# External Economies of Scale: Definition and Examples

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## What Are External Economies of Scale?

In economics, [economies of scale](https://www.investopedia.com/insights/what-are-economies-of-scale/) dictate that the more units a business produces, the less it costs to produce each unit.

External economies of scale describe the same phenomenon, except as applied to an entire industry rather than within a single company. For example, if a city creates a better transportation network to service a particular industry, then all companies in that industry will benefit from the new transportation network and experience decreased production costs.

### Key Takeaways

*   External economies of scale are business-enhancing factors that occur outside a company but within the same industry.
*   In addition to lower production and operating costs, external economies of scale may also reduce a company's variable costs per unit because of operational efficiencies and synergies.
*   On the downside, external economies of scale could dull the competitive edge of a company, as it cannot exclude its competitors from benefiting.

As an industry grows larger or becomes clustered in one location—as with, say, the banking and financial services in New York or London—than the average costs of doing business within that industry over the long run become lower. This is an example of external economies of scale.

With external economies of scale, costs also may fall because of increased specialization, better training of workers, faster innovation, or shared supplier relationships. These factors are typically referred to as positive [externalities](https://www.investopedia.com/terms/e/externality.asp); industry-level negative externalities are called external [diseconomies](https://www.investopedia.com/ask/answers/060115/what-difference-between-external-economies-and-external-diseconomies.asp).

## The Basics of External Economies of Scale

Businesses in the same industry tend to cluster in together. For example, a film studio might determine that California is a particularly good location for year-round film-making, so it moves to Hollywood. New movie producers also move to Hollywood because there are more camera operators, actors, costume designers, and screenwriters in the area. Then, more studios might decide to move to Hollywood to take advantage of the specialized labor and infrastructure already in place, thanks to the success of the first firm.

As more and more firms succeed in the same area, new industry entrants can take advantage of even more localized benefits. It makes sense for industries to concentrate in areas where they are already strong.

> **Fast Fact**
>
> An agglomeration economy, or synergy, is when businesses in different industries are beneficial to each other and can share resources and opportunities.

## Agglomeration Economy

If two or more separate industries are incidentally beneficial to one another, there can be external economies of scale across the entire group. This phenomenon is sometimes called an "agglomeration economy," in which businesses are located close to one another and can share resources and efficiencies. It is similar to the business governance concept of [synergy](https://www.investopedia.com/terms/s/synergy.asp).

Scale economies that occur outside of a company, but from which all companies in an industry benefit could include the following:

*   New production methods
*   Transportation modes
*   Government tax breaks
*   Increased tariffs against a foreign competitor
*   New off-label use of a prescription drug or other product

## Pros and Cons of External Economies of Scale

External economies of scale have several advantages. They include:

*   **Egalitarian**: All of the businesses in an industry enjoy these economies of scale equally.
*   **Growth**: External economies of scale can drive industry growth in particular regions and can also encourage the rapid economic development of support industries and the entire city or geographic area in general.
*   **Lower costs**: In addition to lower production and operating costs, economies of scale may also reduce [variable costs](https://www.investopedia.com/terms/v/variablecost.asp) per unit because of [operational efficiencies](https://www.investopedia.com/terms/o/operationalefficiency.asp) and synergies.

But external economies of scale are not without drawbacks. Disadvantages include:

*   **Lack of control**: Individual firms have no direct control over what happens externally. In particular, this means that a company would not have a [competitive edge](https://www.investopedia.com/terms/c/competitive_advantage.asp), as it cannot exclude its competitors from benefiting from an external economy of scale.
*   **Limited locations**: External economies of scale may develop so strongly in one geographic region that it becomes difficult for companies in a certain industry to locate anywhere else.
*   **Company instability**: A business might not be able to exploit existing external economies because of its internal shortcomings, such as poor management, or other circumstances.

## Real-Life Example of External Economies of Scale

From the late 1960s to the early 1990s, the arguable epicenter of the U.S. high-tech sector was a region just outside of Boston. It was known as Route 128, named for the freeway that ringed the city, and around which a cluster of technology companies grew—including those in the burgeoning computer business.

A variety of factors enticed entrepreneurs there, including proximity to corporations and educational institutions with their research centers and talent, financial services and venture capital firms, and military bases. The more businesses that came, the more external economies of scale developed, making it easier for more ventures to find facilities, skilled labor, suppliers, sub-contractors, and support services—and to markets themselves, staging conventions and conferences.

Interestingly, toward the end of the 20th century, Route 128 was eclipsed as the center of the high-tech industry by Silicon Valley in the San Francisco Bay Area, where the external economies of the scale grew bigger and faster.

## What Is the Difference Between External and Internal Economies of Scale?

Internal and external economies of scale both refer to downward pressure on production costs. The central difference between the two concepts is that internal economies of scale are specific to a single company, whereas external economies of scale apply across an industry.

## What Are Economies of Scale Internationally?

Just as economies of scale can exist on a municpal, state, or national level, they can also manifest on an international level. Consider the rise of air travel. As more consumer choose to fly internationally, demand spurs the creation of new routes and more flight options. This may open up new revenue paths for airlines. Simulataneously, increased competition among airlines to meet consumer demand may push down costs for certain itineraries. As such, both consumers and firms in multiple markets across the globe may benefit from economies of scale.

## How Do You Achieve External Economies of Scale?

External economies of scale can be achieved a number of different ways. Technological advancements may drive down production costs for an entire industry, as can government support in the form of infrastructure investments or tax subsidies.

## The Bottom Line

External economies of scale refer to the phenomenon in which production costs fall for all firms in a certain sector. This is different from economies of scale as the idea is commonly understood, in which production costs decline for a single company. External economies of scale can encourage widespread and egalitarian economic growth, but they can also be geographically limited and dull competition among firms.