Diseconomies of Scale | Definition, Examples, Categories, Types
- What is Diseconomies of Scale?
- How does Diseconomies of Scale occur?
- What are the Two Categories of Diseconomies of Scale?
- What are the Three Types of Internal Diseconomies of Scale?
What is Diseconomies of Scale?
Diseconomies of scale are which the company experiences an increase in average unit cost when the production output increases. The production process starts to become less efficient after a specific point in production output. The company will experience an increase in average per-unit cost when they start to produce an additional unit of output beyond a certain level.
The firm normally experiences the economies of scale first, where unit cost decreases when the level of output increases. There will be an optimum minimum average unit cost at a certain level of output. Company experience Diseconomies of Scale when they try to produce more than this optimum output quantity and company will experience an increase of the average per-unit cost.
Diseconomies of scale are which the marginal cost of production increases with the output, which results in a reduction of profitability. Opposite of economy of scale happens and costs increase with the production of each additional unit.
The diagram below illustrates both the economy of scale and the diseconomy of scale concepts. The company is producing at the point of lowest average unit cost in the Quantity Q1. The average cost per unit will be higher if the Production Quantity is less than or more than Q1.
When the production quantity is higher than Q1 then the average unit cost will increase with experiencing diseconomies of scale.
How does Diseconomies of Scale occur?
Diseconomies of Scale occur when the company expands and the economies of scale no longer operate for the company. This may result from technical issues in a production process, management issues, workforce inefficiencies due to bottlenecks, or resource constraints on productive inputs.
Diseconomies of scale can involve factors internal to an operation or external conditions beyond a firm’s control.
Following are some internal factors that the company can cause diseconomies of scale,
1) Less Effective Coordination
As a company grows in size, it becomes more difficult to conduct inter-department coordination. Even it could be difficult to coordinate effectively within the same department. This will result in a decrease in production efficiency.
2) Loss of Focus by the Management
Management may lose focus when the company grows. There can be an increase in the number of problems and situations which management should attend to. Efficiency in decision-making and problem-solving can be reduced due to the same.
3) Inefficiency of Communication
Efficient communication is a vital factor to properly execute any business. When the company expands, the communication layers will be increase horizontally and vertically. As the company hierarchy grows, the company tends to depend on written communication more. This will result in a decrease in communication efficiency.
4) Lack of Motivation
Employees will feel isolated and less motivated when the business grows and the number of employees increased. An increase of the layers in the corporate hierarchy will have less interaction between employees and senior management.
Senior management will not see the ground-level problems of the company. Also, proper accurate employee performance appraisals could be challenging with a large workforce.
5) Increase of Business Risk
Impact of the business risk increases when the company scales its operations more. Any management mistake could cause a huge loss since the company operates on an expanded scale.
6) Over Production
Over-production can happen frequently when the company has a large production. Production could be more than the actual demand which would lead to a fall in prices. The company may have to make decisions to offer a high discount to clear their production stock.
7) Difficulty to Manage Finance Capital
A large corporate will require high capital to operate. Also debt level and the shareholder expectation of the profits can be huge. Also, these companies require a high amount of capital for business expansion. It would be hard to manage these situations in an optimal way.
8) Difficulty to Manage Human Capital
When the company expands the employee workforce will also expand. This will result in monopoly and boredom. Also, there could be the establishment of trade unions also. It will be difficult for the management to control these challenges in a large corporate.
What are the Two Categories of Diseconomies of Scale?
Diseconomies of Scale can be categorized as internal or external.
1) Internal Diseconomies of Scale
Internal Diseconomies of Scale is purely based on the maximum level of the abilities of the company and management decisions. As an example, the entire production flow will not be optimized to achieve a higher number of production. There could be bottlenecks to reduce the efficiency of production.
2) External Diseconomies of Scale
External diseconomies of scale can arise due to restraints forced by the external environment across the industry. As an example, the government could impose a special tax for the companies who gain a higher profit than a certain amount.
What are the Three Types of Internal Diseconomies of Scale?
Below are the three types of internal diseconomies of scale,
1) Technical Diseconomies of Scale
The company might be unable to scale up all the required aspects of the company when the company expands its production. Technical Diseconomies of Scale happens when a company invests heavily in new capacity.
As an example, an existing production plant may be highly efficient, which promotes management’s decision to invest in a new production plant. After the investment, the new production plant may not be efficient as the first.
Technical diseconomies of scale are more related to physical capacity in the production cycle.
2) Organizational Diseconomies of Scale
Organizational diseconomy is where the management of human capital will be difficult when a large workforce is there. There could be many inefficiencies such as
- The rigid quick decision-making process
- Lack of accountability
- Communication Barriers
- Increase of Communication Layers
3) Purchasing Diseconomies
Big companies receive more discounts on the raw material purchase since they are buying in bulk. But in some instances, large companies could end up more than small companies due to many factors.
Factors for this will be overproduction issues, sales forecasting problems, an increase of wastage, production inefficiencies.
Difference Between Economies of Scale and Diseconomies of Scale
Economies of scale are cost reductions experienced by companies when they increase their level of output. Simply the cost per unit of an individual item decreases when increasing the scale of production. This concept is related to operational efficiencies and synergies as a result of an increase in the level of production. The simple meaning is that companies tend to do things more efficiently with increasing size.
When a company’s production output increases, there is an increase in the average unit cost, which is known as diseconomies of scale. The production process starts to become less efficient after a certain point in production output. The company will experience an increase in average per-unit cost when they start to produce an additional unit of output beyond a certain level.