What Are External Economies of Scale? (Plus Pros and Cons)

By Indeed Editorial Team

Published December 14, 2021

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

There are many outside forces that can improve the financial condition and cost savings of companies, such as government legislation and geographical localization. These factors, or external economies of scale, are out of the control of the organizations and create equitable benefits for all related firms. Learning about these elements can help you become more knowledgeable about how it works and affects your employer. In this article, we discuss what external economies of scale are and why they're important, including a few pros and cons.

Related: Economies of Scale: Definition and Types (With Examples)

What are external economies of scale?

External economies of scale, or EEOS, are factors that help decrease production costs while simultaneously increasing output volume and financial gains. These factors are outside of the control of individual companies and organizations. Instead, these are industry-wide changes that relevant firms can inadvertently benefit from. For example, if a local government enacts an ordinance to build new affordable city housing units, then relevant agencies, such as construction and brokerage firms, benefit from this new decree and may lower their production costs for each new housing unit.

Often, companies within the same or similar industries congregate towards one another when there are significant external economies of scale in a specific area. For example, the city of Canby has tax incentives for electric automobile manufacturing, so a major electric car company moves to that city. Other electric car manufacturers also move to Canby because there is greater infrastructure, talent, resources, equipment and other localized industry benefits. There are also several sources of external economies of scale, including:

  • Economies of concentration: This describes when similar businesses group together to share benefits and networks.

  • Economies of innovation: This describes the companies that usually choose centers that offer significant production, research, innovation and development benefits.

  • Economies of information: This describes companies that locate in close proximity so they can gain access to real-time information, like prices, best suppliers and lucrative consumer markets.

  • Tax breaks: It's common for local governments to offer tax concessions for specific industries, such as film or real estate.

Related: Economies of Scale vs. Economies of Scope: Definition and Differences

Why are external economies of scale important?

External economies of scale are important because they help to drive organic competition between similar industry organizations. As companies move to the same location, there are more options for consumers to choose from. This means that firms must accommodate an over-saturated industry by offering incentives that entice consumers to choose their goods and products instead of their business competitors. This natural business competition often depends on the type of industry that is affected.

For example, bookstores may have more incentive to provide customers with better book deals and promotions to drive book sales. Movie production studios are less likely to have this condition because their success usually relies on more independent determining factors. However, because all companies in the industry benefit from external economies of scale, no one firm gets a direct competitive edge or advantage over the others.

Related: Diseconomies of Scale: Different Types and How They Work

Pros and cons of external economies of scale

There are several pros and cons to consider with external economies of scale, such as:

Pros

Here are some of the pros of external economies of scale:

Shared benefits

Every business in the industry can enjoy economies of scale equally. Therefore, no one company can outright gain a competitive edge or unfairly take advantage of other firms in the industry. How each firm capitalizes on those benefits ultimately shapes how they develop financially, but economies of scale don't innately cause business inequality. Equitable benefits can drive new business development in the area. For example, if there are many economies of scale benefits for coffee shops in the city, then that can incentivize people to start their own coffee shop businesses because it's a potentially lucrative venture.

Supporting industries grow

As the primary industries benefit from the external economies of scale, supporting industries grow as well. This often includes companies like manufacturers, raw material providers, equipment operators and transportation and courier services. For example, if a particular city offers many EEOS factors that benefit the film industry, then any subsidiary company related to film agencies may also reap the benefits. This might include talent agencies, camera and lighting manufacturers, facilities services and set renters.

Cost savings

One of the primary pros of EEOS benefits is that companies can usually save significant amounts of money. Depending on the industry, cost savings may vary. Generally, most companies can save on production, operational and purchasing costs. This can create greater synergies between interconnected industries and reduce corporate expenses for both the main companies and their related partners.

For example, if a technology company in a big city gains many cost-savings benefits from EEOS, they are likely to pass down those same financial savings to other relevant companies, like tech consulting firms and manufacturers. This may ultimately transfer to consumers as lower prices and better services.

Related: Cost Avoidance and Cost Savings: What's the Difference?

Increased job growth

Companies moving to one location often drive job growth. This can increase the overall gross domestic product of a specific location and decrease homelessness. More jobs mean more money flowing into the area's economy and an increase to the overall GDP (gross domestic product). In turn, this provides the local government with the financial means to make improvements to the area, such as fixing infrastructure, building more affordable housing, improving education and health care and starting more recreational developments.

Related: What Is GDP? (Plus Different Types and Ways To Calculate)

Cons

Here are some of the cons of external economies of scale:

Restricted locations

External economies of scale often drive companies to move to one geographical location. This condition means that specific jobs may be more challenging to find outside of a specific region or city center. For example, many tech companies consolidate in big cities because there is more talent and resources there for those businesses to thrive.

However, because these companies continuously move to these larger cities and metropolitan areas, people who live in suburban or rural areas don't have access to these organizations and may see decreases in job opportunities and diversity. This may also drive population loss as people move into these big city centers for better work.

No control over external factors

Individual businesses and companies have no control over the forces that cause EEOS. This sometimes means that the development and benefits that companies gain are often at the whim of these external elements. They cannot gain a competitive edge and therefore, have to capitalize on the benefits for themselves. Some companies may not be able to capitalize on these external economies because of their own internal deficiencies, like poor budgeting or management. This may ultimately lead to company instability as they try to keep up with their industry competitors.

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