Diseconomy of Scale: What it is, Why it Happens

In economics, the term diseconomies of scale describes the phenomenon that occurs when a firm experiences increasing marginal costs per additional unit of output. It is the opposite of economies of scale. This is usually caused by a deployment problem with one or more factors of production, such as overcrowding in a factory or mismatches in optimal outputs of separate operations.

Economic theorists have long believed that companies can become inefficient if they become too large. For any given combination of the factors of production (land, labor and capital equipment), there is an optimal scale for operational efficiency. Firms that outgrow their optimum scales cease experiencing economies of scale and begin experiencing diseconomies of scale.


Diseconomies of Scale

Why Companies Become Inefficient

There are several reasons why companies become inefficient. Larger ones are difficult to coordinate effectively, often requiring multiple channels of communication and authority. When mismanaged, these coordination problems slow down production. Others might outgrow their physical locations or run short on capital supplies, such as computers or mechanical equipment.

A company may specialize in a productive market before deciding to branch out into less profitable markets. It may overpay for resources, including upper-level staff. Sometimes, laborers become disenchanted in a company and suffer from low motivation if it becomes too large. This causes the output per worker to decline, which raises the marginal cost per additional unit.

Globalization may expose a firm to unanticipated levels of competition, which lowers its relative efficiency. While this does not necessarily fall into the standard definition of diseconomy of scale, it could be an example of when economies of scale stop existing. On the other hand, exporting labor to lower-cost environments can help reduce marginal costs to the firm.

Diseconomies of scale are not permanent, but they do usually require a period of additional capital investment or a new approach to process management. Many economists point to the existence of diseconomies of scale to show natural monopolies cannot form, making antitrust legislation redundant.

(For related reading, see: "What Is the Difference Between External Economies and External Diseconomies?")

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