External economies are a key driver in international trade, but they are even more important in interregional trade. External economies of scale arise when the cost per unit of output depends on the size of the industry, and not on the size of any one firm within the industry. With external economies of scale, the efficiency of firms within an industry is increased with a larger industry. This is the opposite of internal economies of scale, where the cost of a unit of output depends upon the size of the producing firm, but not necessarily on the size of the industry to which it belongs.
An industry that has purely external economies of scale will be made up of many small firms and tend towards a market structure that is closer to being perfectly competitive. Internal economies of scale, in contrast, provide large firms with a cost advantage over smaller firms and tend to lead to an imperfectly competitive market structure.
External economies of scale play an important role in determining the location of production. Firms that are subject to external economies of scale will tend to cluster together where they can benefit from each other’s presence. Clustering will allow these firms to gain from access to larger base of specialized suppliers, a pooled market for workers, and knowledge transfer among firms. In short, external economies of scale tend to promote the creation of specialized clusters within local regions.
External economies of scale may be more important in driving regional cluster development than either access to factors of production or resources. Factors of production such as labour and capital play a less decisive role in interregional trade because these factors tend to be relatively mobile within countries, and will go to where the industries are rather than the other way about.