What it means
Internal economies of scale come from a company growing larger, for example by buying materials in bulk. External economies come from outside the company, when a large industry in one area makes everyone's costs lower.
A classic example is a technology hub where many firms compete for the same pool of engineers, and training institutions respond by producing more of them. Several forces create these savings.
Specialist suppliers set up nearby because there are enough customers to justify it, and transport links and utilities improve. Knowledge spreads between firms as staff move jobs and meet at industry events, which helps all of them improve faster.
For a business, external economies are an important reason to choose a location. A new firm in an established cluster can hire trained staff, rent suitable premises and find suppliers in weeks, which might take years elsewhere.
This lowers the cost of starting and the cost of running. There is a limit.
As an industry keeps growing in one place, congestion, higher wages and rising property prices can push costs back up, which economists call external diseconomies of scale. The cluster that was cheap at first can become expensive.
Finance teams use the idea when they model location choices and long-term cost trends. If an industry is expected to grow in a region, unit costs may fall without any action by the firm, and forecasts can reflect it.
Treat such gains with caution, because they depend on the industry and not on your own control. In practice you cannot capture external economies by yourself, but you can position the company to benefit.
That may mean locating in a cluster, joining industry bodies or building relationships with the local supply base. The savings then show up in lower costs per unit as the industry matures.
In practice
Real-world examples.
Example
A film production company moves to a city with a large film industry. It finds editors, lighting crews and equipment hire firms all within a short drive. Pre-production time falls from ten weeks to six.
Example
A winemaker joins a region with hundreds of other vineyards. A shared bottling plant and a local agricultural college are already in place, so the winemaker avoids building its own. Costs per bottle fall by about 8%.
Example
A garment maker in a textile town benefits as dye suppliers, fabric traders and machine repairers cluster nearby. When one repair firm closes, there are others ready to step in. Downtime is short and cheap.
Formula
Calculation
Annual saving = (old unit cost - new unit cost) x annual volume
Suppose a firm making electronic components has a unit cost of $12.00. As the regional electronics industry grows, local suppliers cut delivery costs and skilled labour becomes easier to hire, lowering the unit cost by 15%. New unit cost = 12.00 x 0.85 = $10.20. With annual volume of 500,000 units, annual saving = (12.00 - 10.20) x 500,000 = 1.80 x 500,000 = $900,000.Case study
Seen in the real world.
Northgate Robotics is an illustrative, fictional company that moved its workshop to an industrial park where six other robotics firms were already based. Within two years the park attracted a specialist machining supplier and a university training scheme.
The finance team saw component costs fall by $2.00 per unit and recruitment costs by about a third. On annual output of 40,000 units, the unit saving alone was worth $80,000 a year.
In this fictional story, rents in the park rose by 25% as demand grew, and part of the benefit was lost to higher property costs. The lesson is that external economies are valuable but not permanent, and the trend should be reviewed every year. The CFO now includes a line in the annual plan that compares the savings from being in the cluster with the extra rent and wage costs of staying there. If the gap narrows for two years in a row, she will ask the board to consider a cheaper location nearby that can still use the same supplier network.
Watch out
Common mistakes.
- Confusing external economies of scale with the savings a single company gets from buying in bulk, which are internal.
- Assuming cluster benefits will continue indefinitely, when congestion and rising rents can reverse them.
- Counting these savings as the result of management effort, when they come from the wider industry.
Questions
People also ask.
What causes external economies of scale?
Typical causes are a pool of skilled labour, specialised suppliers, shared infrastructure and spread of knowledge between firms.
Can a small business benefit from external economies?
Yes, that is one of their main advantages, because the gains come from the industry and do not require the firm to be large.
What is the opposite of external economies of scale?
External diseconomies of scale, where industry growth raises costs through congestion, shortages or higher input prices.
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