External Economies of Scale

What are External Economies of Scale?

Talent, skill, management, education, and experience are not connected to a specific firm or external economies of scale and benefit all enterprises equally. 

Economies like these develop as a result of the industry’s overall growth. For example, as the sector grows, machinery and raw materials become more affordable for all businesses. 

There has been a discovery of new and improved production methods. There are more effective modes of communication and transportation. Additionally, accessible skilled labor and workshop facilities have seen growth.

There are established service industries, support industries, and research facilities. Introducing new businesses enables existing businesses to develop their systems and manufacture goods more affordably. 

For instance, if a business invests in transportation for a certain industry, the expenses for a business operating in that industry will go down.

When an industry as a whole expands, there are external economies of scale, which help businesses by lowering long-term average costs. External economies of scale are also advantageous external outcomes of industrial development.

In terms of economies of scale, bigger is better for businesses.

Economists describe the relationship between a company’s size and the cost of producing its goods. It increases as a company grows and becomes more established.

It generally costs more for smaller firms or enterprises that have a shorter lifespan to produce goods and products.

The Basics of External Economies of Scale

Economies of scale are the relationship between a company’s size (especially its manufacturing/production facilities) and its capacity to sell its goods and products at the lowest possible costs.

According to this theory, a corporation can more readily reduce the cost of producing its goods and products by increasing the output of the things it produces. 

Economists refer to cost savings following more robust and long-lasting production as economies of scale.

When studying this concept, there are two major considerations to keep in mind, and business executives who are concerned with sales and production costs would be well to pay attention:

1. The line defining economies of scale is unmistakable

For a company, economies of scale are at work when manufacturing costs start to decline and sales increase. 

Usually, only larger businesses with extensive networks of mass production lines can accomplish that.

2. In a discussion about line production and costs, the term “scale” is particularly applicable on both sides of the seller-buyer equation.

Typically, the cost of creating a certain product decreases when a company expands and produces more products. For example, consider a store that purchases large quantities from a soap producer. 

By purchasing the soap in bulk, that shop may typically anticipate saving money. Following a price cut, the merchant may offer the soap for less than rivals, attracting more customers and boosting revenues.

Reasons behind External Economies of Scale

We understand from this concept that when a particular industry expands, this phenomenon gives rise to external economies of scale. 

Organizations can reduce their costs of manufacturing a particular good or product by increasing the overall output of the same, and this technique is referred to as “economies of scale.”

1. Skilled Labor: Similar businesses setting up shops in a specific area will entice skilled labor to look for employment there. For instance, the area outside of San Francisco, known as Silicon Valley, has become a hub for IT-related businesses. This draws in talent-rich personnel. As a result, less money is needed from businesses to hire skilled labor.
2. Transport Links: Better transportation linkages for delivering the items to the market will emerge if mining concentrates in one place. Thus, if new businesses enter the market or established businesses grow, they can enjoy the existing infrastructure to cut costs.
3. Support Legislation: In the political sector, if an industry develops and becomes significant to a region, it may have more political popularity. Local politicians would work to get favorable terms for their local industry, such as subsidies or tariffs.
4. Cluster Effect: When businesses cluster together, it is easier for suppliers to reach a wider range of customers. For instance, if you establish a chemical company in an industrial area, there are already suppliers and transportation connections to handle the related components of the sector.

Models of Economies Of Scale

External economies of scale occur outside the organization, inside the sector. For example, the cost per unit depends on industry size. Hence average cost falls as industry size rises. 

A company operates under the premise of the scale of economies and diseconomies.

Internal economies of scale are those production efficiencies that arise within the company due to increased output or manufacturing scale. 

This theory focuses on a corporation’s size and breadth in production manufacturing. 

Companies have internal special processes, strategies, disciplines, and skills for producing items in large quantities (like Henry Ford and Ford Motor Co.). These are referred to as internal economic scale variables and are typically problems and demands that a business can influence. 

Illustrations of internal economies of scale:

• Managerial economies
• Developed by in-house manufacturing expertise, streamlined and/or increased product line efficiencies.
• Technical economies
• Commercial economies
• Discounts for purchasing the raw ingredients a company needs to make its products in bulk.
• Investments in technology help a business provide goods and services at a lower cost over time.

What are Economies of Scale?

Contrarily, external economies of scale refer to factors and situations external to the organization, generally outside of its control, and may impact economies of scale. 

These factors could include positive and negative regional or national economic trends, such as an increase in the gross domestic product and the high consumer demand resulting from it, which can encourage economies of scale. 

External economies of scale typically reduce manufacturing costs when sales rise in a corporate sector and a country’s economy grows.

They are the associated advantage that exists outside the business and within the same industry. It is connected to an expansion of the sector.

In this case, the cost per unit is determined by the industry’s scale rather than the company.

Types of external economies

Some of the types are:

• The industry-specific economic expansion increases customer demand and revenues.
• Skilled labor
• Faculty of workshop
• Tax breaks offered by the local, state, and federal governments are intended to keep businesses “stable” and cut their cost of doing business.
• Banking facility

A business that can offer its goods to customers at a reduced price will probably draw even more customers, giving it a clear price edge over its rivals.

Economists refer to this kind of price undercutting as creating a “moat” around the corporation taking advantage of this phenomenon. 

The issue for rivals in this situation is that they frequently lack the substantial financial resources necessary to maintain their competitiveness in a market where rivals have already attained economies of scale.

There is no comparison to the retail behemoth Walmart (WMT), founded in Arkansas, for a good example of this concept.

Walmart is the biggest general retailer in the US, with a market cap of $293 billion and sales of $503 billion.

The company’s economies of scale result from its exceptional ability to buy its goods in quantity, frequently at large reductions. 

Dealing with Walmart is helpful for vendors because its goods are seen by millions of customers every day all around the world. However, the cost of access is that for Walmart to maintain its good reputation, suppliers must accept low prices.

More on the Types of External Economies of Scale

The role of transportation and communication in external economies is in line with a better communication system provided for everyone by business concentration. All now have access to rail and road infrastructure, and transportation costs are coming down.

Skilled labor plays a vital role in this theory. For example, firms or companies concentrating in one area have more skilled laborers. Since the workers live nearby, the firms get more specific technical training.

Given specialization and generalization of skills, we can also look at the localization of industries in regards to splitting up some of the processes. The concentration of a particular type of firm gives rise to an economy. 

Research and development is the key factor for the success of an economy and an enterprise. If an enterprise or economy is not contributing enough to its R&D activities, it will be left behind in an era of globalization.

Banks have a primary aim to generate profits. And they open more branches in major cities for the sole purpose of maximizing profits, increasing the number of public deposits, and being able to provide credit to traders, businessmen, and industrialists.

Sources of External Economies of Scale 

This theory can be used for various organizational and commercial issues and at different levels, such as production, facility, or an entire company. 

The emergence of this concept is signaled by a decline in average costs as output rises. 

Some economies of scale have a physical or engineering foundation, such as the capital cost of manufacturing facilities and friction loss in transportation and industrial equipment.

The few sources of this concept are as follows:

1. Advantages of Concentration

A corporation enjoys this advantage as a result of its concentration. In addition, the organization’s economy is supported by a wide range of extra factors, such as excellent transit alternatives, skilled labor, etc.

Maintenance, communication, insurance, and special services are all things that the company may readily organize.

2. Economies of Information

A company needs ongoing information from the market, such as the price of the products, policies, and other services that the organization needs. When an industry offers these services to businesses, it creates enterprise economies.

3. Economies of specialization surrounding industries 

To boost specialization in a particular set of work, firms can have many workspaces, or the industry at large can have multiple firms in one place to do this. This will help reduce the costs of operation in addition to providing support.

4. Research and development initiatives

There could be an R&D division in the sector. By creating more effective procedures and methods, running such a department lowers expenses.

5. Taxation policy

When governments decide to reduce taxes on industries, the associated costs tend to fall.

Diseconomies of Scale

Diseconomies of scale is a concept used in economics to describe the tendency for average costs to rise in tandem with output. This is because the production process becomes less effective at a certain stage. 

It’s typical practice in a company to change operational procedures to accommodate increasing demand or output requirements.

These modifications can occasionally result in manufacturing cost savings, but scaling up can occasionally increase business costs. 

Diseconomies of scale occur when prices per unit rise in response to greater production levels.

Diseconomy of scale occurs when an organization expands its operations to create a greater number of items but does so at the expense of raising the cost of producing each product.

This phenomenon is the polar opposite of economies of scale, which occur when the cost of producing one unit falls as output rises.

Technical, organizational, and financial scale diseconomies are examples of internal scale diseconomies. Infrastructure scale diseconomies are examples of external scale diseconomies.

In other words, producing an extra production unit starts to cost more.

The external diseconomies of scale are the main factors limiting industrial growth. These issues develop as the sector grows due to the rise in individual factor costs.

If we look at it from an economics jargon perspective, when the average unit cost of anything supposedly starts to rise, it generally leads to diseconomies of scale.

Example of Diseconomies of Scale

Diseconomies of scale are the financial disadvantages that economic actors experience due to growing their organizational size or output, leading to higher production costs per unit of goods and services.

Suppose a cafe has 200 customers per day. It has employed ten people at $10/hr. This equates to $100/hr in costs. Let’s assume each employee serves 20 customers. 

The cafe suddenly sees a surge in demand, hence in the number of customers.

Suppose there are 300 customers per day now. The cafe responds to this by hiring five more employees to serve the new 100 customers. 

Now, however, the number of customers has increased, but the area or space of the cafe remains the same. 

Due to this, the employees make mistakes with the orders and make double orders.

This means that they can only serve 70 customers in real life. So the new workers can serve only 70 customers, about 14 each, which is far lower than the 20 being served before. 

These workers cost the cafe an extra $70, which is gotten by working out at the cost of $1 per customer. This is far less than the 200 customers served by ten employees at $100 or $0.5 per customer. 

Researched and authorized by Marazban Tavadia | LinkedIn

Reviewed and edited by Raghav Dharmarajan

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