One of the most crucial concepts in economics is economies of scale, which refers to the advantages gained by a business as it grows larger.
Internal economies of scale refer to cost savings achieved by a single firm due to its increased production, while external economies of scale refer to cost savings achieved by multiple firms in an industry or region due to factors outside of a single firm’s control.
Internal vs External Economies of Scale
| Internal Economies of Scale | External Economies of Scale |
|---|---|
| Internal economies of scale refer to cost savings achieved by a single firm due to its increased production and operational efficiency. | External economies of scale refer to cost savings achieved by multiple firms in an industry or region due to factors outside of a single firm’s control, such as infrastructure, labor pool, or knowledge spillovers. |
| They are limited to a single firm and are specific to its internal operations. | They are industry or region-wide and are influenced by external factors that affect multiple firms. |
| Internal economies of scale are within the control of a single firm as they depend on the firm’s own production and operational decisions. | External economies of scale are beyond the control of individual firms as they are influenced by external factors that may be common to all firms in an industry or region. |
| They arise from a firm’s ability to achieve cost savings through increased production levels, specialization, and economies in procurement, production, and distribution. | They arise from factors such as infrastructure, access to resources, knowledge sharing, and other external conditions that benefit multiple firms in an industry or region. |
| Internal economies of scale are firm-specific and cannot be easily transferred to other firms. | External economies of scale can be enjoyed by multiple firms in an industry or region, making them more transferable and beneficial to a wider range of firms. |
| They are dependent on a firm’s own operations and decisions. | They are dependent on external factors that may change over time and may not be under the control of individual firms. |
| Internal economies of scale may be subject to diminishing returns or diseconomies of scale if a firm grows too large. | External economies of scale may be subject to changes in external factors or industry dynamics that can affect all firms collectively. |
Introduction: Internal and External Economies of Scale
Internal economies of scale are cost savings that a company achieves by increasing its output. The main source of internal economies of scale is the division of labour, which is the specialization of workers in specific tasks. This specialization leads to increased efficiency and output per worker. Other sources of internal economies of scale include the learning curve, economies of scope, and vertical integration.
- Larger production units can achieve greater efficiency in production through specialization and division of labor
- Increased buying power for raw materials and other inputs can lead to lower costs
- Greater financial resources can be used to invest in new technology and processes
External economies of scale are those that arise when an industry or sector grows in size. This can lead to lower costs for firms within the industry as a result of increased competition, improved technology, and higher levels of specialization. There can also be positive spillover effects on other industries as a result of the growth in the size of the market for inputs and outputs.
Benefits and drawbacks of internal economies of scale
On the plus side, internal economies of scale can lead to increased efficiency and productivity as a company grows and becomes more organized. This can in turn lead to cost savings for the company.
So, internal economies of scale can create barriers to entry for competitors, as it can be difficult for them to duplicate the same level of efficiency and productivity.
Finally, companies with strong internal economies of scale often have a competitive advantage over their rivals.
On the downside, however, internal economies of scale can sometimes lead to bureaucracy and red tape as a company grows larger.
Also, companies with strong internal economies of scale may become less flexible and less able to respond quickly to changes in the marketplace.
Finally, over-reliance on internal economies of scale can make a company less competitive in the long run if they are not also investing in external economies of scale.
Benefits and drawbacks of external economies of scale
External economies of scale are those that arise due to the firm’s location. For example, if a company is located in an area with a well-educated workforce, it will have access to better talent than if it were located in a less educated area.
Also, being located in close proximity to suppliers can lead to lower input costs. And finally, being located in an area with good infrastructure can lead to lower transportation costs.
There are also drawbacks to external economies of scale. One is that they can be difficult to change if the company’s circumstances change.
For example, if a company needs to move to a different location because its current one is no longer conducive to business, it may have difficulty finding another location that offers the same benefits as its current one.
Also, external economies of scale are typically out of the control of the firm and therefore subject to change beyond the firm’s control.
Key differences between internal and external economies of scale
- Definition: Internal economies of scale refer to cost savings achieved by a single firm due to its increased production and operational efficiency, while external economies of scale refer to cost savings achieved by multiple firms in an industry or region due to factors outside of a single firm’s control, such as infrastructure, labor pool, or knowledge spillovers.
- Scope: Internal economies of scale are limited to a single firm and are specific to its internal operations, whereas external economies of scale are industry or region-wide and are influenced by external factors that affect multiple firms.
- Control: Internal economies of scale are within the control of a single firm as they depend on the firm’s own production and operational decisions, while external economies of scale are beyond the control of individual firms as they are influenced by external factors that may be common to all firms in an industry or region.
- Origin: Internal economies of scale arise from a firm’s ability to achieve cost savings through increased production levels, specialization, and economies in procurement, production, and distribution. External economies of scale, on the other hand, arise from factors such as infrastructure, access to resources, knowledge sharing, and other external conditions that benefit multiple firms in an industry or region.
- Transferability: Internal economies of scale are firm-specific and cannot be easily transferred to other firms, while external economies of scale can be enjoyed by multiple firms in an industry or region, making them more transferable and beneficial to a wider range of firms.
- Difference between consumer goods and capital goods
- Difference between demand pull and cost push inflation
- Difference between internal and external stakeholder
Examples of internal and external economies of scale
Examples of internal economies of scale
Economies of scale in production: As a firm increases its scale of production, it can benefit from lower average costs due to specialization, efficient use of capital and labor, and increased bargaining power with suppliers.
Economies of scale in marketing: As a firm grows and expands its customer base, it can benefit from lower average costs of advertising, brand recognition, and distribution due to economies of scale in marketing.
Economies of scale in research and development: As a firm invests more in research and development, it can benefit from the increased efficiency of developing new products, lowering average costs and increasing competitiveness in the market.
Examples of external economies of scale
Skilled Labor: If an industry is located in a region where there is a large pool of skilled labor, all firms in that industry can benefit from lower labor costs, improved productivity, and access to specialized skills and knowledge.
Infrastructure: Access to high-quality infrastructure, such as transportation networks, communication systems, and utility services, can reduce transaction costs, improve supply chain efficiencies, and increase market access for firms in an industry.
Knowledge Spillovers: When firms in an industry are located in close proximity to one another, they can benefit from knowledge spillovers. For example, a new technology or innovation developed by one firm can be quickly adopted by others, leading to productivity gains, cost savings, and improved competitiveness for all firms in the industry.
Conclusion
Internal economies of scale come from improved efficiency within the company while external economies of scale come from outside sources such as suppliers or the government.
