IGCSE Economics 0455: External vs Internal Economies of Scale

Ashford Motors is a large car-assembly plant in the town of Ashford. Over the last twenty years, many car-component makers have also chosen to set up their factories in Ashford, so the town is now home to a whole cluster of car-related firms, not just Ashford Motors itself. As a result, the local college now runs specialist courses in vehicle-engineering skills, and the local council has upgraded the roads around the town to handle heavy component deliveries.

(a) Define external economies of scale. [2]

(b) Using the Ashford example, explain how the growth of the WHOLE car-making industry in the town, rather than the growth of Ashford Motors alone, has lowered Ashford Motors' average costs. [3]

(c) Explain one way this kind of economy of scale differs from an internal economy of scale, such as a technical economy gained from Ashford Motors installing larger production-line machinery. [3]

Part (a): Defining external economies of scale

External economies of scale are falls in a firm’s average (unit) cost of production that come from the growth of the whole industry in a town, region or country, rather than from the growth of that individual firm. They are “external” because the firm itself does not need to expand to benefit from them. The benefit comes from developments outside the firm.

Part (b): How the growth of Ashford’s car industry has lowered Ashford Motors’ average costs

As more and more car-component makers have chosen to locate in Ashford, the whole town has developed into a specialised car-industry cluster. Two consequences of this follow directly:

The local college now runs vehicle-engineering courses, because there is enough demand from the whole cluster of car-related employers to justify offering them. This gives Ashford Motors access to a larger pool of already-skilled workers ready to be hired, without Ashford Motors having to pay for that specialist training itself, lowering its average labour cost.
The council has upgraded local roads to cope with heavy component deliveries across the whole cluster of firms, not just for Ashford Motors. Better roads reduce the time and cost of transporting components to and from Ashford Motors’ plant, lowering its average transport cost.

Crucially, neither benefit exists because Ashford Motors itself grew bigger, they exist because the surrounding car-making industry in the town as a whole grew, which is exactly what makes them external economies of scale.

Part (c): How this differs from an internal economy of scale

If Ashford Motors installed larger production-line machinery, that would be a technical economy of scale: its average cost would fall specifically because Ashford Motors itself increased its own scale of production. Crucially, this benefit belongs only to Ashford Motors. A small, independent component maker elsewhere in Ashford that has not grown at all would see no benefit from Ashford Motors’ new machinery.

The skilled-labour pool and upgraded roads described in part (b) are different in kind: they are available to any firm based in Ashford’s car-industry cluster, including small component makers who have never expanded themselves, simply because they are located in the same growing local industry. External economies of scale therefore depend on the size and growth of the industry or region, while internal economies of scale depend on the size and growth of the individual firm.

Final answers

(a) External economies of scale are falls in average cost arising from growth of the whole industry/region, not the individual firm.
(b) A larger local pool of vehicle-engineering skilled labour (from the college) and upgraded local roads (from the council) both lower Ashford Motors’ average costs because the whole car-industry cluster in Ashford grew.
(c) Internal economies (e.g. larger machinery) benefit only the firm that grows; external economies (e.g. skilled labour, infrastructure) benefit any firm in the growing industry/region, regardless of that firm’s own size.