External Economies and Diseconomies of Scale

TL;DR

External economies and diseconomies describe how an entire industry's growth or decline affects individual firms within it, even if those firms don't change their own scale. Economies lead to lower average costs for all firms as the industry grows, while diseconomies lead to higher average costs. These effects shift a firm's average cost curve.

1. The Mental Model

Think of it like a rising or falling tide. A rising tide (industry growth) lifts all boats (firms benefit through lower costs), while a falling tide (industry contraction) can ground them (firms face higher costs).

2. The Core Material

When we talk about economies and diseconomies of scale, we usually think about what happens when a single firm expands. But external economies and diseconomies are different: they refer to cost changes that affect all firms in an industry due to the growth or decline of the entire industry.

External Economies of Scale

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These occur when the expansion of an entire industry leads to a fall in the long-run average cost (LRAC) for all individual firms within that industry. Essentially, as the industry gets bigger, it becomes more efficient or gets better access to resources, and this benefits every firm.

Imagine the industry's supply curve. External economies mean that as the industry output increases, the industry's long-run supply curve shifts downwards (or to the right), indicating lower costs of production for any given output. For an individual firm, its entire LRAC curve shifts downwards.

Here's how they typically arise:

• Improved Infrastructure: As an industry grows in a specific area, the government or private sector might invest in better roads, ports, or communication networks tailored to that industry's needs. This lowers transport or communication costs for all firms.
• Specialised Suppliers: A larger industry attracts more specialized raw material suppliers, machinery producers, or service providers (like skilled labor training centers). These specialized inputs are often cheaper and better quality, reducing costs for all firms.
• Skilled Labour Pool: When an industry grows, it often leads to an increase in the supply of skilled labour specific to that industry. This can happen through specialized training institutions or workers gaining experience, making it easier and cheaper for firms to hire qualified staff.
• Technological Spillovers/Knowledge Sharing: More firms in an industry can lead to greater research and development, and the benefits (new techniques, information) can spill over to other firms, improving efficiency industry-wide.

graph TD
    A["Industry Output Increases"] --> B["Attraction of Specialized Suppliers"]
    A --> C["Development of Specialized Labour Pool"]
    A --> D["Improved Infrastructure"]
    A --> E["Technological Spillover"]
    B --> F{"Lower Input Costs"}
    C --> F
    D --> G{"Lower Transport/Communication Costs"}
    E --> H{"Improved Production Techniques"}
    F --> I["Individual Firm's LRAC Curve Shifts Down"]
    G --> I
    H --> I

External Diseconomies of Scale

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These happen when the expansion of an entire industry leads to a rise in the long-run average cost (LRAC) for all individual firms within that industry. As the industry gets bigger, it faces certain bottlenecks or negative consequences that push up costs for every firm.

In terms of the industry's supply curve, external diseconomies mean that as industry output increases, the industry's long-run supply curve shifts upwards (or to the left), indicating higher costs of production for any given output. For an individual firm, its entire LRAC curve shifts upwards.

Here's how they typically arise:

• Increased Competition for Inputs: As an industry grows, it demands more raw materials, land, or specific types of labour. If the supply of these inputs is limited, their prices will be bid up, increasing costs for all firms.
• Congestion and Pollution: A larger, more concentrated industry can lead to increased traffic congestion, higher land rents, or greater pollution in the area. These can translate into higher transport costs, rental costs, or regulatory compliance costs for firms.
• Strain on Infrastructure: While initial infrastructure improvements can be an economy, excessive growth can strain existing infrastructure (e.g., roads, electricity grids, water supply) beyond its capacity, leading to inefficiencies, delays, and potentially higher utility costs for all firms.

3. Worked Example

Let's consider the semiconductor manufacturing industry in a particular region, say, "Silicon Valley North."

Initial State:
When only a few small semiconductor firms existed, they had to import many specialized components, train their own staff from scratch, and rely on general-purpose infrastructure. Each firm's average cost of production was relatively high, perhaps $1.00 per chip.

External Economies of Scale in action:
As more and more semiconductor firms moved into Silicon Valley North, the industry grew significantly.
1. Specialised Suppliers Emerged: Companies started specializing in producing silicon wafers, etching chemicals, and packaging services specifically for semiconductor manufacturers, often located nearby. These specialized suppliers could achieve their own internal economies of scale, selling components cheaper to all firms in Silicon Valley North.
2. Skilled Labour Pool: Universities and technical colleges in the region started offering specialized courses in semiconductor engineering. Experienced engineers and technicians were attracted to the area, creating a deep pool of skilled labor. This reduced recruitment and training costs for all firms.
3. Improved Infrastructure: The local government, seeing the industry's growth, invested in better high-speed data networks and specific utility upgrades to support the demanding power and water needs of chip fabrication plants.

Result: Due to these external economies, the average cost of producing a semiconductor chip for every firm in Silicon Valley North decreased, perhaps from $1.00 to $0.80, even if individual firms didn't change their own production scale. Their entire LRAC curve shifted downwards.

External Diseconomies of Scale (hypothetical future):
Now imagine the industry grows even more massively, to the point where it becomes over-concentrated.
1. Input Scarcity: The demand for highly specialized rare earth metals used in chips, or for specific cleanroom-certified components, could outstrip local supply, driving up prices for all firms.
2. Labour Cost Escalation: The deep pool of skilled labour might eventually become fully employed. Further growth would require firms to poach employees from each other, driving up wages significantly across the board.
3. Congestion and Pollution: The sheer number of fabrication plants and associated transport could lead to severe traffic congestion, increasing logistical costs. Local water supplies might become strained, or environmental regulations might tighten significantly due to increased emissions, leading to higher compliance costs for all.

Result: These factors could push the average cost of production back up for all firms, perhaps to $0.95 per chip, even if individual firms are still operating efficiently internally. Their entire LRAC curve would shift upwards.

4. Key Takeaways

• External economies/diseconomies affect all firms in an industry, unlike internal ones which affect a single firm.
• External economies lead to a downward shift of an individual firm's LRAC curve as the industry expands.
• External diseconomies lead to an upward shift of an individual firm's LRAC curve as the industry expands.
• These effects are caused by factors outside the direct control of an individual firm.
• Key sources of external economies include specialized inputs, skilled labour pools, and improved infrastructure.
• Key sources of external diseconomies include input price increases due to scarcity and congestion.

Common Mistakes to Avoid:
- Don't confuse internal economies/diseconomies (from a firm's own scale change) with external ones (from industry scale change).
- Don't assume all industry growth automatically leads to economies; diseconomies can set in.
- Remember that external effects shift the entire LRAC curve, not just move along it.
- Don't forget that external effects can be positive (economies) or negative (diseconomies).

5. Now Try It

Think about the fast-food industry in a major city. Imagine the industry as a whole grows significantly (e.g., many new chains and outlets open). Describe one plausible external economy of scale and one plausible external diseconomy of scale that would affect all fast-food firms in that city. For each, explain why it shifts the individual firm's average cost curve and in which direction. You should aim for about 15 minutes of thought and explanation.