in a general sense occur any time businesses are able to lower their per-unit costs of producing goods or services by increasing production. When talking about a specific business or firm, the most relevant economies are usually internal. Internal economies of scale are things that change within the confines of the company at issue, and can often be controlled or at least influenced from the inside. External economies, by contrast, are almost always broader societal changes that directly impact how a company does business or reaches out to clients, but in these cases the companies themselves are more passive players. They need to adapt, but they can’t usually do much to change the progress being made elsewhere.

Role of Outside Market Forces

External scale issues can happen for a number of reasons, but they’re often related to things like industry growth generally or advancements in technology. They impact the ways in which consumers do business and interact with suppliers of goods and essential services. Companies can’t usually control these things, but they can usually anticipate them and almost always adapt because of them. The most successful companies are often ahead of these externalities and are able to benefit because of them. This usually takes a certain amount of flexibility and risk, though.

Automobile as an Example

At least in modern times, of the best examples of an external economy of scale with far-reaching results is the invention of the automobile. Before cars, trucks and tractor-trailers, goods were transported from one place to another by rail, which meant that industries that relied on shipped goods typically needed to be located near train depots. This influenced the cost of real estate and increased overhead and production costs. With the introduction of the automobile, companies could operate in any part of virtually any city, which lowered the transportation costs for goods over short distances. Suddenly it was cheaper to ship these sorts of local goods by car rather than by rail. The lowered transportation costs generally meant a lower cost for producing items.

Positive Aspects of Change

When an industry is expanding, companies within that industry often benefit from external economies of scale. For example, high-tech companies might benefit from factors that result from an expanding high-tech industry, such as a government improving communications networks or from colleges and universities producing more qualified workers to meet the demands of the industry. These companies also might capitalize on an expanding industry because the number of suppliers could increase, creating competition and lowering the suppliers' prices.

Consequences and Potential Drawbacks

Like most things, there are also some drawbacks. Companies that don’t quickly adapt often face being left behind and may not be able to remain competitive. There is something valuable about sticking to the “old ways” in certain sectors, but in others, keeping up with the times is crucial to continued success, both when it comes to relationships with customers and cost differentials.

These sorts of changes often mean lower prices and more convenience, which can advantage consumers. In some cases they can also lead to monopoly power and what’s known as “price fixing,” though, two practices widely accepted as negative for consumers and smaller competitors. Both are more likely to happen when big companies enter generally open market sectors and establish control over certain services or production lines. If the company is aggressive enough, it can become the sole dominant player, and as such can choke out smaller competitors and then regulate prices. Many countries have laws that prohibit these and other anticompetitive behaviors, but not all do — and not all are enforced, either.

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ysmina
Post 3

Economies of scale are good for businesses, but it's not always good for consumers.

Sometimes economies of scale lead to monopolies in industries. A monopoly is always bad for consumers because it drives prices up and consumers have less spending power. Businesses don't affect external economies of scale but they do know how to take advantage of them. Businesses locate themselves in a way that they can take advantage of economies of scale to monopolize that industry and push other businesses out.

fify
Post 2

@ZipLine-- That can happen and it's called diseconomies of scale because it's the exact opposite of economies of scale.

If we take the transportation example, if the transportation industry experiences problems and the price of shipping goods increase, this will also increase businesses' costs.

In both external economies and diseconomies of scale, businesses have no hand in the external factors that affect them. But their cost of production partly depends on these factors. This is why when foreign firms are looking to work in other countries, they consider these factors before they invest.

ZipLine
Post 1

What if external factors cause production costs to go up instead of lowering them? Are they considered external economies of scale as well?

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