In this video we’ll learn about external economies of scale.
We’ll examine what’s meant by the term external economies of scale and then look
at specific economies and diseconomies.
In the previous video we saw that economies of scale occur as a firm expands its production
capacity.
Beyond the minimum efficient scale, average costs are constant or start to rise due to
diseconomies of scale.
In this video we’re going to look at external economies of scale which have a different
effect on the long run average cost curve.
External economies of scale are the reductions in average costs a firm benefits from as the
industry expands or the economy develops.
External economies of scale drive down average costs and thus force a firm’s LRAC to shift
downwards.
This is demonstrated by the shift from LRAC to LRAC1.
I’ll explain why this happens next.
One external economy that can drive down average costs is the development of transport infrastructure.
As an area develops, the infrastructure, including roads and highways, improves.
This results in lower transportation costs for all the firms in the area.
The second external economy of scale that could arise is the benefit from concentrated
pools of labour.
Once an industry develops in a local area, there tends to be an growth in the quantity
of skilled labour available in that region.
Two examples include Wall Street and Silicon Valley in the US.
For firms operating in these areas, recruitment costs may fall because talent is drawn to
living and working here.
Many bankers and business people live in and around New York City due to the opportunities
available and the same holds true for highly skilled technology workers in Silicon Valley.
As an area develops there could be an increase in the number of suppliers providing support
to the industry.
An example of this would be car parts suppliers in the UK’s Motorsport Valley, the home
of F1 racing development.
A large number of F1 racing teams have their bases here, so F1 parts suppliers would benefit
from locating here.
Similarly for the IT industry in Silicon Valley, many different services supporting larger
technology firms have sprung up in the area.
If you can think of your own example, leave it below and share it with us.
Now we’ll move on to external diseconomies.
External diseconomies of scale have the opposite effect of external economies.
They drive up average costs and thus force the LRAC to shift upwards.
This is demonstrated by the shift from LRAC to LRAC1.
Regulation can be a significant external diseconomy of scale.
As an industry grows in size it will start to attract government attention and oversight.
A good example of this would be social media platforms and the increasing level of oversight
from the government with regards to personal data.
As firms like Facebook and Google are required to protect our data more carefully, their
production costs are going to rise.
The increased compliance costs will require significant spending from such firms.
Earlier I mentioned the external economy of scale related to concentrated pools of labour.
This could also be an external diseconomy if the competition for labour resources drives
up wages.
If labour is inelastic in supply, then it is likely that workers will be able to secure
higher wages as firms compete for workers.
If labour supply is more elastic, then this is less likely to be an issue.
That wraps up this video on external economies of scale.
Now that we’ve discussed internal and external economies and diseconomies, you should have
a better understanding of the factors affecting a firm’s long run average costs.
This list is not exhaustive and there are other factors that could result in external
economies and diseconomies.
As always, leave any questions or comments below and I’ll do my best to get back to
you.
That’s us done for now and I will see you in the next one!