Diseconomies of Scale Examples | Internal & External Diseconomies of Scale
Diseconomies of Scale Definition
What are Diseconomies of Scale?
Diseconomies of scale occur when the per-unit costs for running a company increase as the company’s size increases. It is when a company’s cost per unit increases as the number of units produced increases.
The concept of diseconomies of scale is based on the idea that a company operating at higher production levels will cost more on average to produce goods.
This is because fixed costs, such as labor and equipment, must be spread out over more units.
The average cost per unit decreases as production increases, but the overhead cost per unit may increase.
This may be due to the company having less space for the equipment, having to pay the same lease and property taxes for every square foot of space, or paying for more qualified staff.
As production continues to grow, companies experience diminishing returns on their investments in capital equipment and facilities.
The ultimate result is that an increase in output can lead to a decrease in productivity.
A diseconomy of scale is a type of inefficiency that arises when increased production increases unit costs. This can happen for many reasons, including the following:
- The larger the business, the harder it is to control costs and ensure efficiency.
- It is more difficult to manage a larger workforce, so managers may not be able to monitor employee performance.
- Larger businesses need more support staff, such as accounting and human resources departments, which increases costs.
- Larger businesses are likely to be less nimble than smaller ones, which can be a disadvantage in fast-moving markets.
Diseconomies of Scale Examples
What are some examples of external diseconomies?
Diseconomies of scale are economic phenomena that can lead to a decline in productivity and efficiency.
This phenomenon has been noted in many different industries such as manufacturing, production, and agriculture.
A company has a disproportionate amount of its workers based in one location and cumbersome processes that are benefitting the business.
These together make the company lose business because of increased production costs, labor, and other resources needed to provide service in other locations. This is an example of diseconomies of scale.
Diseconomies of scale can happen when the size of the restaurant becomes too large.
For example, the restaurant would have to maintain a larger inventory and more employees. The diseconomies of scale will outweigh the benefits of economy of scale.
A restaurant will purchase food in bulk and receive a lower price per pound of food than if they bought individual amounts.
However, they have to pay their employees to prepare the food, which becomes more expensive as more customers visit.
This is an example of economies of scale because their costs stay relatively even with increased business.
At the same time, competitors who buy small quantities of food are required to hire all these workers, which lowers profit margins.
Another example is that of a company that increases in size by buying up smaller companies.
The newly merged corporation is able to lower many costs, including administrative and advertising costs while gaining more market share.
However, the company won’t have as much employee diversity as the smaller companies: their interests will be more similar than those of employees of a conglomerate. This would raise the cost of training new employees.
An optimal amount of growth for a company would be a balance between keeping expenses and acquiring new benefits.
Some industries, such as oil production, have a tendency to grow past the point of being cost-efficient.
Real-life examples of diseconomies of scale
- The cost of running a restaurant increases as the number of customers increase. As production levels increase, the average cost per unit decreases. When an organization grows beyond a certain size, it becomes too large .to manage and oversee all its operations efficiently.
- When a company has too many employees and not enough work to do.
- When the cost of renting or buying property goes up as more people want it.
- When there are so many products or services that they all compete with each other for customers
- When a company’s size makes it difficult to maintain quality control over its products.
- When the cost of production increases as the number of units produced decreases
Internal & External Diseconomies of Scale
Internal diseconomies of scale
Internal diseconomies of scale are the costs associated with a firm growing beyond optimal size and are often caused by management issues.
When a firm grows beyond the optimal size, it is usually due to the need for additional capital and its higher cost or because of the attraction of larger markets.
The firm can continue growing only if it has enough savings or access to credit that will enable it to maintain its high level of efficiency.
If capital becomes too expensive as the firm grows, overall performance will deteriorate due to such factors as wastefulness and misallocation of resources.
An example includes firms that fall into bankruptcy because they become too big too fast.
Internal diseconomies of scale example
An example of a management issue is seen in large-size firms’ failure to utilize the benefits of specialization.
This is due to the fact that as a firm grows larger, the communication problems become worse, and it becomes difficult to manage a large number of employees.
Managers will not be able to make full use of specialization, which would provide an opportunity for enhancing profits.
Another problem faced by firms that grow rapidly is that they have a reduced ability to respond effectively to market changes.
External diseconomies of scale
External diseconomies of scale are conditions or expenses that are not directly related to the production or distribution of given goods and services but, nonetheless, affect the production process.
External diseconomies of scale occur when a firms’ cost increases as it increases production. This is due to factors such as higher taxes and increased administrative burden associated with the larger volume of output.
For example, as a firm increases in size, it might be subject to higher taxation levels (either corporate or personal). This is because of the increase in revenue to the government.
This is a diseconomy of scale as it is an expense that is not directly related to production but has an effect on the cost of production.
External diseconomies of scale example
For example, a company might decide to provide a pension fund as an employee benefit. This is an outlay of money that is not directly related to the manufacturing process.
However, providing the pension scheme has some advantages for the firm, such as reduced staff turnover, affecting production.
Types of Diseconomies of Scale
Diseconomies of scale are a type of economic inefficiency that arises when the cost per unit increases as production expands. Examples include:
- Increased transportation costs,
- Higher input prices
- More difficult coordination among plants or departments & more costly management for large organizations
- Diseconomies of scale can also be caused by fixed costs such as taxes and interest on loans.
- Diseconomies can be caused by limitations in technology, natural resources, or other factors.
Allocative and technical diseconomies of scale
There are two kinds of diseconomies: Allocative and technical. Diseconomies of scale arise when the larger the enterprise, the more resources it needs to function, and the more competitive and productive it becomes.
In business, a firm’s growth is constrained by the resources available. As businesses grow, they run up against limits like available resources and market opportunities, which prevent them from further growth.
If the business tries to grow beyond these limits, it will find that its productivity declines and may have to reorganize as a smaller firm.
If the business is growing by increasing its own capacity, it will run into problems with allocative diseconomies.
The law of diminishing returns shows that the larger you make a factory, the more expensive each extra unit of production becomes.
When the cost of facilities and production exceeds that of your competitors, your business may be too large to compete profitably.
An example would be if you owned a shoe factory in China. You could make more shoes by closing down your company and moving all operations to a bigger factory elsewhere.
However, as long as the shoes you are making are less expensive than the shoes your competitors are making, you will not be able to gain any market share.
When its own resources constrain a firm’s growth, it is limited by the firm’s technical capability. Technological innovation is necessary for firms to improve their products in order to increase profits.
Therefore, businesses can successfully compete only if they absorb new technology and keep up with changes in their industries; that keeps them flexible and competitive.
If a business tries to grow beyond its technical or technological capabilities, it will find that its productivity declines.
This is the case when a business makes an effort to spread itself too thin by trying to compete in new markets with products it isn’t familiar with.
For example, in an effort to increase market share by selling its product into other markets such as oil drilling equipment, the company would run into technical diseconomies because its expertise is in shoes. The company could increase its market share by making drill bits.
However, the company would then find that it has to do research on the drill bits themselves and become involved in new learning processes.
This makes it too difficult for their product to be competitive in the first place.
How can diseconomies of scale be avoided?
Diseconomies of scale can be avoided, for example, by setting up a smaller competitive factory to produce parts for the larger factory.
This will exclude the pitfalls of diseconomies of scale and will maintain the requirements of the production process.
The diseconomies of scale can be avoided if the company’s size is kept manageable. This would mean that the company avoids having to hire many more people to handle the extra work.
The only way to do this would be to focus only on a few products that the company will make. This would allow them to handle the extra work without having to hire more people to work for them.
Which firm is experiencing diseconomies of scale?
Diseconomies of scale is the idea that as large organizations increase in size, the cost per unit of production will increase disproportionally to the increase in size.
The company can continue to function if they increase their prices to compensate for the higher costs or choose to reduce the scope of their production to keep prices low.
Determinants of diseconomies of scale
Diseconomies of scale are the result of a decrease in efficiency as production increases. Factors that may contribute to diseconomies of scale include:
- Decreasing returns to specialization, where an increase in specialization leads to less efficient production;
- Increasing marginal costs, which is when the average total cost (ATC) rises as output changes; and
- Increasing fixed costs, which is when ATC remains constant but FC continues to rise with increased output.
Disadvantages of diseconomies of scale.
- Diseconomies of scale may lead to a decrease in quality.
- Diseconomies of scale can cause an increase in the cost of production.
- Diseconomies of scale may result in a lack of competition, which could lead to higher prices for consumers
- The production process becomes less efficient as economies of scale are reached
Compare economic and diseconomies of scale.
Economies of scale is the concept that larger outputs will lead to lower production costs per unit. In other words, as production increases, the cost per unit decreases.
This means that firms are able to offer the same good or service at a lower cost. For example, the cost of producing the iPhone decreases as Apple begins producing more of them. T
his concept is also known as decreasing marginal cost.
Diseconomies of scale is the opposite, where prices are higher because of a lack of economies in larger outputs.