Economies of scale that occur within the industry and are largely beyond an individual firm’s control are known as external economies of scale.
External economies of scale occur when cost per unit of output depends on the size of the industry. These are cost-saving benefits of large-scale operations arising from outside the business.
1. Country’s technological progress
Advancements in technology increase the productivity within the whole industry. With better, faster and more precise machinery, companies can produce goods and provide services faster, or produce many more goods and provide more services within the same period of time. Technological progress also makes it easier and faster for managers to reach final customers.
Example 1: The invention and widespread application of the Internet and computers has created cost savings opportunities for many retail businesses engaged in E-commerce, trading on the Internet. To run an E-commerce store using online platforms such as Alibaba, eBay or Amazon versus a physical store translates into lowering Fixed Costs (FC) which then translates into lower prices for final consumers.
2. General growth of the industry
The countries with large industries will have low costs of producing goods or providing services in those industries. It is because industry growth will allow businesses to access specialist or low-cost suppliers. In large industries, the large number of suppliers competes with one another bringing down the cost of purchasing supplies.
Example 2: With the development of renewable energy industry in recent years, the cost of replacing a battery in an electric vehicle is going down. A good example is Nissan Leaf, which is a battery electric vehicle. At the moment, it costs USD$5,500 to replace its battery. In 2017, the cost of replacing the Chevy Bolt’s battery stood at a whopping USD$15,000.
3. Improved transportation networks
Having developed industry infrastructure already in place such as railways, highways and airports will support business growth in many areas.
Improved transportation networks help to ensure prompt deliveries of raw materials to companies and final products to customers.
With reliable means of transportation workers will arrive to work on time therefore eliminate wasting valuable time.
More efficient packaging with bigger containers (e.g. trains and ships) reduces transportation costs per product. Therefore, transporting larger quantities leads to lower average costs.
Example 3: Shipping lines such as Maersk or COSCO strove over the last few decades to enlarge their shipping vessels. Container transportation benefits from economies of scale by increasing vessel capacity which creates advantage on the cost of transportation per TEU (a twenty-foot equivalent unit). Increased capacity per vessel reduced the cost per TEU.
4. Favorable location
In specific locations, there is a large concentration of businesses from the same industry. It promotes cooperation between those firms and the cost of acquiring new customers can then be lowered. With favorable choice of industrial location, it will be easier for the business to determine the optimum number and capacities of manufacturing plants, the sources of raw materials and the outlets for the final products.
5. Availability of skilled labor
An abundance of skilled labor might exist in the local area. This provides local businesses with a suitable pool of high-quality employees, thereby helping to reduce external recruitment costs without compromising productivity levels. Labor pooling happens when a large and concentrated industry attracts a pool of workers, hence reducing employee search and hiring costs.
6. Regional specialization
Regional specialization means that a particular location or country has a highly regarded and trustworthy reputation for producing a certain product. This allows the industry to benefit from easier access to specialist labor, sub-contractors and suppliers, thus helping to reduce average costs of production.
Example 4: Silicon Valley in California has a large concentration silicon chip companies, which are serviced by companies that make special machines for manufacturing silicon chips. These machines are cheaper and more easily available for Silicon Valley firms than for firms elsewhere.
7. Knowledge spillover
When a large and concentrated industry exists, workers from different firms may more easily share ideas, information and knowledge. This valuable knowledge transfer generates additional benefits for workers to solve problems faster, improve product quality or eliminate waste from the production process.
Example 5: Bordeaux in France is famous for its red wine. Sophisticated wine production requires not only knowledge and skills, but also many years of experience and passion in this craft. Bordeaux’s impeccable reputation also allows grape harvesters and wine producers from this region to charge higher prices to customers from around the world that directly translated to higher profits.
The previous article identified and analyzed internal economies of scale which occur inside the firm and are within its control. By operating on a larger scale, a business can reduce its average costs of production due to a combination of different factors that are present within the firm.
