Main causes of external economies are as follows:
(a) Localization of the industry, and
(b) Specialization.
(a) Localization:
By localization of industry we mean concentration of a number of firms belonging to a particular industry at a particular place.
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This concentration of firms, producing the similar products at a particular place, may be due to some natural advantages or acquired advantages that the place has for the production of a particular commodity.
Thus-we find heavy concentration of Jute industry in Bengal, tea industry in Assam, cotton textile at Ahmadabad, sports goods at Meerut and woodwork at Saharanpur.
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The concentration of industry results in endowing certain advantages to the individual firms which are in the nature of external economies to an individual firm.
Thus, to quote Prof. S.E. Thomas, “External economies are those which arise from the localization of industries and are at the disposal of all firms in same industry.”
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(b) Specialization:
A second source of external economies is specialization among centralized firms. Specialization takes the form of division of labour among the different firms belonging to the same area and to the same industry.
For example it may be observed that when an industrial area develops, it makes possible the growth of a number of firms that act as complements to each other, serving as consumers of waste products and suppliers of ancillaries for each other.
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Growth of a bicycle manufacturing firms in a particular area may induce the growth of a number of firms that may supply the various components to the bicycle manufacturing firm at a lower cost.
Similarly growth of an area induces the emergence of firm supplying specialized services such as advertisement, legal consultation accountancy, distributorship, etc.
These specialized agencies are in a position to provide these services to a firm at a cost lower than what that firm would have to incur if it decides to take up these services itself.
Similarly, provision of common services and distribution of their costs among a number of firms shall work to reduce the cost of production of the different firms.
To sum up, provision of the specialized services bring in reduction in the costs of those firms who decide to take advantage of these services.
Prof. Stigler rightly puts it as, “the progressive specialization of firms as the industry grows in the major source of external economies.”