External diseconomies of scale are diseconomies of scale that occur within the industry (outside the firm) and are largely beyond an individual firm’s control.
Problems that affect the whole industry often happen because there are just too many firms in the same market.
1. Scarcity of land
Very high demand for businesses to locate their headquarters in central city districts such as Midtown Manhattan in New York City, Gangnam District in Seoul, The City in London, Shibuya in Tokyo, Lujiazui in Shanghai or Central Business District (CBD) in Beijing has resulted in a continuous rise in the price of land parcels in these prime locations.
2. Increasing rents
Too many businesses wishing to locate their offices or factories in a certain area can cause available rental inventory to become scarcer, thereby increasing rent prices. Higher rent adds to the Fixed Costs of all businesses in the area without any corresponding increase in output causing unit costs to rise.
Example 1: Beijing and Shanghai have been transforming themselves into regional and international financial centers with the aggressive expansion of their business districts since 2010. Even though supply of office space had an average of 1 million m2 per year between 2013 and 2020, rents have surged in China’s largest cities in recent years due to the constant supply deficiency of office space.
3. Transportation problems
Traffic congestion results from too many businesses operating in the same area. And congestion increases business costs whilst reducing revenues. Employees who are late to work due to poor transportation links will cost the business lost sales. Deliveries to customers are likely to be delayed due to overcrowding, therefore customers will choose to buy from other businesses located more conveniently closer to their homes. Increases in transportation costs caused by higher usage of gasoline will contribute to an increase in unit costs of production.
Example 2: India’s biggest cities may be losing billions annually to traffic congestion as traffic jams in just four Indian cities cost USD$22 billion per year. On average, travelers in Delhi, Mumbai, Bengaluru, and Kolkata spend 1.5 hours more on their daily commutes than their counterparts in other Asian cities.
4. Higher recruitment costs
Since workers have greater choice from a large number of employers being located in the local area, it may take much longer for companies to sign new employees. Many of the job seekers may delay signing their labor contracts trying to negotiate a better deal putting one company to bet against the other.
5. Higher wages
Due to higher demand for quality workers, businesses might be forced to offer increased wages and financial rewards to retain the best workers, or to attract new staff. This will increase labor costs without necessarily increasing output anyhow, thereby raising average costs of production.
Example 3: In Silicon Valley, California, which includes around 3 million people, workers make an average annual salary of approximately USD$150,000. While the median wage for all workers in the United States is around USD$50,000 per year.
Because external economies of scale come from outside of the business, and are not under the business’s direct control, those average costs of production increase for all businesses in the industry. And higher costs of production lead to less profit, or even a loss, for all market players, causing the country’s industry to become less competitive internationally.
