What’s it: Diseconomies of scale are the economic disadvantages when a firm increases its production. Instead of lowering average costs, increasing output results in higher average costs.
It usually occurs when the company has reached the minimum efficient scale, which is the lowest point of average cost. Before that point, the company achieved economies of scale. When increasing production, it realizes a decrease in average costs. After that point, however, average costs increase as production increases.
Diseconomies of scale have an impact on increasing operating costs. Assuming the selling price unchanged, it leads to decreased profitability.
Meanwhile, if the company passes the increased cost per unit on the selling price, it will reduce its competitiveness. Market share decreases as consumers switch to cheaper competing products.
Diseconomies of scale graph
Well, to explain the diseconomies of scale concept, let’s take an average cost (or unit cost or cost per unit) curve. In the curve, the X-axis represents total output (quantity), while the Y-axis represents costs.
The average cost curve is U-shaped. Look at the graph above. Until the output is Q1, the firm achieves economies of scale as the average cost decreases. However, any increase in output beyond Q1 leads to an increase in the average cost.
In areas of economies of scale, the average cost decreases for several reasons. First, the company spreads the total fixed costs to more output. Thus, although total costs remain unchanged, the average fixed cost decreases as production volume increases.
Remember, the average cost is the sum of average variable costs with average fixed costs.
Thus, unit cost also decreases as the average variable cost decreases. For example, when purchasing raw materials in a larger volume, the company usually receives a discount. Thus, the company bears lower total raw material costs. Therefore, the cost of raw materials per unit of output will also decrease.
After reaching the point of minimum efficient scale, the unit cost behavior changes. An increase in output does not result in a decrease in costs, but an increase in costs. There are several factors why it happened. I will discuss them below.
The difference between internal diseconomies of scale and external diseconomies of scale
Like economies of scale, diseconomies of scale fall into two categories:
- Internal diseconomies of scale
- External diseconomies of scale
Under internal diseconomies of scale, the average cost increase is due to internal factors of the company. So, it only applies to that company, not to other companies.
On the other hand, for the external diseconomies of scale, the increase in cost per unit comes from external factors. The company has no control over those factors. Also, cost increases occurred for all firms in the industry.
Causes of internal diseconomies of scale
Four reasons why diseconomies of scale emerge. Here are the details:
- Bureaucratic inefficiency. As companies become more extensive, operations become more complex and lead to less effective communication. Companies cannot rely on old methods to operate on a larger scale. They need transformation.
- Decreased motivation from management and employees. The complexity of work reduces focus and consumes a lot of energy. Without adequate compensation (e.g., more extended leave and higher pay), it can lead to demotivation.
- Duplication of work and business functions. As operations become more extensive, the company may form several new divisions. However, without a clear mapping, it will only lead to duplication.
- Increased costs of special arrangements. For example, when the amount of output is large, the company needs special waste disposal arrangements. These arrangements are often expensive.
Larger companies require the development of a broad managerial hierarchy. Such transitions do not always end in success.
When the scale of operations is small, the company adopts a more flexible organizational structure. And when the scale of operations becomes larger, companies adopt a tall organizational structure with several command chain layers.
However, such transitions often fail because employees and management cannot adapt. They are accustomed to flat structures without multiple chains of command.
A more complex chain of command produces a distortion of information. I mean, top decision-makers don’t receive the exact same message as bottom-level operational information. That’s because information flows through several managerial layers. In the end, it results in poor decision making.
Also, larger operations increase administrative and bureaucratic procedures. It often hinders quick decision making. Companies rely more on written forms of communication, such as notice boards and memos. And, such communication has the disadvantage of not allowing feedback.
Large manufacturing requires a variety of different stages. When individual manufacturing processes have reached their optimum capacity, they cannot produce anymore. This creates problems such as congestion due to more people using the same machine.
As the operation grows, the number of employees increases. Companies adopt specializations and divide complex processes into smaller tasks. Employees perform the same tasks from time to time.
When operations increase as output increases, each employee must complete more tasks. Although they are still doing the same task, they are likely to be more stressed because of their higher targets.
Increasing the target reduces the likelihood of employee interaction. They feel isolated and easily lose focus. That, in turn, leads to decreased productivity because they lose motivation.
Lack of coordination
The growing size of the business makes coordination and empowerment of employees more difficult. Managers find it more challenging to relate day-to-day with workers and build a conducive work environment, such as listening to their aspirations. As a result, managers have difficulty coordinating operations and ensuring that everyone plays their role effectively.
Such situations require companies to hire or promote more supervisors to oversee operations and monitor employee performance. As a result, they bear more costs.
Causes of external diseconomies scale
When the size of all companies’ output increases, it creates several problems, which causes an increase in unit costs for all firms in the industry.
Increase in input prices
Some inputs are available on a more limited basis. Increased production creates more demand for these inputs.
When the demand is so great while the amount of resources is relatively limited, it will lead to a market shortage. As a result, input prices will slowly move up. The impact may not be on just one company but all companies in the industry.
For example, the eCommerce industry’s rapid growth rate increases the demand for programmers to handle big data. Supply becomes an obstacle due to the low quality of local labor and does not meet the qualifications.
Then, companies in the industry recruit foreign programmers to make ends meet. Finally, they have to pay higher salaries to recruit foreign workers.
On the other hand, foreign programmers also have a stronger bargaining position. When they realize the labor market is insufficient, they are likely to negotiate a higher salary.
The rapid development of industry creates more negative externalities. Without government control, it contributes to an increase in long-term average costs, not only for firms in a specific industry but also in almost all industries.
An example is the increased risk of global warming and climate change due to pollution. This not only increases the risk of doing business in one industry but also has other consequences such as carbon taxes, which are additional costs for other industries.
Negative externalities also arise in the case of agglomeration. When industrial growth in an area increases, it can cause traffic jams, thus increasing logistics costs.