Diseconomies of Scale

Diseconomies of scale definition – It is a state where the long-run average cost (LRAC) of production increases with the increase per unit of goods produced. It occurs when the firms outgrow in size, resulting in increased employee costs, compliance costs, administration costs, etc.

The increase in the firm’s average price is mainly due to increasing inefficiencies in the system. These inefficiencies may be because of in falling employee coordination, delayed decision making, managerial issues, and communication problems. This is a huge challenge that business need to face during expansion and thus cost control and effective growth strategy is extremely important at this stage.

• In diseconomies of scale, the Long Run Average Cost (LRAC)of production rises with the rise per goods unit created.
• The curve is divided into three states - economies of scale, constant returns of scale, and diseconomies of scale. 
• The causes of diseconomies of scale are - employee costs, communication failure, compliance costs, and administration costs.
• When entities experience economies of scale, the long-run average cost diminishes with increasing production volumes, and the reverse happens in the case of diseconomies of scale.

Diseconomies of scale in economics is the increase in cost due to expansion of the business size or production. At this stage, strategic planning and effective cost control measures are crucial; otherwise, the business profitability gets affected negatively.
Various factors influence the LRAC. For example, when a firm outgrows in size, it is common to experience maturity or saturation. In addition, making a ground-breaking decision is challenging in such firms because the authorities are decentralized. As a result, a decision undergoes many approval processes before any implementation. If this is not done, the firm may experience internal diseconomies of scale.
The diseconomies of scale are precisely the opposite of economies of scale. When entities experience economies of scale, the long-run average cost reduces with increasing production volumes, and the reverse happens in the case of diseconomies of scale.

Let us look at the diseconomies of scale diagram to understand the concept.

In the above chart, the Y-axis represents the cost in $, and X-axis represents production units in Q. The upward-facing curve represents the long-run average cost – LRAC.

In the above diseconomies of scale diagram, the curve is divided into three parts –

• 1) Economies of Scale – It is a state where the firm experiences the highest operational efficiency. The LRAC of the firm keeps falling with the increase in the production of units.

• 2) Constant Returns of Scale – The constant return of scale is a state where the firm begins to start entering the maturity stage. At this stage, the LRAC remains static with the increase in production.

• 3) Diseconomies of Scale – It is a state where a firm experiences a lower operational efficiency. That is because the LRAC keeps increasing with the increase in the production of units.

The average cost of production ($) from the left shows a decreasing trend that reflects the scale’s economies. The average production price in a zone of economies of scale keeps decreasing when we have constant scale returns (represented in dotted lines).

From dotted lines, when we move towards the right, this side of the curve represents the diseconomies of scale. The average costs ($) rise due to operational inefficiencies and other factors as we add more production units.

Various factors influence the LRAC. For example, when a firm outgrows in size, it is common to experience maturity or saturation. In addition, making a ground-breaking decision is not easy in such firms because the authorities are decentralized. As a result, a decision undergoes many approval processes before any implementation.

Below is an example of diseconomies of scale in economics. Paul Mitchell, EY Global Mining & Metal advisory, mentions that the size and complexities of mining operations result in internal diseconomies of scale created when the mining industry had to ramp up production in response to high prices.

source: businessinsider.com.au

Few factors influence the long-run average costs. Let us understand the reasons for diseconomies of scale.

#1 - Employee Costs

Employee cost is directly related to the production of units. They remain relevant costs until firms are in economies of scale. In times of diseconomies of scale, the employees in production processes are relatively higher than required. This situation happens due to the overcrowding of employees in the production, marketing, and administrative process.

A large organization has many departments, which increases the possibility of duplication of work or processes. Employees are reluctant to identify such strategies and avoid proper coordination to bring operational efficiency. That incurs an extra cost in server space and employee costs.

In a large firm, the communication passes through various levels and hierarchies, leading to communication gaps. When communication passes through multiple levels, it doesn’t remain effective. The distortion or leakages at each stage reduce the effectiveness of communication. Most of the time, firms communicate through notices and memos, which is a form of one-way communication and fails to motivate employees towards the required organizational objectives. Communication failure results in low process coordination and poor employee engagement. Failing to communicate effectively is the beginning of diseconomies of scale.

#2 - Communication Failure

An increase in the number of employees resulted in an increasing number of communication channels. However, complex communication channels result in high costs, wastage of time, and effort.

In a large firm, the communication passes through various levels and hierarchies, leading to communication gaps. When communication passes through multiple levels, it doesn't remain effective as intended. The distortion or leakages at each stage reduce the effectiveness of communication. Most of the time, firms communicate through notices and memos, which is a form of one-way communication and fails to motivate employees towards the required organizational objectives. Communication failure results in low process coordination and poor employee engagement. Failing to communicate effectively is the beginning of diseconomies of scale.

#3 - Administration Costs

As the firm grows, it requires a good administration to manage logistics, inventory control, human resources, security system, etc. Therefore, the additional cost incurred on administration increases the average cost of units produced.

#4 - Compliance Costs

Large-size firms are bound to comply with the regulatory bodies. Maintaining the required records and complying with the statutory bodies requires huge costs and efforts. Therefore, an increased level of compliance is common in large firms. As monitoring in such firms is high, the excess risk control measures are placed, which brings some bureaucracy to the system, which is unavoidable. Currently, banks are spending heavily on their compliance and risk consultancies. The surge in compliance costs for the banking industry can be observed after the financial crisis of 2008-2009.

Thus, the above are a list of reasons for diseconomies of scale.

The solutions for diseconomies of scale are given below: -

• The organization can identify large processes that can be parted from the large firm. They can transfer such methods to a newly formed company or subsidiary, working as a service or supplying entity for the leading firm. As a result, it will ensure a good span of control and will increase efficiency.
• Firms can adopt strategies like forwarding and backward integration. It can help the firm use the potential of existing employees and facilities in newly integrated processes (production or sales). That can help reduce the average cost of existing products because the firm has sufficient labor and resources to execute the new strategy and add more revenues.
• Such firms can move for mergers and acquisitions depending on a case-to-case basis. In addition, mergers and acquisitions can help the organization extend or lend the excess labor, administrative strength, and compliance expertise with merged and acquired entities.
• Layoffs can be a last resort, but such decisions come with legal and reputational risk. They can effectively do it with the help of the consultancies which conduct the study on organizational efficiencies and then can conclude those studies.

Some advantages of diseconomies of scale are as follows:

• The business will tend to make a better effort to devise ways and means to control cost and at the same time increase production through better technology, innovation, planning.
• It helps the business identify the areas that are not functioning properly or need upgradation.

The various disadvantages of the process is as given below:

• It leads to rise in cost of production per unit.
• The price of the goods and services the company produces also rise.
• It results in decrease in profitability of the business due to rise in cost per unit.
• The business becomes vulnerable to external competition and threats. Thus any other strong entity can easily try to takeover the company.
• To control cost and increase revenue, business experiencing diseconomies of scale may compromise on the quality of the products, which is very harmful in the long run.

Diseconomies of scale is the rise in cost per unit of goods whereas economies of scale in fall in cost per unit of goods. Let us look at the differences between them.

This article has been a guide to what is Diseconomies of Scale. We explain it with examples, differences with economies of scale, graph, causes & advantages. You may also have a look at these other articles on Economics: -

• Economies of Scale vs Economies of Scope
• Monetary Policy Meaning
• What is Normative Economics?
• Positive Economics