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What are the differences between internal and external economies of scale?

Level:
A-Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 4 Sept 2023

Internal economies of scale and external economies of scale are two concepts in economics that describe the cost advantages a firm can achieve as it expands its operations and production capabilities in the long run. However, they differ in their sources and implications:

  1. Internal Economies of Scale:
    • Source: Internal economies of scale refer to the cost advantages a firm can achieve as a result of its own growth and expansion. These cost reductions are generated from within the firm itself, primarily by optimizing its production processes and utilizing its resources more efficiently.
    • Examples:
      • Technical Economies: As a firm grows, it may invest in better machinery and technology, leading to increased efficiency and reduced production costs per unit.
      • Managerial Economies: Larger firms can spread management and administrative costs over a larger output, reducing average costs.
      • Financial Economies: Bigger firms may have better access to capital markets, enabling them to secure loans at lower interest rates.
      • Marketing Economies: Larger firms can often negotiate better deals with suppliers and distributors, leading to lower input costs and distribution expenses.
    • Implication: Internal economies of scale typically result in lower average costs per unit of production for the expanding firm, making it more competitive in the market.
  2. External Economies of Scale:
    • Source: External economies of scale, on the other hand, are cost advantages that result from the growth and expansion of an entire industry or cluster of firms in a particular geographic area. These cost reductions are external to individual firms and benefit all firms in the industry.
    • Examples:
      • Skilled Labour Pool: If multiple firms in a specific industry cluster in a region, a skilled labor force with industry-specific expertise may develop. All firms in the industry can benefit from this shared resource, as it reduces labor training costs.
      • Specialised Suppliers: When several firms in an industry are located close to each other, specialized suppliers may emerge to serve them. These suppliers can provide specialized inputs at lower costs due to proximity.
      • Infrastructure: The development of transportation and communication infrastructure in a region with a concentration of firms can benefit all companies by reducing transportation costs and improving connectivity.
    • Implication: External economies of scale provide cost advantages to firms operating in a specific industry or geographic area, which can enhance the competitiveness of the entire industry.

In summary, the key difference between internal and external economies of scale is the source of the cost advantages. Internal economies of scale arise from a firm's own growth and optimization of internal operations, while external economies of scale result from the growth and clustering of multiple firms or the entire industry in a particular location or market, leading to shared cost benefits.

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