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 in per unit of goods produced.
Diseconomies of scale occur when the firms outgrow in the size which results in the increase in employee cost, compliance cost, administration cost, etc. The increase in the average cost of the firm is mainly due to increasing inefficiencies in the system and these inefficiencies may be in the form of falling employee coordination, delayed decision making, managerial issues, and communication problems. The diseconomies of scale are exactly the opposite of economies of the scale. When entities experience economies of scale, the long run average cost reduces with increasing volumes of production, and the reverse happens in the case of diseconomies of scale.
Diseconomies of Scale Example
Below is the Diseconomies of Scale Example. Paul Mitchell, EY Global Mining & Metal advisory mentions that the size and complexities of mining operations are resulting in diseconomies of scale which were created when the mining industry had to ramp up production in response to high prices.
Diseconomies of Scale Graph
Below is the graph of diseconomies of scale
In the above chart, the Y-axis represents the cost in $, and X-axis represents production units in Q. The upward-facing curve represents the long-run average cost – LRAC
The curve is divided into three states –
- 1) Economies of Scale – It is a state where the firm experiences the highest operational efficiency. The LRAC of the firm keeps falling with the increase in the production of units.
- 2) Constant Returns of Scale – The constant return of scale is a state where the firm begins to start entering the maturity stage and at this stage, the LRAC remains static with the increase in production.
- 3) Diseconomies of Scale – It is a state where a firm experiences a lower operational efficiency. The LRAC keeps increasing with the increase in the production of units.
The average cost of production ($), from left shows a decreasing trend which reflects the economies of the scale. The average cost of production in a zone of economies of the scale keeps decreasing to the point where we have constant returns of the scale (represented in dotted lines).
From dotted lines, when we move towards the right, this side of the curve represents the diseconomies of scale. As we add more units of production, the average costs ($) keeps on rising due to operational inefficiencies and other factors.
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There are various factors that influence the LRAC. When a firm outgrows in size then it is common for that firm to experience maturity or saturation. In such firms, taking a ground-breaking decision is not easy because the authorities are decentralized and a decision undergoes many approval processes before any implementation.
Causes of Diseconomies of Scale
There are few factors that influence the long-run average costs and cause diseconomies of scale.
#1 – Employee Costs
Employee cost is directly related to the production of units and they remain relevant cost until firms are in the zone of economies of scale. In times of diseconomies of scale, the employees in production processes are relatively higher than required. This situation happens due to over-crowding of employees in production, marketing, and administrative process.
The large organization has many departments, which increases the possibility of duplication of work or processes. Employees are reluctant to identify such processes and avoid proper coordination to bring operational efficiency. This incurs an extra cost in the form of server space and employee cost.
In a large organization, the hierarchy is not flat hence, the bottom and middle-level employees have very little access to senior management. As there is a low level of interaction, it is very tough to motivate employees in the middle and bottom levels of the organization. Generally, in such organizations, motivating employees remains a big challenge due to the volume of inflexibility in them resulting in low efficiencies and contributions.
#2 – Communication Failure
Increase in the number of employees resulting in an increasing number of communication channels. Complex communication channels result in high cost, wastage of time, and efforts.
In a large firm, the communication passes through various levels and hierarchies leading to communication gaps. When communication passes through various levels then it doesn’t remain effective as it was intended. The distortion or leakages at each stage reduces the effectiveness of communication. Most of the time firm communicate through notices and memos which is the form of one-way communication and which finally 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 facilitations like logistics, inventory control, human resources, security system, etc. The additional cost incurred on administration increases the average cost of units produced.
#4 – Compliance Costs
The 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. Increased level of compliance is common in large firms. As monitoring in such firms is high, the excess risk control measures are placed and that brings some amount of bureaucracy to the system which is unavoidable. Presently, 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 2008-2009.
The factors mentioned above directly and indirectly contribute to the long-run average cost of the firm.
Solution for Diseconomies of Scale
Solutions For Diseconomies of Scale which are given below:
- The organization can identify large processes which can be parted out from the existing large firm. Such processes can be transferred to a newly formed company or subsidiary, which can work as a service or supplying entity for the main firm. It will ensure a good span of control and will increase efficiency.
- Firms can adopt strategies like forward and backward integration. It can help the firm to use the potentials of existing employees and facilities in newly integrated processes (production or sales) and that can help to reduce the average cost of existing products because the firm has sufficient labor and resources to execute the new process and add more revenues.
- Such firms can go for merger and acquisition depending on case to case basis. Mergers and acquisitions can help the organization to extend or lend the excess labor, administrative strength and compliance expertise with merged and acquired entities.
- Layoffs can be used as a last resort, but such decisions come with legal and reputational risk. It can be effectively done with the help of the consultancies which conducts the study on organizational efficiencies and then final conclusions can be drawn from those studies.
Diseconomies of Scale Video
This has been a guide to what is Diseconomies of scale, its graph, and definition? Here we discuss diseconomies of scale examples along with the causes of diseconomies of scale and the solutions. You may also have a look at these other articles on economics –