Types of External Economies of Scale

Types of External Economies of Scale

Reviewed by Raphael Zeder | Updated Sep 10, 2019

Economies of scale (EoS) describe factors that drive production costs down as the volume of output increases. That means when a firm produces more output, its marginal costs of production decrease. There are two major types of EoS: internal and external. Internal economies of scale occur based on factors within a single firm, whereas external EoS are caused by changes outside an individual firm but within the entire industry. Starting from there, we will take a closer look at the following four different types of external economies of scale: (1) infrastructure, (2) supplier, (3) innovation, and (4) lobbying economies of scale.

Infrastructure Economies of Scale

Infrastructure economies of scale occur based on public infrastructure that is put in place to benefit a specific industry. That means when many firms of the same industry are located in close proximity, the government will usually expand public infrastructure (e.g., roads, public transport) in those areas to meet their needs.

To give an example, let’s look at an imaginary area in the United States called Tech Valley. This area is home to an increasing number of large tech companies because it provides a favorable legal infrastructure for them. Of course, the significant growth of the industry also has its downsides. One of those being an increase in traffic. Hence, to tackle this issue, the government eventually decides to upgrade the highway and add two additional lanes on both sides. That significantly improves the flow of traffic and allows local firms and their employees to save time and work more efficiently.

Specialization Economies of Scale

Specialization economies of scale arise when suppliers and workers start to focus on a particular industry due to its size. That means as the companies within an industry increase in size and numbers; it becomes more profitable for suppliers to focus exclusively on that particular industry (by specializing and leveraging internal economies of scale). Similarly, it becomes easier for specialized workers to find a job in their field because the availability of jobs in the industry rises as well.

For example, in the case of Tech Valley, suppliers of advanced sensors for sophisticated computer systems find a growing customer base. That allows them to expand their business and focus on improving the sensors even further. Similarly, it becomes easier for computer science graduates to find a job, because all the new and growing tech companies need computer scientists. As a result, more students will enroll in computer science, and the number and quality of specialized employees increase.

Innovation Economies of Scale

Innovation economies of scale occur based on increased public and private research. That means as industries become increasingly significant, their impact on society grows into a matter of public interest. That allows them to collaborate with universities and other research facilities to improve their products and processes while simultaneously reducing their own research expenses.

To illustrate this, let’s say that many of the firms in Tech Valley are developing ways to make self-driving cars more secure. Because of the public interest and importance of this topic, several universities join their efforts. This allows the firms to collaborate with some of the best research facilities in the world to develop better sensors and computer systems and improve their products.

Lobbying Economies of Scale

Lobbying economies of scale arise from an increase in bargaining power as industries become more significant. That means most governments will be ready to compromise because they want to keep large industries in the area. The reason for this is that these industries provide a lot of jobs and pay a significant amount of taxes. That gives them a lot of bargaining power, which they’ll often use to negotiate favorable terms to cut costs or increase profits.

For example, let’s assume that the self-driving cars developed in Tech Valley are ready to be tested on public roads. Unfortunately, the local government does not allow any vehicles without drivers to navigate on public roads, for safety reasons. However, Tech Valley is a significant contributor to the local economy, and the government is determined to keep it that way. Therefore, after several months of negotiations, it eventually allows them to test their cars on public roads under certain conditions.

In a Nutshell

There are four different types of external economies of scale: infrastructure, supplier, innovation, and lobbying economies of scale. Infrastructure economies of scale occur based on public infrastructure that is put in place to benefit a specific industry. Specialization economies of scale arise when suppliers and workers start to focus on a particular industry due to its size. Innovation economies of scale occur based on increased public and private research. And finally, lobbying economies of scale arise from an increase in bargaining power as industries become more significant.

Leave a Reply

Your email address will not be published. Required fields are marked *

I agree that my data may be stored and used as stated in the privacy policy.