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Unlock This CourseImagine you're running a small tech company. Suddenly, loads of other tech firms move into your area. You might think this would be bad news - more competition, right? Actually, it could be brilliant for your business! This is because of something called external economies of scale.
External economies of scale happen when businesses benefit from cost reductions that come from outside their own company. These benefits occur because the whole industry or area is growing, not just because one business is getting bigger.
Key Definitions:
Internal economies happen inside one company as it grows bigger - like buying materials in bulk for cheaper prices. External economies happen outside the company - like when a whole area becomes known for making cars, so specialist suppliers move nearby to serve all the car companies.
There are several main types of external economies that can help businesses reduce their costs and improve their operations. Let's explore each one with real examples you can relate to.
When lots of similar businesses cluster together, specialist suppliers and service providers often set up nearby. This creates a whole ecosystem of businesses supporting each other.
Companies that make specific parts or provide particular services just for that industry. For example, in areas with lots of car manufacturers, you'll find businesses that only make car seats, engines, or provide car design services.
Services like specialist transport, maintenance, or consulting that serve multiple businesses in the area. This spreads the costs and makes these services cheaper for everyone.
Colleges and training centres that develop courses specifically for the local industry's needs, creating a steady supply of skilled workers.
Silicon Valley in California is famous for its tech companies like Apple, Google and Facebook. But it's also home to thousands of specialist suppliers - companies that make computer chips, software, provide venture capital funding and offer tech consulting. This means any new tech startup can easily find all the specialist help it needs nearby, keeping costs down and making it easier to grow quickly.
When an industry grows in an area, the local infrastructure often improves to support it. This benefits all businesses in the region, not just the ones that paid for the improvements.
Infrastructure improvements might include:
When Heathrow Airport expanded its cargo facilities to serve London's financial district, it didn't just help banks - it made it easier and cheaper for all sorts of businesses to import and export goods quickly. Even small companies could benefit from the improved logistics without having to pay for the infrastructure themselves.
When similar businesses cluster together, they create what economists call a 'thick labour market'. This means there are lots of workers with the right skills available and lots of jobs for those workers.
This creates benefits for both businesses and workers:
London's financial district (known as 'The City') employs hundreds of thousands of people in banking, insurance and finance. Because so many financial firms are located close together, there's a huge pool of experienced financial workers. This means banks can easily recruit staff with exactly the right skills and workers can move between jobs without having to relocate. The competition for good staff also drives up wages, attracting even more talented people to the area.
When businesses in the same industry locate near each other, they often share research and development costs. This can happen formally through partnerships, or informally through knowledge spillovers.
This is when ideas and innovations spread between companies without any formal agreement. It might happen when:
These knowledge spillovers help all businesses in the area innovate faster and more cheaply than they could on their own.
Near Cambridge University, there's a cluster of biotech and pharmaceutical companies. These businesses benefit from being near the university's research, sharing expensive laboratory equipment and learning from each other's discoveries. Even small startups can access world-class research facilities and expertise that would be impossible to afford alone.
While external economies usually benefit businesses, they can sometimes create problems too. It's important to understand both sides of the story.
When lots of similar businesses cluster together, some negative effects can occur:
Detroit became the centre of America's car industry in the early 1900s. The city benefited enormously from external economies - specialist suppliers, skilled workers and supporting industries all clustered there. However, when the car industry declined in the 1970s and 80s, Detroit suffered badly because it had become too dependent on one industry. This shows why diversification is important even when external economies are working well.
Governments often try to encourage external economies by creating business parks, improving infrastructure, or offering incentives for businesses to locate in particular areas.
Many governments create special areas designed to attract businesses and encourage external economies:
The government helped create MediaCity UK in Salford, near Manchester, as a hub for media and creative industries. They moved BBC departments there, invested in high-speed broadband and offered incentives for other media companies to relocate. This created external economies as production companies, post-production services and creative agencies all clustered together, sharing costs and expertise.
Businesses and governments need to understand whether external economies are actually working. They can measure this in several ways:
External economies of scale show how businesses can benefit from working together and locating near each other, even when they're competitors. By understanding these concepts, you can better appreciate why certain industries cluster in particular locations and how government policies can help create successful business environments.
The key is finding the right balance - enough clustering to gain the benefits of external economies, but not so much that the drawbacks outweigh the advantages. Successful business locations are those that manage to create positive external economies while avoiding the potential pitfalls.