Internal vs External Economies of Scale – Detail Explanation with Examples

What is Economies of Scale?

Economies of Scale is which the company grows bigger and better it will experience cost decreases along with the increase in its level of output. Simply the cost per unit of an individual item decreases when increasing the scale of production.

This is related to operational efficiencies and synergies as a result of an increase in the level of production. The simple meaning is that companies tend to do things more efficiently with increasing size.

What is Internal Economies of Scale?

  • Technical Economies – Technical economies arise from efficiencies gained through advanced machinery and technology. Larger firms can afford high-capacity, sophisticated equipment that boosts production efficiency and reduces the average cost per unit. For instance, automated assembly lines in the automotive industry allow for faster, more consistent production, minimizing labor costs and waste.
  • Managerial Economies – As firms grow, they can hire specialized managers for different departments, enhancing overall efficiency and effectiveness. Specialized managers, such as those in finance, marketing, and production, improve strategic decision-making and optimize operations. For example, a marketing manager can create targeted campaigns, while a production manager can streamline manufacturing processes.
  • Marketing Economies – Marketing economies of scale occur when advertising and promotional costs are spread over a larger output. Large firms can negotiate better rates for bulk advertising, reducing the cost per unit of marketing. For example, a national advertising campaign costs the same whether it reaches one million or ten million customers.
  • Financial Economies – Larger firms often have better access to capital markets and can secure financing at lower interest rates due to their perceived lower risk. They can also use sophisticated financial instruments to manage risks and optimize their capital structure. This access to cheaper financing reduces the overall cost of capital, allowing these firms to invest more in growth opportunities and operational improvements, enhancing their competitive edge.
  • Risk-Bearing Economies – Risk-bearing economies emerge from the ability of large firms to diversify their products, services, and markets. By spreading operations across various segments, they can mitigate the impact of a downturn in any single area. For example, a multinational corporation with a diverse product portfolio can offset losses in one product line with profits from another. This diversification reduces overall risk exposure, stabilizes income streams, and ensures consistent financial performance.
  • Labor Economies – Large firms can attract and retain skilled and specialized labor due to better compensation packages, career development opportunities, and job security. Skilled employees contribute to higher productivity and efficiency, reducing the per-unit cost of production. Additionally, larger firms can implement comprehensive training and development programs, improving employee performance and adaptability. This investment in human capital drives down operational costs and enhances the firm’s ability to innovate and compete effectively.

What is External Economies of Scale?

  • Industry Clusters – Industry clusters refer to the geographic concentration of interconnected companies, suppliers, and associated institutions in a particular field. These clusters facilitate the sharing of knowledge and innovation, enhance collaboration, and create a competitive environment that drives efficiency. Firms benefit from proximity to suppliers and customers, reducing transportation costs and improving logistics. For example, Silicon Valley’s concentration of tech companies and talent creates a supportive ecosystem that benefits all firms within the region through shared resources and collaborative opportunities.
  • Skilled Labor Pool – The presence of a large, skilled labor force in a specific area can lead to external economies of scale. Companies in such regions can easily find and hire qualified workers without incurring high recruitment and training costs. Educational institutions often align their programs with industry needs, ensuring a steady supply of skilled graduates. For instance, Wall Street benefits from the proximity of prestigious universities that produce a continuous stream of finance and business graduates, enabling financial firms to hire skilled professionals efficiently.
  • Infrastructure Development – Improved infrastructure, such as transportation networks, telecommunications, and utilities, benefits all firms within a region. Good infrastructure reduces operational costs, improves efficiency, and enhances connectivity. For example, the advanced transportation networks and communication systems in major financial centers like London and New York allow firms to operate more efficiently, facilitating swift movement of goods and information, which reduces costs and improves productivity.
  • Supplier Networks – A dense network of suppliers within a region allows firms to source raw materials and components more efficiently and at lower costs. The proximity of suppliers reduces lead times and transportation costs, enabling firms to respond quickly to market demands. In the automotive industry, regions like Detroit benefit from a well-developed supplier network that provides parts and components to manufacturers, enhancing production efficiency and reducing costs for all firms in the area.
  • Research and Development (R&D) Synergies – The concentration of research institutions, universities, and corporate R&D centers in a particular region fosters innovation and technological advancements. Firms benefit from access to cutting-edge research, collaborative projects, and a flow of new ideas and technologies. For example, the close collaboration between companies and research institutions in biotech hubs like Boston accelerates innovation and reduces the cost of developing new products, benefiting all firms involved.
  • Shared Services and Facilities – Regions with a high concentration of firms in a particular industry often develop shared services and facilities, such as testing labs, business incubators, and training centers. These shared resources reduce individual company costs and improve access to essential services. For instance, Hollywood benefits from shared production facilities, studios, and post-production services, which lower costs for all entertainment companies in the area and streamline the production process.

Difference Between Internal Economies of Scale and External Economies of Scale

The Below Table Illustrates the Difference Between Internal Economies of Scale and External Economies of Scale

Internal Economies of ScaleExternal Economies of Scale
Economies of scale which unique within the companyEconomies of scales for the industry as a whole
Purely based on the outcomes and the unique capabilities of the company
Purely based on the external factors which common for the entire industry
Unit cost advantages for the business when expanding their scale of production
Unit cost advantages for the business from the advancement of their industry
Internal economies of scale occur inside the company (company-specific)
External economies of scale occur outside of the company but within an industry/location area
Typically occur in large companies
Usually, it is commonly applicable across all size of companies in the industry
Example 01: A company has a patent for their unique production technology, which leads to lower the average cost of production compared with similar competitors
Example 01: The average cost of raw material in the country gets lower, the cost of production will reduce on all similar companies that require this supply
Example 02: A production company had forward integrated with the distribution of their products by acquiring the largest distributor. This results in a decrease in sale price compared to their competitors
Example 02: IT services delivery industry grows larger with the cultural changes and technology advancements, then the demand for the individual company also grows
Example 03: Apparel manufacturing company had conducted successful research about using robotics for their production which none of the other competitors looked into. They have implemented it which results in lowering the unit cost of production
Example 03: Assume if Alaska state in The United States reduces its taxes to attract companies to the area that will provide the most jobs. Then the advantage applicable for all companies located in Alaska
Internal Economies of Scale vs External Economies of Scale

Comparison of Internal Economies of Scale and External Economies of Scale

  1. Internal economies of scale are unique within the company whereas external economies of scale apply to the industry as a whole.
  2. Internal economies of scale are purely based on the outcomes and the unique capabilities of the company whereas external economies of scale are purely based on the external factors which common for the entire industry.
  3. Internal economies of scale are typically the unit cost advantages for the company when expanding their scale of production whereas external economies of scale are typically the unit cost advantages for the company from the advancement of their industry.

Further Explanation of Economies of Scale

Economies of Scale – Average Cost Movement with Production Quantity

The above diagram shows that if a company increases output from Q1 to Q2, the average cost decreases from C1 to C2. Economies of scale reduce both per-unit fixed cost and per-unit variable cost. The fixed cost gets spread over more output than before when production increases. Also, the variable cost gets deducted with the efficiency of the production process when expanding the scale of production. However, the total fixed cost of production will remain unchanged.

How Companies Achieve Economies of Scale?

Sources of Economies of Scale (also called as Types of Economies of Scale)

  1. Technical Economies
    Use of advanced machinery and technology to increase production efficiency and reduce per-unit costs.
  2. Managerial Economies
    Employment of specialized managers to improve operational efficiency and decision-making within the company.
  3. Marketing Economies
    Spreading the cost of advertising and promotional activities over a larger output, reducing the per-unit marketing cost.
  4. Financial Economies
    Access to lower interest rates and better financing options due to larger size and perceived lower risk.
  5. Risk-Bearing Economies
    Diversification of products and markets to spread risk and stabilize income streams.
  6. Labor Economies
    Attraction and retention of skilled labor due to better compensation and career opportunities, enhancing productivity.
  7. Bulk Purchasing
    Buying raw materials and components in large quantities at discounted rates, reducing per-unit costs.
  8. Research and Development (R&D)
    Spreading the high costs of R&D over a larger production base, making innovation more cost-effective.
  9. Supply Chain Integration
    Streamlining supply chain processes to reduce costs and improve efficiency through better coordination with suppliers and distributors.
  10. Learning and Experience
    Gaining efficiencies from improved skills and faster production times through repetitive manufacturing processes.

Pros / Benefits of Economies of Scale

  • Cost Reduction
    Economies of scale enable companies to produce goods at a lower average cost per unit as production volume increases. This cost reduction enhances profitability and competitiveness in the market.
  • Increased Efficiency
    Larger scale operations often lead to efficiencies in production processes, resource allocation, and overall management, allowing companies to operate more smoothly and effectively.
  • Enhanced Profit Margins
    Lower per-unit costs mean that companies can maintain or increase profit margins even when selling goods at competitive market prices, improving financial performance.
  • Competitive Pricing
    Economies of scale allow companies to offer competitive pricing, attracting more customers and gaining market share by providing affordable products or services.
  • Greater Investment Capacity
    Reduced costs free up capital that can be reinvested in expanding operations, innovation, research and development (R&D), or improving product quality, fostering long-term growth.
  • Improved Access to Resources
    Larger firms can negotiate better terms with suppliers and access capital markets more easily, enhancing their ability to secure resources needed for expansion and development.
  • Diversification Opportunities
    Economies of scale provide financial stability and flexibility, enabling firms to diversify their product lines or enter new markets without significantly increasing operational costs.
  • Risk Mitigation
    Spreading fixed costs over larger production volumes and diversified product lines reduces the impact of market fluctuations or changes in demand, enhancing overall business resilience.
  • Technological Advancements
    Larger firms often invest in advanced technologies and innovation, driving industry advancements and maintaining a competitive edge through continuous improvement.
  • Brand Recognition
    Economies of scale can support investments in marketing and branding efforts, increasing brand visibility and customer loyalty through widespread market presence and competitive pricing strategies.

Cons / Drawbacks of Economies of Scale

  • Decreasing Marginal Returns
    As production increases, the marginal benefit of each additional unit of output may decrease, leading to diminishing returns and reduced efficiency gains.
  • Complexity in Management
    Larger organizations may face challenges in coordinating and managing operations across multiple departments or locations, potentially leading to bureaucratic inefficiencies and slower decision-making processes.
  • Risk of Over-Expansion
    Pursuing economies of scale may tempt companies to expand too quickly or beyond their core competencies, leading to overextension, financial strain, and increased operational risks.
  • Vulnerability to External Shocks
    Larger firms heavily reliant on economies of scale may face greater vulnerability to disruptions in supply chains, changes in market conditions, or regulatory changes, affecting their ability to adapt quickly.
  • Quality Control Issues
    Maintaining consistent product or service quality can become challenging as production volumes increase, potentially leading to quality control issues and customer dissatisfaction.
  • Erosion of Entrepreneurial Spirit
    Large-scale operations may stifle innovation and entrepreneurial initiatives within the organization, as bureaucratic processes and hierarchy can discourage risk-taking and creativity.
  • Higher Fixed Costs
    While spreading fixed costs over larger volumes can reduce per-unit costs, it also means higher overall fixed costs. This can pose financial challenges during periods of economic downturn or reduced demand.
  • Loss of Flexibility
    Large firms may find it more difficult to quickly respond to changes in consumer preferences, technological advancements, or competitive pressures due to their size and established processes.
  • Environmental Impact
    Economies of scale can lead to increased resource consumption and environmental impact, as larger production volumes may result in higher energy consumption, waste generation, and carbon emissions.
  • Antitrust Concerns
    In some cases, achieving economies of scale may lead to market dominance or monopolistic practices, raising antitrust concerns and regulatory scrutiny, which can impact business operations and growth strategies.

Effects of Economies of Scale on Production Costs

  • Decreased Average Costs
    As production volume increases, economies of scale allow firms to spread their fixed costs (such as machinery, buildings, and administrative expenses) over a larger number of units. This reduction in average costs per unit makes production more efficient and lowers the overall cost structure of the firm.
  • Increased Efficiency
    Larger scale operations often lead to improved production processes, resource allocation, and management efficiencies. Companies can leverage economies of scale to streamline operations, optimize supply chains, and adopt advanced technologies, all of which contribute to lower production costs and improved productivity.
  • Competitive Pricing
    Lower production costs due to economies of scale enable firms to offer competitive pricing in the market. By reducing their cost per unit, companies can set more attractive prices for consumers while maintaining profitability, which enhances their competitiveness and market share.
  • Expansion Opportunities
    Economies of scale provide firms with the financial resources and flexibility to invest in expansion initiatives, such as entering new markets, diversifying product lines, or increasing production capacity. This growth potential is fueled by the cost efficiencies gained through economies of scale.
  • Barriers to Entry
    For new entrants into the market, established firms with economies of scale pose significant barriers. Larger companies can produce goods at lower costs, making it challenging for smaller competitors to compete on price. This advantage can solidify the market position of firms benefiting from economies of scale.

Diseconomies of Scale

The concept of diseconomies of scale is the reverse of economies of scale. Considering the diagram illustrated above. After the quantity of production increase beyond the level of 10,000 (Q2) the average cost per item increases. Enterprises’ experiences cost disadvantages due to an increase in organizational size or output. That will result in the production of goods and services at increased per-unit costs. As enterprises get larger the complexity drives in.

To read more about diseconomies of scale.

FAQs about Economies of Scale

Recommended Articles:

1. Meaning of Economies of Scale?
2. Diagram illustrates Economies of Scale
3. Types of Internal Economies of Scale with Examples

4. Advantages and Disadvantages of Economies of Scale
5. Diseconomies of Scale with Examples

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