Companies in the same industry often cluster together because of the prospect of external economies of scale. It is easier for a firm to find suppliers, transportation infrastructure, and workers when it is well established in a region. In the industry, new firms would like to benefit from existing infrastructure by settling nearby.
External economies of scale: what are they?
For an individual firm to benefit from external economies of scale, factors beyond its control must occur within its industry. By imposing higher tariffs on the import of a certain good, the government reduces competition for domestic firms that produce the good.
Firms’ average cost of production (AC) decreases as their output levels increase. Economizing on scale is the process of reducing costs by increasing production levels.
- Economic benefits are gained by an individual firm as a result of external factors that are beyond their control inside an industry.
- Companies in the same industry often cluster together because of external economies of scale.
- The formation of economies of agglomeration is often caused by external economies of scale and cluster industries. An arrangement in which mutually beneficial firms from different industries are based close to one another.
A comparison of internal and external economies of scale
In contrast to external economies of scale, internal economies of scale are influenced by factors that are unique to each company. There will be no impact on other firms in the industry if a firm develops a production technique that reduces time and cost for itself.
The formation of economies of agglomeration is often facilitated by external economies of scale and cluster industries. Various industries are grouped together to form mutually beneficial companies.
With such an arrangement, all firms, irrespective of industry, can benefit from external economies of scale. There is often a close connection between food processing industries and agricultural fields, reducing transportation costs for both.
Economies of scale derived from external sources
One or more of the following factors contribute to external economies of scale:
1. The concentration economies
The infrastructure and supply networks of firms within the same industry can be utilized when they cluster together. Additionally, skilled workers tend to move close to such clusters for work, making labor convenient for firms.
2. Information economies
The prices of inputs can be perfectly known when several companies are located near one another. Suppliers cannot charge different prices to different firms for inputs since all firms buy them from the same sources. Eliminating discriminatory pricing allows firms to pay a lower average input price, and it also prevents firms from paying a higher input cost.
3. Innovation economies
In order to develop efficient production methods, many firms prefer to locate near research centers. The centers will then be able to create innovations that will improve the efficiency of production and, therefore, lower the cost of the firms.
4. Breaks from taxes
An industry’s cost of production decreases when the government of a country offers tax concessions or subsidies on the production of certain products. Economies of scale can also be found externally.
Assume that an X is a new firm whose premises can be set up independently or in clusters. Material costs, labor costs, and transport costs make up production costs.
Since facilities for each input are already available in the cluster region, the cost of each input is lower. Here is the breakdown of costs (all figures are in dollars) for producing 1,000 units:
When Firm X establishes its offices near the cluster, it can reduce its average production costs by $11.
External economies of scale: advantages and disadvantages
A positive externality is an economy of scale that provides a firm with the following benefits:
1. Benefits that are equitable
External economies of scale benefit all firms in an industry equally.
2. Infrastructural growth
The growth of supporting industries, such as industries that provide raw materials and equipment, as well as transportation services, is enabled by external economies of scale.
External economies of scale, however, have certain drawbacks, which include:
Such advantages are a result of factors beyond a firm’s control. The benefits are therefore available equally to all firms, so no firm can gain a competitive advantage.
2. Restricted locations
Economies of scale and cluster industries commonly foster mutually beneficial relationships. Firms may be unable to relocate away from the cluster if it restricts their move.