(a) EXTERNAL ECONOMIES OF SCALE
External economies of scale are the cost-saving advantages that accrue to the industry as a whole, as a result of the firms being close to each other and an increase in the number of firms in the industry. (size of the industry). An industry is a number of firm producing similar goods. They are external advantages because they derive from conditions outside the firm. For instance the use of common facilities such as transportation; use of skilled labor attracted to the area; banking and insurance services attracted to the area, water, electricity and others.
While the firm can plan its internal economies, it can only hope to benefit from external economies which arise as the industry grows. The concentration of similar firms in an area may produce mutual benefits. A skilled labor force attracted to the area may cooperate in providing common services, such as marketing and research; better roads and social amenities etc. The firm must take into account such economies when deciding where production shall take place.
External economies can take the form of common information services provided either by association of the firms or even by the government. The firms may also collectively finance research which benefits all the firms. These external economies result in a fall in the cost of production of the industry.
(b) EXTERNAL DISECONOMIES OF SCALE
External diseconomies of scale are the disadvantages that arise due to over concentration and over-production as a result of an increase in the number of firms in an industry. There are a number of factors which might give rise to external diseconomies of scale.
1. The concentration of similar firms in an area, may lead to an increase in demand for raw materials used by the firms. This will cause the prices of raw materials to increase provided the supply of the raw materials remains unchanged. This consequently would increases the cost of production in the industry.
2. The localization of firms in an area results in urbanization problems such as traffic congestion. This slows down the movement of labor, goods and raw materials and thereby retarding the rate at which goods and services are produced. This increases the cost of production in the industry.
3. As the industry grows, demand for skilled labor mainly needed in the industry increases. Wage rates will tend to increase as firms begin to compete for the services of the skilled workers.
4. Problems of waste disposal may arise. Firms may be compelled to employed costly waste disposal methods in order to keep the area clean.
5. Competitive advertisement would have to be resorted to and more money will have to be spent on that if each firm is to maintain its position.
6. Structural unemployment may be created as the size of the industry grows. This may be due to changes in taste and preference. This may create declining industry.
All the above lead to a rise in the long-run average cost of production. In conclusion, reduction in cost (average cost) in the long-run is due to both internal and external economies of scale. Increase in the long-run average costs is due to internal and external diseconomies of scale.
AKINRINOLA SERAH on March 18, 2016:
EXTERNAL ECONOMIES ARE BENEFITS A FIRM DERIVES FROM CONCENTRATION OR LOCALISATION OF INDUSTRIES IN A PARTICULAR AREA.
Chrisagbe (author) on March 09, 2011:
Thanks Phoebe Pike for the kind remark and observation.Yes, that is the purpose- to bring these concepts down to as much understandable and reader-friendly terms as possible. You are welcome!
Phoebe Pike on March 08, 2011:
This hub was very informative, though, to be completely honest, the concept is fairly easy to grasp, but I'm glad someone finally wrote about it. Good job.