I've connected a 500GB external hard drive to my 40GB PS3 and can transfer files back and forth from it, but how do I transfer actual game utility back and forth or downloaded games. I can only seem to delete them or do a whole system backup. Is there anyway to pick what to transfer or am I going to have to install a new internal hard drive.

To use an external USB hard-drive as a part of the system hard drive (to save game data, demos etc) you have to follow very specific steps and create the same folder names found on the PS3 internal hard drive.

The link below can guide you on that.

How to Add an External Hard Drive to a PlayStation 3 - wikiHow