External Economies of Scale: Economies Gained From Industry-Wide Growth

External Economies of Scale refer to the cost advantages that arise for all firms in an industry when the industry's output expands, resulting in reduced average total costs.

External Economies of Scale refer to the cost advantages that accrue to all firms within an industry due to the industry’s overall expansion. Unlike internal economies of scale, where individual firms’ costs decrease with increased production, external economies emerge when the collective growth of the industry leads to reduced costs across the board.

Historical Context

The concept of external economies of scale has roots in the early 20th century, as economists explored how industries develop and how collective activities could lead to cost savings. The seminal work by economist Alfred Marshall introduced this phenomenon, explaining how localized industry expansion could reduce costs for all firms involved.

Categories and Types

External economies of scale can be categorized into:

1. Pecuniary Economies: Cost savings achieved through changes in the prices of inputs.
2. Technological Economies: Improvements in technology available to all firms.
3. Agglomeration Economies: Cost benefits from spatial concentration of industries.

Key Events and Examples

• Silicon Valley: The growth of Silicon Valley in the United States is a prime example. The concentration of tech companies has led to reduced costs for all firms in the area due to better infrastructure, skilled labor pool, and innovation spillovers.
• Automobile Industry: The automotive cluster in Detroit witnessed similar external economies during its heyday, leading to reduced costs for all manufacturers involved.

Detailed Explanation

External economies of scale occur through several mechanisms:

1. Input Prices Reduction: As the industry grows, suppliers of inputs achieve economies of scale, reducing the cost of inputs for all firms.
2. Technological Advances: Industry-wide technological improvements reduce costs.
3. Shared Services: Firms benefit from shared services like research institutions, skilled labor, and infrastructure.

Mathematical Models and Charts

Economists use the long-run industry supply curve to illustrate external economies of scale, often depicted as downward sloping due to reduced costs:

    graph TD
	A[Industry Output Increase] --> B[Input Price Reduction]
	A --> C[Technology Improvement]
	A --> D[Shared Services]
	B --> E[Reduced Average Costs]
	C --> E
	D --> E
	E --> F[Downward Sloping Long-Run Supply Curve]

Importance and Applicability

• Economic Growth: External economies of scale are crucial for understanding regional economic growth and development.
• Policy Making: Helps policymakers design strategies to foster industry clusters.
• Business Strategy: Informs companies’ decisions on location and expansion.

Considerations

• Dependency: Firms’ cost advantages are dependent on industry-wide expansion, making them vulnerable to industry downturns.
• Negative Externalities: Over-concentration can lead to congestion and increased competition for resources.

Related Terms

• Internal Economies of Scale: Cost reductions due to increased production by individual firms.
• Economies of Scope: Cost advantages due to the diversity of products.
• Agglomeration Economies: Cost savings due to geographic concentration of firms.

Comparisons

• Internal vs. External: Internal economies benefit individual firms’ scale of operations, whereas external economies benefit all firms due to industry growth.

Interesting Facts

• Industry Clusters: Cities like Bangalore and San Francisco are renowned for their industry clusters providing significant external economies of scale.

Famous Quotes

“Efficiency is doing things right; effectiveness is doing the right things.” – Peter Drucker

Proverbs and Clichés

• “A rising tide lifts all boats.”
• “Strength in numbers.”

Jargon and Slang

• Cluster: A geographic concentration of interconnected companies and institutions.
• Spillover: Benefits accruing to firms beyond those directly involved.

FAQs

How do external economies of scale affect small firms?

Small firms can benefit significantly from industry-wide growth as input prices and shared resources become more affordable.

Can external economies of scale be a disadvantage?

Yes, over-dependence on industry growth can be risky if the industry faces a downturn.

References

1. Marshall, A. (1920). Principles of Economics. London: Macmillan.
2. Krugman, P. (1991). Geography and Trade. MIT Press.

Summary

External economies of scale play a pivotal role in reducing costs industry-wide as the collective output of the industry expands. This concept not only aids firms in achieving cost efficiency but also provides valuable insights for economic development and policy-making. Understanding the dynamics of these economies helps businesses make strategic decisions regarding location, expansion, and innovation.