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External economies of scale refer to economies of scale originating from outside the company, rather than by internal companies. It arises when the average cost for each company goes down as the industry’s output rises.
We can also call it as positive external benefits from the industry expansion. When the whole industry grows bigger, all companies get benefits from a lower long-run average cost.
External economies of scale are essential to promote sectoral growth in certain regions. It explains to us why many companies have production facilities that are close together in a particular industrial area.
Differences in internal and external economies of scale
Economies of scale occur when average cost declines as output increases. Two types of economies of scale, namely internal and external economies of scale. Internal economies of scale only apply to specific companies. Because it comes from internal, management has control over it.
Whereas, external economic scale, all companies in the same industry enjoy a reduction in average costs. Management has no control over the determining factors and impacts of economies of scale.
Sources of economies of scale
For an internal economic scale, companies reduce their unit costs from various ways, such as purchasing and marketing. When buying inputs in large quantities, companies often receive discounts. Discounts reduce input costs, hence the average production cost.
Another source of lower average production cost is from marketing economics. When selling more extra output, the company spreads the fixed costs of promotion over larger quantities.
The company also reduces average costs through labor division. More specialized workers, in combination with specialized technology, ultimately increase production volumes at lower average cost.
Meanwhile, external economies of scale occur outside the company. For example, when the government builds a transportation network in an industrial area, it will result in lower costs for companies in the area.
The next source of cost reduction is the agglomeration economy, where various identical companies are in the same location, such as Silicon Valley and Hollywood. Agglomeration attracts a variety of skilled workers to attend to those areas, allowing smaller recruitment costs and higher productivity. It also makes suppliers more efficient to meet a more extensive buyer base.
Negative side
External economies of scale might also be negative. It occurs outside the control of the company. Because all companies get the same benefits, it doesn’t make a company superior. The company cannot exclude competitors from benefiting.