External economies and diseconomies are those advantages of large scale production which depend on increases in the output level of the whole industry and not on increases in the output of an individual firm. Such economies occur not due to an increase in the scale of operation or the size of a particular firm but due to expansion of the whole industry.
External economies arise when an increase in the size of an industry leads to lower costs for each individual firm. For example, in coal mining, it is observed that in pumping water from its own workings a mine also pumps water from the workings of other mines. This means that the more pits there are in the area, the cheaper it is to keep each pit dry.
Another important type of external economy is to be found where the efficient development of an industry depends greatly on the interchange of technical information among firms. In such a case it is obvious that the larger the size of the industry is, the easier and more worthwhile it is to set up large-scale information services to publish trade journals, magazines and news bulletins.
On the other hand, it is quite possible from the growth of an industry to lead to rise in unit costs due to external diseconomies. It is quite possible that as an industry expands it needs more workers skilled in a particular kind of work.
In such conditions if all workers are not equally efficient, it will be necessary to attract less efficient workers from other industries. Even if money wages remain constant, wage costs will rise as less and less efficient workers are employed. Moreover, higher wages will have to be paid in order to attract workers having a particular type of skill.
This will generate external diseconomy which arises due to increased production of an individual firm but the source of such diseconomies is external to the individual firm: the increased size of the industry as a whole raises costs of individual firms.
For the sake of analysis the effect of externalities (i.e., external economies and diseconomies) on the marginal cost curve of a firm can be divided into three parts:
(i) Industry supply with diseconomies of scale,
(ii) Industry supply with economies of scale and
(iii) Industry supply with no external effects.
External Diseconomies of Scale:
Our analysis here is based on an important assumption there is a limited number (n) of potential firms all having the same production functions. We can simplify our analysis further by assuming that all factors of production are homogeneous and are in perfectly elastic supply to the industry so that the prices of all units of each factor are the same.
The representative firm is shown on the left hand size of Fig. 21.18 and the industry on the right hand side. When industry output is Q0 factor prices are such that the marginal cost of each firm is MC0. So ΣMC0 is a quasi-supply curve.
As industry output increases from Q0 to Q1, factor prices rise and the firm’s marginal cost curve rises as is shown by the shift of the marginal cost curve to the left — from MC0 to MC1. The point’s e and f represent the industry supply function as they show the one-to-one correspondence between output and prices.
At the initial price P0, Q0 is supplied and each firm produces Q0/n. Now price rises to P1 and each firm tries to produce the amount indicated by its marginal cost curve — an amount which is much bigger than Q1/n. But, as all the firms try to expand simultaneously, they find their factor prices rising and eventually they expand their output only to Q1/n each — much less than their planned expansion. The basic point to note here is that with external diseconomies of scale the supply curve is less elastic than the sum of the marginal cost curves of all firms at given factor prices.
Usually it is anticipated that external diseconomies would not prevent the expansion of output in any way. But the opposite thing happens in the real business world as is shown in Fig. 21.19 wherein external diseconomies might be sufficient to eliminate any expansion of output or even to cause a decline in output.
The change in factor prices and in technical conditions associated with the change in the price of the product of the industry from 0P0 to 0P1 need not be uniform for all factors- or all firms. Firms whose ‘entrepreneurial capacity’ happens to require relatively large use of factors will find that their cost curves have risen relatively more than the cost curves of other firms, and, in consequence, may curtail output or go out of businesses; and similarly for firms in which technical conditions of production have deteriorated the most.
Industry Supply with Economies of Scale:
In the case of external economies marginal cost falls when output expands. So the industry supply curve is less steep than the sum of the marginal cost curves of individual firms. It is surely possible, but not necessary, that it slopes downward in a forward-falling fashion.
Such a phenomenon gives rise to what is known as ‘absolute cost advantage’ and the emergence of a natural monopoly in case the production function exhibits the operation of increasing returns to scale throughout (i.e., at all levels of output).
Output expansion by an individual firm might confer external economies on other firms which tended to lower their cost curves: ‘external pecuniary economies’ if purchases of factors in large scale lowered their price; ‘external technical economies’ if the expansion of output of a firm somehow favourably affected the technical conditions faced by other firms.
If these effects are more important than external diseconomies affecting marginal cost we say that there are ‘net external economies’ affecting marginal cost curves.
The consequent decline in the marginal cost curves may be consistent with a positively sloped ‘quasi-supply curve , with a horizontal ‘quasi-supply curve’ or with negatively sloped ‘quasi-supply curve’ as depicted in Fig. 21.20, Fig. 21.21 and Fig. 21.22, respectively.
The situation depicted in Fig. 21.22 has an important practical implication: if the technical effects of external economies are favourable the industry should be subsidized. The problem of pecuniary effects is that any action on the part of one firm affects the prices faced by other firms and the firm itself as well.
So long as there is no distortion in the economy and the price change is very small, its net effect on the rest of the world is zero. Only transfers occur i.e., the gainers gain exactly what the losers lose. However, if an increase in industry output reduces the price of an input, this must be due to internal economies of scale. But these economies should be exploited by subsidizing the input.
So the basic point to note here is that only those externalities which are technical in nature should be considered for government intervention.
No External Effects:
We started our analysis by assuming that each firm has its own supply function for given factor prices and technology (ceteris paribus). So for the i-th firm
Qi = Qi (P, w, r).
So the industry supply function is given by-
Q = ΣQi (P, w, r).
In Fig 21.23 when demand curve is D0, the market price is P0. Output is q0A and is produced by firm A alone. If firm B were to produce anything at that price, it would incur a loss.
However, firms A makes a profit of q0A times [P0 – AC (q0A)], where AC is average cost. This residual income is a rent since the entrepreneur of firm A would be willing to produce q0A at price P0 which exceeds AC. If now demand rises to D1, price will rise to P1 and firm B produces a quantity q1B. Firm A, at the same time, expands its output to q1A.
So industry output is:
Q = q1A + q1B
The important point to note is that if technology and factor prices are independent of industry output, the industry supply curve is the horizontal sum of the supply curves of all potential firms; is firms differ in efficiency it slopes upward. The greater the differences in efficiency among firms the less elastic is the industry supply curve.
In another case we analyse the situation where all firms are equally efficient. Let us suppose there are 20 firms in an industry. So S (20) denotes the aggregate supply for this given number of firms. When demand is D0, price is P0 and the firms make no profit.
So there is no entry of new firms into the industry. As demand rises to D1 price rises to P1 and output expands as well. Since each firm is as efficient as any existing one new firms enter the market. The entry of the new firms occurs until all profit is eroded and price again falls to its initial level (P0).
At any price above P0, industry output will be infinite in the long run and at any price below it, it will be zero. So the industry supply curve is infinitely (completely) elastic at a particular price.