Internal vs. External Economies of Scale: What’s the Difference?

An economy of scale is a microeconomic term that refers to factors driving production costs down while increasing the volume of output. There are two types of economies of scale: internal and external economies of scale. Internal economies of scale are firm-specific—or caused internally—while external economies of scale occur based on larger changes outside the firm. Both result in declining marginal costs of production, yet the net effect is the same.

Economist Alfred Marshall first differentiated between internal and external economies of scale. He suggested broad declines in the factors of production—such as land, labor, and effective capital—represented a positive externality for all firms. These externality arguments are offered in defense of public infrastructure projects or government research.

An internal economy of scale measures a company's efficiency of production. That efficiency is attained as the company improves output when the average cost per product drops. This type of economy of scale is a consequence of a company's size and is controlled by its management teams such as workforce, production measures, and machinery. The factors, therefore, are independent of the entire industry.

There are several different kinds of internal economies of scale. Technical economies of scale are achieved through the use of large-scale capital machines or production processes. The classic example of a technical internal economy of scale is Henry Ford's assembly line. Another type occurs when firms purchase in bulk and receive discounts for their large purchases or a lower cost per unit of input. Cuts in administrative costs can cause marginal productivity to decline, resulting in economies of scale.

External economies of scale are generally described as having an effect on the whole industry. So when the industry grows, the average costs of business drop. External economies of scale can happen because of positive and negative externalities. Positive externalities include a trained or specialized workforce, relationships between suppliers, and/or more innovation. Negative ones happen at the industry levels and are often called external diseconomies.

There are several contributing factors behind external economies of scale. When competing companies set up shop in one area, specialized workers will seek employment. An example of this would be the IT industry in Silicon Valley, which has attracted a special set of skilled workers. Secondly, certain industries may become so important, they can develop bargaining power with politicians and local governments. This, in turn, can lead to more favorable treatment in the form of subsidies or other concessions. The oil industry has a long history of subsidies in the United States, which were historically given to continue a steady flow of domestic supply.

Internal economies of scale offer greater competitive advantages than external economies of scale. This is because an external economy of scale tends to be shared among competitor firms. The invention of the automobile or the internet helped producers of all kinds. If borrowing costs decline across the entire economy because the government is engaged in expansionary monetary policy, the lower rates can be captured by multiple firms. This does not mean any external economy of scale is a wash. Companies can still take relatively greater or lesser advantage of external economies of scale. Nevertheless, internal economies of scale embody a greater degree of exclusivity.