Internal economies of scale are firm-specific, or caused internally, while external economies of scale occur based on larger changes outside of the firm. Both types result in declining marginal costs of production, yet the net effect is the same. External economies of scale are generally described as having an effect on the whole industry.
Economist Alfred Marshall first differentiated between internal and external economies of scale. Marshall 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.
There are several different kinds of internal economies of scale. Technical economies of scale are achieved from 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.
Internal economies of scale tend to 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.
(For related reading, see: What Are Economies of Scale?)