Diseconomies of Scale

What Are Diseconomies of Scale?

Diseconomies of scale happen when a company or business grows so large that the costs per unit increase. It takes place when economies of scale no longer function for a firm. With this principle, rather than experiencing continued decreasing costs and increasing output, a firm sees an increase in costs when output is increased.

Understanding Diseconomies of Scale

The diagram below illustrates a diseconomy of scale. At point Q*, this firm is producing at the point of lowest average unit cost. If the firm produces more or less output, then the average cost per unit will be higher. To the left of Q*, the firm can reap the benefit of economies of scale to decrease average costs by producing more. To the right of Q*, the firm experiences diseconomies of scale and an increasing average unit cost.

Image by Julie Bang © Investopedia 2019

Special Considerations

Diseconomies of scale specifically come about due to several reasons, but all can be broadly categorized as internal or external. Internal diseconomies of scale can arise from technical issues of production or organizational issues within the structure of a firm or industry.

External diseconomies of scale can arise due to constraints imposed by the environment within which a firm or industry operates. Essentially, diseconomies of scale are the result of the growing pains of a company after it's already realized the cost-reducing benefits of economies of scale.

The first is a situation of overcrowding, where employees and machines get in each other's way, lowering operational efficiencies. The second situation arises when there is a higher level of operational waste, due to a lack of proper coordination. The third reason for diseconomies of scale happens when there is a mismatch in the optimum level of outputs within different operations.

Types of Diseconomies of Scale

Internal diseconomies of scale involve either technical constraints on the production process that the firm uses or organizational issues that increase costs or waste resources without any change to the physical production process.

Technical Diseconomies of Scale

Technical diseconomies of scale involve physical limits on handling and combining inputs and goods in process. These can include overcrowding and mismatches between the feasible scale or speed of different inputs and processes.

Diseconomies of scale can occur for a variety of reasons, but the cause often comes from the difficulty of managing an increasingly large workforce.

An overcrowding effect within an organization is often the leading cause of diseconomies of scale. This happens when a company grows too quickly, thinking that it can achieve economies of scale in perpetuity. If, for example, a company can reduce the per-unit cost of its product each time it adds a machine to its warehouse, it might think that maxing out the number of machines is a great way to reduce costs.

However, if it takes one person to operate a machine, and 50 machines are added to the warehouse, there is a good chance that these 50 additional employees will get in each other's way and make it harder to produce the same level of output per hour. This increases costs and decreases output.

Sometimes, diseconomies of scale happen within an organization when a company's plant cannot produce the same quantity of output as another related plant. For example, if a product is made up of two components, gadget A and gadget B, diseconomies of scale might occur if gadget B is produced at a slower rate than gadget A. This forces the company to slow the production rate of gadget A, increasing its per-unit cost.

Organizational Diseconomies of Scale

Organizational diseconomies of scale can happen for many reasons, but overall, they arise because of the difficulties of managing a larger workforce. Several problems can be identified with diseconomies of scale.

Another drawback to diseconomies of scale is motivation. Larger businesses can isolate employees and make them feel less appreciated, which can result in a drop in productivity. 

External Diseconomies of Scale

External diseconomies of scale can result from constraints of economic resources or other constraints imposed on a firm or industry by the external environment within which it operates. Typically, these include capacity constraints on common resources and public goods or increasing input costs due to price inelasticity of supply for inputs.

External capacity constraints can arise when a common pool resource or local public good cannot sustain the demands placed on it by increased production. Congestion on public highways and other transportation needed to ship a firm's products is an example of this type of diseconomy of scale.

As output increases, the logistical costs of transporting goods to distant markets can increase enough to offset any economies of scale. A similar example is the depletion of a critical natural resource below its ability to reproduce itself in a tragedy of the commons scenario. As the resource becomes ever more scarce and ultimately runs out, the cost to obtain it increases dramatically.

Price inelasticity of supply for key inputs traded on a market is a related cause of diseconomies of scale. In this case, if a firm attempts to increase output, it will need to purchase more inputs, but price inelastic inputs will mean rapidly increasing input costs out of proportion to the increase in the amount of output realized.