This phenomenon is sometimes called an "agglomeration economy," in which businesses are located close to one another and can share resources and efficiencies. It is similar to the business governance concept of synergy. Scale economies that occur outside of a company, but from which all companies in an industry benefit could include the following:.
External economies of scale have several advantages. They include the following:. But external economies of scale are not without drawbacks as well. These disadvantages include:. From the late s to the early s, the arguable epicenter of the U. It was known as Route , named for the freeway that ringed the city, and around which a cluster of technology companies grew—including those in the burgeoning computer business.
A variety of factors enticed entrepreneurs there, including proximity to corporations and educational institutions with their research centers and talent, financial services and venture capital firms, and military bases. And the more businesses that came, the more external economies of scale developed, making it easier for more ventures to find facilities, skilled labor, suppliers, sub-contractors, and support services—and to markets themselves, staging conventions and conferences. Interestingly, toward the end of the 20th century, Route was eclipsed as the center of the high-tech industry by Silicon Valley in the San Francisco Bay Area, where the external economies of the scale grew—as things in California tend to do—bigger, faster, and on a grander scale.
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I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Economics Microeconomics. Table of Contents Expand. What Are External Economies of Scale? This could be explained intuitively as follows. Starting from point E, where the economy is at internal and external balance, an increase in government expenditure from E to A would result in a balance of payments deficit and inflation. To restore external balance, credit expansion has to be reduced by the amount represented by the distance from A to C.
This reduction is relatively smaller than that required to restore internal balance, which is represented by the distance from A to D. The comparative advantage of G over DC in influencing real income could be explained in the same way.
This is a situation in which the economy is suffering from inflation and a balance of payments deficit. Usually, a credit restraint combined with a tightening of fiscal policy is required to deal with this combination of imbalances, with or without a change in the exchange rate. This would best be achieved by the monetary and fiscal authorities coordinating their policies to avoid any overadjustment or overshooting that would require future corrections.
In the absence of policy coordination, macroeconomic balance can still be restored, provided that each policy instrument tries to attain the target over which it has the greatest influence. At point F, the monetary authorities may tighten credit, bringing the economy toward H , so as to restore external balance. At point H, however, the economy is experiencing a recession. This may prompt the fiscal authorities to pursue a moderate fiscal expansion to bring the economy toward internal balance.
This pattern of policy reaction and adjustment will eventually move the economy toward E. Another convergent adjustment pattern would be for the monetary authorities to try first to tighten credit to achieve external balance at point C. Subsequently, the fiscal authorities could tighten fiscal policy to move the economy toward internal balance at J. Since at J the balance of payments reaches a surplus, the monetary authorities would need to expand credit moderately, bringing the economy toward external balance.
This pattern could continue until the economy arrives at E. Inappropriate policy mixes, or policies that do not follow according to their comparative advantage, can be destabilizing, thwarting efforts to effect simultaneous internal and external balance. Consider the case of a Southeast Asian country. This country undertook comprehensive structural reforms while maintaining macroeconomic stability in the s.
The successful macroeconomic and structural adjustment program created an investment boom in the early s. However, inflation began to accelerate, and the balance of payments began to show signs of strain, while the economy continued to grow rapidly.
To contain inflation, the monetary authorities curtailed credit sharply, while maintaining the fixed exchange rate. The sharp credit tightening, however, resulted in a steep increase in domestic interest rates.
To restore external balance, particularly to increase imports, the government implemented an expansionary fiscal policy, moving the economy from point D to point L. But the expansionary fiscal policy worsened inflation, while capital inflows continued. The monetary authorities responded by tightening credit further, which moved the economy from point L to point M.
As can be seen, the inappropriate combination of tight monetary policy and expansionary fiscal policy moved the economy away from point E. Table 2. The years indicate the adjustment periods during which the World Bank loans were disbursed plus one year after the final disbursement. Out-comes were observed during both adjustment and postadjustment periods, up to They are sorted into four categories: The countries that followed the right policy and obtained the right result constitute the majority for each policy area, for a total of 87 out of cases.
There are 17 cases in which countries followed the wrong policy and got the wrong result, consistent with the analytical framework presented above. For countries that followed the right policy but got the wrong result, the reason could generally be explained by unanticipated exogenous shocks, such as drought, civil strife, or deterioration in the terms of trade. There are nine cases in which countries followed the wrong policy but got the right, or seemingly perverse, result.
Some of these cases could be explained by unanticipated favorable exogenous events, but others cannot. The authorities tightened monetary policy to compensate for expansionary fiscal policy to reduce domestic demand and to contain inflation. This combination generated an extended recession. The improvement in the resource balance came entirely from import compression. Policy coordination is crucial in the formulation and implementation of comprehensive economic adjustment programs.
All relevant policy agencies must work together to set common objectives and quantitative targets, and agree among themselves on the economic projections and required policy measures. Typically, a country will formulate such an adjustment program if it seeks a financial arrangement with the IMF. Other than on these occasions, however, the general tendency is for policy authorities to operate without coordinating among themselves. What are the reasons for lack of policy coordination?
First, the fiscal and monetary authorities may have different policy objectives. For example, the monetary authorities may aim at a lower inflation rate than the fiscal authorities, and the fiscal authorities may be more concerned about economic growth than are the monetary authorities. Second, the two authorities may have different forecasts of the likely outturns in the absence of policy changes.
Divergent forecasts reflect different theories or models used in forecasting, which in turn are the results of different training backgrounds and experiences. The third and related reason is that the two authorities may have different opinions on the likely effects of policy measures on the economy, because they may adhere to different theories or use different forecasting models.
In the absence of policy coordination, and particularly if precise quantitative information is lacking about the location of general equilibrium that is, simultaneous internal and external balance relative to the current situation, policy assignment could avoid destabilizing actions, as has been shown above.
A financial programming exercise is an example of perfect policy co-ordination. All forecasts and policy measures are internally consistent within the same accounting and analytical frameworks used to formulate the program. However, it is important not only to analyze the causes of the imbalances but also to consider the comparative advantage of each policy when determining the policy objectives and the required measures.
For example, if the predominant problem is inflation, which is mainly caused by unsustainable fiscal policy, then cutting the budget deficit should be made the linchpin of the program design. On the other hand, if the main issue is an unsustainable current account deficit and the real exchange rate is significantly overappreciated, then depreciation of the nominal exchange rate could be a key policy measure, supported by appropriate monetary and fiscal policies.
Finally, if the problem is not only an unsustainable current account deficit but also a capital outflow caused by inappropriate interest rate differentials, monetary policy should be given prominence in the program design. The degree of credit restraint should take into account the extent to which both government and private sector borrowing requirements would be met by the banking system, consistent with the overall quantitative targets.
The greater integration of capital markets in the s has important implications for the analytical framework presented in this chapter.
First, exogenous changes in the attractiveness of capital inflows influence both the external and the internal balance. Large capital inflows, for example, are likely to be associated with rising investment, consumption, imports, and money demand. Depending on the exchange rate arrangement, policymakers can face either accelerated inflation or a nominal appreciation in the first instance if the large inflows, particularly of a short-term nature, are not sterilized.
Box 2. In a small, open economy operating under a free float, capital inflows K normally will result in an appreciation of the nominal exchange rate e with no change in either international reserves NFA or broad money M2. The exchange rate appreciation will lead to a worsening of the current account balance CA. Under a fixed exchange rate regime and without sterilized intervention, money market equilibrium will be achieved via an increase in net foreign assets and a corresponding increase in the money supply.
With full sterilization, the increase in net foreign assets will be offset by a decrease in domestic credit NDA , with no change in broad money. For intermediate cases with a managed floating regime, the degree of monetary expansion following capital inflows depends on the extent to which the inflows are sterilized and the nominal exchange rate is allowed to appreciate.
Continued sterilized intervention without complementary fiscal tightening generally results in higher domestic interest rates and real exchange rate appreciation. In fact, the role of monetary policy in dealing with the short-run trade-off between a real exchange rate appreciation and inflation has been one of the main themes of recent debate about the appropriate response to surges in capital inflows and the causes of currency crises in emerging market economies.
Moreover, since sterilization may involve increasing the quantity of government securities to offset the currency inflow, it may result in an undesirable rise in public debt and interest costs. Conversely, when economies experience currency pressure because of a loss of market confidence or contagion, tightening of monetary policy with high interest rates is expected to discourage capital out-flows and stabilize the exchange rate. Higher domestic interest rates not only raise the nominal returns to investors from assets denominated in domestic currency but also make speculation more expensive by increasing the cost of shorting the domestic currency.
Moreover, tight monetary policy is expected to lower domestic demand, improve the current account, and reduce expectations of future inflation and, therefore, of future currency depreciation. However, until market confidence is regained and interest rates are gradually lowered, the tight monetary policy could cause insolvency of weak banks and firms and could have a long-term adverse effect on output.
Discussions of appropriate responses to large capital inflows and currency crises emphasize policy coordination. It has been suggested, for instance, that during the initial phase of large capital inflows, credit tightening should be complemented by fiscal restraint to reduce the differential between domestic and foreign interest rates and to decrease the current account deficit.
A cut in government spending is also expected to reduce the demand for nontradables relative to the demand for tradables, thus limiting the appreciation of the real exchange rate.
Similarly, countries have combined fiscal stimulus with lower interest rates to reduce the recessionary effects of the initial adjustment in response to currency crises. As regards exchange rate policy, the recent crises in some Asian and Latin American countries have reopened the question of whether a fixed exchange rate system is consistent with free capital mobility, particularly in view of rapid adjustment in globalized capital markets.
There is no generally agreed answer to that question, although experience has shown that fixed rates are more vulnerable to speculative attacks. When a country is experiencing large capital inflows, policymakers need to decide on the direction of the exchange rate. If capital inflows are predominantly portfolio investment or other short-term inflows, the equilibrium real exchange rate will probably depreciate if the capital is used to finance consumption or unproductive activities and will probably appreciate if it is channeled into productive capital formation.
The argument has been made that, because of the difficulties in predicting the equilibrium real exchange rate and the advantages in adjusting the real exchange rate through a change in the nominal exchange rate rather than through domestic prices, it is better to make the nominal exchange rate sufficiently flexible for market forces to establish equilibrium.
Flexible exchange rates would isolate the monetary base from changes in net foreign assets, thus enabling monetary authorities to exercise more control over the monetary aggregates and to focus on other necessary measures, such as strengthening the financial system. Moreover, greater exchange rate flexibility, by letting foreign investors and domestic borrowers bear higher exchange risks, could discourage speculative capital flows.
A disadvantage of a free float, however, is that it may be associated with high volatility in both the nominal and the real exchange rate. Large capital inflows, for example, may induce a drastic exchange rate appreciation that could have negative long-lasting effects on the export sector. To reduce the risk of excessive exchange rate volatility, several countries have adopted crawling exchange rate bands, which can be regarded as an intermediate stage between fixed and flexible exchange rate regimes.
However, even when a country adopts an exchange rate-band, the policy authorities should stand ready to move the band, if circumstances warrant. Such an action would also require coordination with monetary and fiscal policies to ensure its effectiveness.
Aghevli , Bijan B. Khan , and Peter J. Calvo , Guillermo A. Citrin , Daniel A. Lahiri , eds. Clark , Peter B. Corden , W. Fleming , J. Frenkel , Jacob A. Hinkle , Lawrence , and Peter J. Montiel , eds. Isard , Peter , and Hamid Faruqee , eds. Kenen , Peter B. Khan , Mohsin S. Branson , Jacob A. Montiel , Peter J. Mundell , Robert A. Polak , Jacques J. Swan , Trevor W. Arndt and W. Max Corden Melbourne : Cheshire , pp. A basic reference for this topic is Clark and others This concept is discussed in detail in Clark and others Some recent extensions of this approach and the manner in which it is applied by IMF staff are described in Isard and Faruqee Subsequently, the framework was refined by IMF staff and academics, mainly in their work on the fundamental equilibrium exchange rate FEER.
An alternative single-equation approach is offered in Edwards a , In this approach, the real exchange rate defined as the relative price of tradables to nontradables is specified as a semilog linear function of the following: 1 potential fundamentals such as the rate of growth of total factor productivity, the terms of trade, the share of government consumption in GDP, the openness of the trade regime, and the degree of capital controls; 2 other variables that could cause the real exchange rate to deviate from its equilibrium value, including proxies for transitory aggregate demand shocks and the change in the nominal exchange rate; and 3 a lagged dependent variable.
The equilibrium real exchange rate is derived by using estimated permanent values of the fundamentals, setting the coefficients of the transitory aggregate demand variables and of nominal exchange rate changes equal to zero, and setting the current and lagged real exchange rates equal to each other in the estimated equation.
For a survey of empirical evidence on the effects of exchange rate policy on exports and growth, see Khan and Knight , among others. Khan and Knight summarize some of the empirical results of the effects of monetary and fiscal policies on growth. This model, originated by Mundell and Fleming , has been extended during the past three decades by others, including Frenkel and Razin It could be argued that in a small, open economy with managed floating and high capital mobility, monetary policy should be used to manage the exchange rate, leaving the management of domestic demand to fiscal policy.
This is because monetary policy would have little or no effect on domestic interest rates. The two instruments could be represented by the rate of credit expansion in percent and the budget deficit as a ratio to GDP. The reduced-form equations are derived under the assumption that the exchange rate is given. For this and other issues in dealing with the recent Asian crisis, see, for example, Goldstein and Lane and others All Rights Reserved.
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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. Tools for Fundamental Analysis. Your Privacy Rights.
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Internal and External Economies of Scale: An Overview An economy of scale is a microeconomic term that refers to factors driving production costs down while increasing the volume of output. Key Takeaways Internal economies of scale measure a company's efficiency of production and occur because of factors controlled by its management team.
External economies of scale happen because of larger changes within the industry, so when the industry grows, the average costs of business drop.
Internal economies of scale offer greater competitive advantages because an external economy of scale is shared among competitors. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate.
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