Diseconomies of Scale

Diseconomies of scale are the forces that cause larger firms and governments to
produce goods and services at increased per-unit costs. The concept is the opposite of
economies of scale. The rising part of the long-run average cost curve illustrates the
effect of diseconomies of scale.

An economic concept referring to a situation in which economies of scale no longer

function for a firm. Rather than experiencing continued decreasing costs per increase in
output, firms see an increase in marginal cost when output is increased.

Economic theory predicts that a firm may become less efficient if it becomes too large.
The additional costs of becoming too large are called diseconomies of scale.

Diseconomies of scale result in rising long run average costs which are experienced
when a firm expands beyond its optimum scale, at Q.

Examples of diseconomies include:

Larger firms often suffer poor communication because they find it difficult to maintain
an effective flow of information between departments, divisions or between head office
and subsidiaries. Time lags in the flow of information can also create problems in terms
of the speed of response to changing market conditions. For example, a large
supermarket chain may be less responsive to changing tastes and fashions than a much
smaller, local retailer.

Co-ordination problems also affect large firms with many departments and divisions,
and may find it much harder to co-ordinate its operations than a smaller firm. For
example, a small manufacturer can more easily co-ordinate the activities of its small
number of staff than a large manufacturer employing tens of thousands.

X inefficiency is the loss of management efficiency that occurs when firms become
large and operate in uncompetitive markets. Such loses of efficiency include over paying
for resources, such as paying managers salaries higher than needed to secure their
services, and excessive waste of resources. X inefficiency means that average costs are
higher than would be experienced by firms in more competitive markets.

Low motivation of workers in large firms is a potential diseconomy of scale that results
in lower productivity, as measured by output per worker.

Large firms may experience inefficiencies related to theprincipal-agent problem. This

problem is caused because the size and complexity of most large firms means that their
owners often have to delegate decision making to appointed managers, which can lead
to inefficiencies. For example, the owners of a large chain of clothes retailers will have
to employ managers for each store, and delegate some of the jobs to managers but they
may not necessarily make decisions in the best interest of the owners. For example, a
store manager may employ the most attractive sales assistant rather than the most
productive one.

Increase in long-term average cost of production as the scale of operations increases

beyond a certain level.

This anomaly may be caused by factors such as

o

(1) over-crowding where men and machines get in each other's way,

(2) greater wastage due to lack of coordination, or

(3) a mismatch between the optimum outputs of different operations. See

also economies of scale.
`

Why it Matters:
When a company/product reaches the point where its marginal cost increases, it becomes a
target for smaller, more efficient firms to compete for its business. A company at this point may
evaluate restructuring its operations, spinning off various production units, or closing some of
its operations. Companies also use a variety of strategies to minimize diseconomies of scale,
such as flattening management structure, investing in technology to improve communication,
careful market segmentation, and decentralizing production.
Internal Economies and Diseconomies of Scale: Meaning and Types (with Graphical
Diagram)
Meaning:
As a firm changes its scale of operation, its average costs are likely to change. Fig. 1 shows the
usual U-shaped LRAC curve. Average costs fall at first, reach an optimum point and then rise.

In very capital intensive industries, such as oil refining, long run average costs may fall over a

considerable range of output as shown in Fig. 2.

In other cases, average costs may fall relatively quickly to their lowest point (the minimum
efficient scale) and then remain constant over a large range of output. This would give an Lshaped LRAC curve as shown in Fig. 3.

External economies and diseconomies of scale have a different effect on a firms LRAC curve. In
the case of external economies of scale, a firms average costs will be reduced not by the
changes in its own output but by the changes in the industrys output. Fig. 4 shows how
external economies of scale result in a downward shift of a firms LRAC curve.

In contrast, external diseconomies of scale will raise a firms LRAC curve at each and every
level of output as shown in Fig. 5.

Types of internal economies of scale:

As a firm increases its scale of operation, there are a number of reasons responsible for a
decline in its average cost. These include:
i. Buying economies:
These are probably the best known type. Large firms that buy raw materials in bulk and place
large orders for capital equipment usually receive discount. This means that they pay less for
each item purchased. They may also receive better treatment than small firms in terms of
quality of the raw materials and capital equipment sold and the speed of delivery. This is
because the suppliers will be anxious to keep such large customers.
ii. Selling economies:
The total cost of processing orders, packing the goods and transporting them does not rise in
line with the number of orders. For instance, it costs less than twice as much to send 10,000
washing machines to customers than it does to send 5,000 washing machines. A lorry that can

transport 40 washing machines does not cost four times as much to operate as four vans which
can carry 10 washing machines each.
A large volume of output can also reduce advertising costs. The total cost of an advertising
campaign can be spread over more units and, again, discounts may be secured. A whole page
advertisement in a newspaper or magazine is usually less than twice the cost of a half page
advertised. Together, buying and selling economies of scale are sometimes referred to as
marketing economies.
iii. Managerial economies:
Large firms can afford to employ specialist staff as they can spread their pay over a high
number of units. Employing specialist buyers, accountants, human resource managers and
designers can increase the firms efficiency, reduce costs of production and raise demand and
revenue. Large firms can also engage in division of labour amongst their other staff. For
example, car workers specialize in a particular aspect of the production process.
iv. Financial economies:
Large firms usually find it easier and cheaper, to raise finance. Banks tend to be more willing to
lend to large firms because such firms are well known and have valuable assets to offer as
collateral. Banks often charge large borrowers less, per $ borrowed, in order to attract them
and because they know that the administrative costs of operating and processing large loans
are not significantly higher than the costs of dealing with small loans.
Large firms can also raise finance through selling shares which is not an available option for
sole traders and partnerships. Public limited companies can sell to the general public. The
larger and better known the companies are, the more willing people are to buy their shares.
v. Technical economies:
The larger the output of a firm, the more viable it becomes to use large, technologically
advanced machinery. Such machinery is likely to be efficient, producing output at a lower
average cost than small firms.
vi. Research and development economies:
A large firm can have a research and development department, since running such a
department can reduce average costs by developing more efficient methods of production and
raise total revenue by developing new products.
vii. Risk bearing economies:
Larger firms usually produce a range of products. This enables them to spread the risks of
trading. If the profitability of one of the products it produces falls, it can shift its resources to
the production of more profitable products.
Internal diseconomies of scale:
Growing beyond a certain output can cause a firms average costs to rise.
This is because a firm may encounter a number of problems including:
i. Difficulties controlling the firm:
It can be hard for those managing a large firm to supervise everything that is happening in the
business. Management becomes more complex. A number of layers of management may be

needed and there may be a need for more meetings. This can increase administrative costs and
make the firm slower in responding to changes in market conditions.
ii. Communication problems:
It can be difficult to ensure that everyone in a large firm have full knowledge about their duties
and available opportunities (like training etc.). Also, they may not get the opportunity to
effectively communicate their views and ideas to the management team.
iii. Poor industrial relations:
Large firms may be at a greater risk from a lack of motivation of workers, strikes and other
industrial action. This is because workers may have less sense of belonging, longer time may be
required to solve problems and more conflicts may arise due to the presence of diverse
opinions.

Economies Of Scale, Diseconomies Of Scale, Constant Returns To Scale

Economies of Scale, Diseconomies of Scale, and Constant Returns to Scale
Economies of scale, diseconomies of scale, and constant returns to scale are all related terms
that describe what happens as the scale of production increases. It is important to understand
the concepts of these returns to scale because they can be an important factor in determining
the optimal and equilibrium size of firms. From that decision, the structure of industries and
their prices and output levels can also be determined appropriately. Therefore, these factors
provide major implications for public policy. Particularly, in case where they lead to the
development of natural monopolies, these companies can claim themselves to be prevented
from government attempts to break them up.

As can be seen in above graph, as the output(production) increases, long run average total cost
curve decreases in economies of scale, constant in constant returns to scale, and increases in
diseconomies of scale
For example, a factory initially expanding its output experiences decreasing long run average
cost. This situation is economies of scale and there are lots of real world examples of
international companies building large plant to take advantage of this situation. However, as a
company passes a certain point it reaches the stage when an increase in output leading
increase in average cost. This situation is diseconomies of scale. And, sometimes the
technology in an industry allows a firm to produce different levels of output at the same
minimum average cost and this condition can be understood as a constant return to scale.
Economies of scale
This term characterizes a production process in which an increase in the number of units
produced causes a decrease in the average cost of each unit. It is also called as increasing
returns to scale as it refers to the situation in which the cost of producing an additional unit of
output, which is the marginal cost of a product decreases as the volume of its production
increases. It could also be defined as the situation in which an equal percentage increase in all
inputs results in a greater percentage increase in output.
An example of an economy of scale would be the production of any established manufacutred
good would decrease with the increase in quantity produced due to the cheaper procurement of
the materials needed for production.
Constant returns to scale
It refers to a technical property of production that examines changes in output subsequent a
proportional change in all inputs (where all inputs increase by a constant). If output increases
by that same proportional change then there are constant returns to scale (CRTS), sometimes

referred

to

simply

as

returns

to

scale.

Diseconomies of scale
A term used to describe processes that do not conform to the definition of economies of scale
due to the costs for production does not decrease with the increased production. This can
happen for several reasons. First this can happen due to the prodcution rates for the creation
of parts for a product may take a set amount of time therefore increasing production would still
be dependent on that part for completetion. The other reason diseconomies of scale can occur
is

from

the

increased

shipping

costs

due

to

distance

or

weight.

A good example of diseconomies of scale would be the phamacutical industry due to their high
research and development costs of producing a new drug.

Diseconomies of scale
A business can become so large that its unit costs begin to rise. Expanding firms can
experience diseconomies of scale. Causes include:
Ineffective communication. Coordinating large numbers of staff becomes a challenge.
Big businesses can develop many levels of hierarchy which slow down communication or even
lead to miscommunication.
Reduced motivation. Staff can feel remote and unappreciated in a large organisation.
When staff productivity begins to fall, unit costs begin to rise.

Diseconomies of scale occur when, as a business expands in the long run, the unit cost of
production increases. Diseconomies are the result of decreasing returns to scale and lead to a
rise in average cost
Diseconomies of scale in a large business may be due to:
1. Control monitoring the productivity and the quality of output from thousands of
employees in big, complex corporations is imperfect and expensive this links to the
concept of the principal-agent problem i.e. the difficulties of shareholders monitoring
the performance of managers.
2. Co-ordination - it can be difficult to co-ordinate complicated production processes
across several plants in different locations and countries. Achieving efficient flows of
information in large businesses is expensive as is the cost ofmanaging supply
contracts with hundreds of suppliers at different points of an industrys supply chain.
3. Co-operation - workers in large firms may develop a sense of alienation and loss of
morale. If they do not consider themselves to be an integral part of the business, their

productivity may fall leading to wastage of factor inputs and higher costs
Big organizations often suffer from the debilitating effects of internal politics, information overload, complex bureaucracy, unrealistic expectations among managers and cultural clashes
between senior people with inflated egos. The result can be that hidden costs increase quickly
expense accounts, a slump in productivity, a deadweight loss of time in slow-moving big
businesses. This is the essence of internal diseconomies of scale.
Avoiding diseconomies of scale
1. Human resource management (HRM) focuses on improvements in recruitment,
communication, training, promotion, retention and support of faculty and staff. This
becomes critical to a business when the skilled workers it needs are in short supply.
2. Performance related pay schemes (PRP) can provide financial incentives for the
workforce leading to an improvement in industrial relations and higher productivity.
The John Lewis Partnership is often cited as an example of how a business can
empower its employees by giving them a stake in the financial success of the
organization. Each partner gets a share of the firms profits each year,
3. Out-sourcing is a tried and tested way of reducing costs whilst retaining control over
production although there may be a price to pay in terms of the impact on the job
security of workers whose functions might be outsourced overseas.
The best way to avoid diseconomies of scale is to make business organization less complex and
more transparent.

Diseconomies of Scale - Meaning and Definition

Introduction
When you manufacture a commodity, you try to utilize all factors of production optimally.
Because, optimization provides you with maximum profit with less cost of production. However,
there is a limit to this optimization. If you try to optimize beyond this limit, diseconomies of
scale arises. Suppose you are truck driver. When you carry few parcels in your truck, you may
incur loss or minimum profit. At the same time, if you utilize the space available in your truck
optimally to carry many parcels, it will give you good profit. If you continue to add parcels
thinking of huge profit, your truck will be damaged because of overload. This is what
diseconomies of scale.
A firm cannot optimize its production continuously because diseconomies arise at some point.
Diseconomies of scale tend to decrease profit by increasing cost of production. Diseconomies do
not arise just because of optimization. In a production environment, there are certain internal
and external forces, which act as diseconomies.

Possible Diseconomies in a Large-Scale Production

The following diseconomies may emerge in a large-scale production:
Diseconomies in management
When you try to optimize the production process beyond certain stage, you will have to face
complex problems. These complex problems, which increase cost of production, are known as
diseconomies. The basic problem of diseconomies is that they result in increased costs. When
cost of production increases, profit reduces eventually. Hence, we can claim that diseconomies
limit the production of a firm.
Diseconomies in management range from labor issues to financial problems. The indifferent
attitude of workers, inefficient supervision, continuous demand for wage raise, increased
wastage and unapproachable management are some of the examples of diseconomies in
management. All these problems certainly hinder the production environment.
In a large-scale production, always there is a room for unethical practices and dishonesty. Both
management and workers equally try to carry out unethical practices for various reasons. The
reason for dishonesty is that it is difficult to keep everything or everybody under close watch.
As stated above, financial problem is one of major diseconomies in a large-scale production. If
an organization is a human body, finance is the heart. Finance is necessary for everything from
day-to-day business administration to future business expansion. Another important point is
that adequate capital should be available at the right time to complete the ongoing projects.
Hence, time element matters a lot in financial management. Furthermore, officials who handle
financial affairs of an organization must be honest.
As the size of a firm increases, risk of uncertainty also increases. This is very similar to trading
stocks or currency instruments. When you trade small quantities, the risk is also small. If you
trade big quantities, the risk is also big.

Diseconomies in marketing
The success or sustainment of a firm depends upon its ability to capture market. Market
capture is not an easy task now-a-days because of huge competition. If appropriate strategy is
not in place to attract customers, the firm will not be able to sustain in the long-run.
Furthermore, projecting market demand accurately is a key point to success. If an organization
fails to estimate market demand accurately, it may face the problem of over-production. What is
the use of producing more commodities when there is no demand for them? Obviously, the firm
incurs heavy losses because of over-production.
Competition from the rivals is another important diseconomy. Today, perfect competition
prevails all over the world. Therefore, companies have to make huge efforts to tackle the rival
products. The only way to tackle the stiff competition is to advertise the products extensively.
Advertising, sales promotion and campaigning requires huge financial resources. Studies on
expenditures of various companies show that they spend substantial portion of financial
resources for advertisements. What happens when the competition increases further is that
companies start spending more on advertising and sales promotion. These activities of a
company lead to higher cost. When cost increases, profit starts declining naturally.
Most of the time, companies miscalculate customers expectations. Production managers must
be knowledgeable to identify customers needs, tastes and preferences. There is no use of
producing a commodity that is not preferred by anybody. In this case, the company is in the
danger of losing its customers to other competitors.
Large-scale producers are often not flexible to customers complaints. They frame policies in the
beginning or adapt existing policies of the industry and strictly follow them. The policies may
be out-dated. When an out-dated policy is followed, the company causes itself an irreparable
damage, which eventually collapses the very foundation of the company.
Political upheavals and abnormal situations are the most important diseconomies for a largescale producer because they directly affect the sales of produced goods and availability of raw
materials. Note that diseconomies like these are not under the control of a producer.
Diseconomies in technology
Technological improvement is undoubtedly helpful to improve the production process and
maximize the output. However, the manufacturer cannot keep on utilizing all innovative
technologies. The reason is that the sale of produced goods depends upon various external
factors. Given this situation, adapting advanced technology continuously may result in overproduction and the overly produced goods may not get sold as expected.
Diseconomies in labor management
One of the biggest problems faced by almost all firms is labor disputes. As the size of a firm
increases, the management has to employ more laborers as well. The very first problem any
organization faces is shortage of qualified laborers. A country with low fertility rate often faces
this type of labor crisis. When there is a shortage of skilled laborers, management has to offer

more wage. It increases the cost of production, which is not so desirable.

Secondly, as the number of laborers increases, more possibility of labor disputes, strikes and
lockouts emerges. No matter how efficiently the manager handles the laborers hostile and
indifferent attitude always prevails among employees. All these can affect the production
process directly or passively and hence result in huge loses.
Diseconomies in flexibility
For a large-scale firm, switching over from one business to another is not easy because of huge
investments and intensive concentration. If the business does not perform well for any reason,
the firm has to suffer a lot for its survival.
External diseconomies
Large-scale production is the primary reason for unequal distribution of wealth. The entire
system is framed in such a way that it works for certain sect of people. Therefore, it causes a
significant gap between the rich and poor. When this gap widens uncontrollably, many social
problems such as civil war and political upheavals start emerging.
Possible Diseconomies in Small-Scale Production
Many of the small-scale firms are not able to compete with large-scale firms because of
financial constraints, or lack of skilled laborers, market and technology. Therefore, small-scale
firms eventually vanish over a period.
Small-scale firms cannot allot adequate financial resources to research and development.
Therefore, these firms have to depend upon big industries for advanced technology to
incorporate in the production process.
In general, wastage in a small-scale firm are huge because it lacks the ability to utilize the byproducts in a useful manner.
Generally, small-scale firms possess labor-intensive technology. When a firm uses laborintensive technology extensively, the cost of production increases drastically.
Diseconomies of Scale and Scope
In class yesterday, one of my exceptional students, Rick Moylan, asked me an interesting
question. He said, "I have heard about diseconomies of scale. Is there such a thing as
diseconomies of scope? It would seem that they must exist." What a terrific question! Clearly,
we hear people talk about diseconomies of scale whenever a firm gets so large and complex that
it becomes difficult to manage effectively. Recall that scale economies exist when costs per unit
fall as the number of units produced rises. In other words, bigger is better. However, costs per
unit often bottom out at some point, and then they start to rise again. We have heard reference
to diseconomies of scale with regard to firms such as Citibank and General Motors, for
instance. Frankly, I think too many executives justify large mergers and acquisitions on the
grounds of scale economies without ever considering the potential for diseconomies.
What do we mean by diseconomies of scope? Well, first let's define economies of scope. We are

talking here about multi-business unit corporations. In those cases, we would argue that scope
economies exist if an economic benefit exists because multiple businesses operate under one
corporate parent. People commonly refer to scope economies as synergies. For instance, one
could argue that Disney's theme parks derive economic benefit from being in the same
corporation as Disney's animation studio.
Can diseconomies of scope exist? Surely, they can. Sometimes, when firms diversify into new
businesses, they actually do more harm than good. The expansion of scope does not enhance
the value of the businesses in the corporate parent's portfolio, but instead diminishes their
value. For instance, consider this hypothetical scenario. Imagine if Disney acquired a video
game company with a reputation for making incredibly violent games. That expansion of scope
may actually harm Disney's other businesses because it would damage Disney's brand image
as a provider of "family entertainment." We would not have synergies, but instead a negative
impact on the value of the firm as a whole. Once again, I think managers often discount the
possibility of such diseconomies, focusing instead on making the argument for synergies that
can justify a particular merger or acquisition.