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Diseconomies of Scale

Updated on April 30, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is 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.

Diseconomies of Scale

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Source: Diseconomies of Scale (wallstreetmojo.com)

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.

Key Takeaways

  • 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 Explained

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.

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Diseconomies of Scale Explained in Video

Graph

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

Diseconomies of Scale Graph

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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 Average Cost Average cost refers to the per-unit cost of production, calculated by dividing the total production cost by the total number of units produced. In other words, it measures the amount of money that the business has to spend to produce each unit of output.read moreof 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.

Example

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 upRamp UpRamp Up in economics refers to the boosting of a company’s production.read more production in response to high prices.

Diseconomies of Scale Example

source: businessinsider.com.au

Causes

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 controlInventory ControlInventory control is adopted by organizations to properly manage the inventory/stock stored in the course of business to minimize storage & carrying charges for the inventory and satisfy its customer’s demands in the market.read more, 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 controlRisk ControlRisk control basically means assessing and managing the affairs of the business in a manner which detects and prevents the business from unnecessary calamities such as hazards, unnecessary losses, etc. that may occurread more 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 crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more of 2008-2009.

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

How To Avoid?

The solutions for diseconomies of scale are given below: –

Advantages

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.

Disadvantages

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 Vs Economies Of Scale

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.

Diseconomies Of ScaleEconomies Of Scale
It leads to rise in cost per unit of goods.It leads to fall in cost per unit of goods.
The business tries to avoid this situation.The business makes effort to achieve it.
It results due to mismanagement, over expansion, saturation, employee dissatisfaction, etc. It results due to good cost control and management strategy, proper resource utilization, innovation, etc.It results due to good cost control and management strategy, proper resource utilization, innovation, etc.
It usually happens in the after continuous expansion over a longer period. It usually happens in the earlier stages of expansion.It usually happens in the earlier stages of expansion.

Frequently Asked Questions (FAQs)

What are economies and diseconomies of scale?

Economies of scale refer to the reduction of cost per unit soaring due to the rise in the total output. On the other hand, diseconomies of scale are when the firms outgrow in size, which results in increased employee costs, compliance costs, administration costs, etc.

What are the types of diseconomies of scale?

The diseconomies of scale types are of two types: internal diseconomies of scale and external diseconomies of scale. Internal diseconomies of scale include technical diseconomies of scale, organizational diseconomies of scale, purchasing diseconomies, competitive/monopoly diseconomies, and financial diseconomies. At the same time, external diseconomies of scale consist of diseconomies of pollution, limited natural resources, and infrastructure diseconomies.

Can diseconomies of scale occur in the short run?

Diseconomies of scale do not occur in the short run. Instead, it happens in the long run.

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: –

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