What Are Diseconomies Of Scale And Why They Matter

In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Aspect	Explanation
Diseconomies of Scale	Diseconomies of Scale refer to a situation in business and economics where a company’s costs per unit of production increase as the scale of production or operation grows. In other words, as a business expands, it becomes less efficient, leading to higher costs.
Causes	1. Complexity: As a company grows, its operations can become more complex, leading to coordination challenges and increased bureaucracy. 2. Communication: Larger organizations may struggle with effective internal communication, causing delays and inefficiencies. 3. Overhead Costs: Expanding often requires larger administrative staff and infrastructure, increasing overhead costs. 4. Specialization Loss: Too much specialization can hinder flexibility and responsiveness to changes. 5. Resource Scarcity: As production scales up, demand for resources like skilled labor or raw materials can outstrip supply, raising costs.
Examples	1. Large Corporations: Large multinational corporations may face diseconomies of scale due to difficulties in coordinating and managing diverse business units across the globe. 2. Government Bureaucracies: Government agencies can experience inefficiencies as they grow, resulting in slow decision-making and increased red tape. 3. Manufacturing: In some cases, expanding a manufacturing facility beyond a certain size can lead to higher production costs due to complexities in managing a larger workforce and logistics.
Impact on Businesses	– Diseconomies of scale can lead to reduced profitability and competitiveness, as higher costs can erode profit margins. – It can also result in slower response times to market changes, making the business less agile. – Addressing diseconomies of scale often requires restructuring, streamlining operations, and improving internal processes.
Balancing Economies and Diseconomies	Businesses must strike a balance between enjoying the benefits of economies of scale (cost reductions at lower production levels) and managing diseconomies of scale. This involves careful planning, efficient organization, and continuous improvement efforts.
Preventing Diseconomies	To prevent or mitigate diseconomies of scale, companies often implement strategies such as decentralization, streamlining processes, investing in technology, and fostering a culture of innovation and adaptability.
Conclusion	Understanding diseconomies of scale is vital for businesses seeking growth. While expanding operations can offer advantages, it’s essential to recognize the potential inefficiencies that may arise and take proactive measures to address them. Effective management and adaptation are key to maintaining competitiveness in a changing business environment.

Table of Contents

Difference between economies and diseconomies of scale

In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages.

More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production.

Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further and more efficiently.

Diseconomies of Scale represent the opposite phenomenon instead.

Where a company has grown too large, the cost per unit increases, thus making the firm no longer able to benefit from its achieved scale.

Diseconomies of scale can happen for a variety of reasons that might span from the inability of the organization to keep organizing its resource efficiently (due for instance, to a too large number of the workforce).

When diseconomies of scale pick up, the firm will have higher marginal costs for each additional unit of output.

Thus a primary consequence for diseconomies of scale is a significant increase in coordination costs and a drastically reduced benefit in scaling.

Examples of diseconomies of scale

Why do companies experience diseconomies of scale? Economists argue that several reasons might cause that to happen:

Coordination issues

As a company becomes too big, it needs more administrative departments, divisions, and management.

When a large organization becomes too hierarchical, centralization might prevent it from being efficient.

Therefore, it might slow down production and manufacturing.

Management inefficiencies

As the company needs more management as it grows, this might also slow-down decision-making processes.

Difficulties in keeping a smooth communication flow

Communications costs might increase exponentially with the size of the organization.

And when the organization becomes too large, those costs might also influence the output and the cost per unit of production.

It is essential to rethink the theory of Diseconomies of Scale as digital businesses manage to take advantage of new business models.

Diseconomies of scale in the digital business world

As we talk about diseconomies of scale in the physical business world, a key question to ask is whether the digital business world is immune from these diseconomies of scale.

For how much we’d love to believe (as digital entrepreneurs) that a digital business has unlimited scalability, in reality, that is not the case.

Digital business models can be classified in various ways. And for the sake of the research on FourWeekMBA, we put together such classification:

stages-of-digital-transformation — Digital and tech business models can be classified according to four levels of transformation into digitally-enabled, digitally-enhanced, tech or platform business models, and business platforms/ecosystems.

In short, you get various levels of digital transformation, which are based on how much the digital side has pervaded the value proposition.

In other words, the more an organization leverages digital to enhance the value proposition for its customers, the more it moves from a digitally enabled to a platform business model.

I explain the four levels below:

Indeed, the platform business model has become one of the defining models of the digital age, as they focus on nurturing a business ecosystem, rather than simply building a final product.

Examples of these comprise Amazon (the mother of all the platforms), Airbnb, Uber, and many, many more.

The maximum expression of digital transformation is the business platform or business ecosystem.

An example of that is Apple, which, by combining hardware (iPhone), operating system (iOS), and marketplace (App Store) has created a multi-trillion business ecosystem.

However, platform business models, and let alone business ecosystems, are the hardest kind of businesses to build.

Indeed, Apple has been probably the company that managed to build a business ecosystem, which, as you saw, might be well worth a few trillion dollars.

By the same token, platform business models are also hard to kick off, scale, and maintain.

In fact, a few companies manage to translate their businesses into platforms, and most remain as digital business players, where the digital side enhances marketing, distribution, and partly the value proposition.

And that’s fine, as many of those digital business models are extremely viable, as platforms require massive amounts of resources to be scaled.

That’s because when launching a platform business model, you got a couple of insurmountable issues:

Where do you start to build momentum? Is it the demand side or the supply side? This is known as the chicken and egg problem, or cold start problem.
How do you kick off network effects? In other words, how do you make the platform valuable enough to enable momentum and the first stage of scale?

Indeed, in the digital business world, network effects are the closest thing we have to economies of scale.

As network effects kick in, the platform gains momentum, and its unit economics start to make sense, as the platform can achieve greater scale at lower costs.

Yet not only kicking off these network effects is hard.

It’s also hard to maintain them – once a certain level of scale – is achieved.

With that in mind, we can now lay the foundation between diseconomies of scale, and what in the digital business world, we call negative network effects.

Diseconomies of Scale and Negative Network Effects

While Diseconomies of Scale might affect linear businesses.

There is a distinction to make with platform businesses.

Indeed, platform business models follow a different logic compared to linear business.

As a platform business model, the main asset is its network, which makes it possible for thousands of consumers and producers to connect, interact, transact, and exchange.

Those platforms can scale quickly and efficiently (provided they can kick off these network effects and pass through the cold start problem).

Thus, they might manage to grab close to total market shares, compared to linear businesses, that instead are affected by the Diseconomies of Scale as they grow.

That’s how the story goes. But is this true?

It’s true that, in part, digital business models might get close to gaining majority shares in a market.

But it’s also true that barriers to entry in the digital business world might be easier to wreck apart.

In short, while Diseconomies of Scale might affect linear businesses, platform business models might not be immune to that!

Reverse network effects, congestion, and when platforms scale too quickly

While many attributes to platforms’ business models the ability to scale at an indefinite level, in reality, also platforms enjoy negative consequences of scale, which are called reverse or negative network effects.

The two classic examples of negative network effects are:

Just like diseconomies of scale take hold of more traditional, physical businesses.

Reverse network effects can create substantial damage to platforms.

Take the case, of a platform that scales so quickly with user-generated content, that as it scales the risk of generating bad content at scale grows exponentially.

There is a threshold where this becomes a real problem and the platform itself might actually collapse!

Case Studies

Diseconomies of Scale in Traditional Businesses:

Large Manufacturing Plant: A factory that becomes too large may suffer from coordination issues, leading to inefficiencies in production and increased costs per unit.
Corporate Bureaucracy: Large corporations often have extensive hierarchical structures that can slow down decision-making processes, causing management inefficiencies.
Communication Overhead: In a large organization, the cost of maintaining effective communication and collaboration among departments and teams can increase significantly, affecting productivity.
Employee Management: As a company grows, managing a large workforce can become challenging, potentially resulting in increased labor costs and reduced efficiency.
Supply Chain Complexity: Expanding to a global scale can introduce complexities in the supply chain, leading to delays, higher transportation costs, and coordination challenges.

Negative Network Effects in Digital Business:

Social Media Spam: On social media platforms, rapid user growth can lead to an increase in spammy or low-quality content, diminishing the user experience and the platform’s value.
Online Marketplaces: E-commerce platforms can suffer from negative network effects when an influx of sellers leads to increased competition, potentially lowering product quality and trust in the marketplace.
Ride-Sharing Services: Ride-sharing platforms like Uber can experience network pollution if too many drivers flood the platform, resulting in decreased earnings for drivers and a less attractive service for riders.
User-Generated Content: Content-sharing platforms may encounter negative network effects as they grow, with an increased risk of misinformation, hate speech, or inappropriate content surfacing.
Online Communities: Internet forums and communities can become less valuable as they expand, with the potential for decreased engagement and an influx of spam.

Scaling Challenges in Platform Business Models:

Online Marketplaces: E-commerce platforms that rapidly expand can struggle to maintain quality control, leading to counterfeit products and negative customer experiences.
Social Media Networks: As social media platforms grow, they face challenges in moderating content, combating fake accounts, and ensuring user safety.
Sharing Economy: Companies like Airbnb and its rapid growth led to concerns about housing shortages and increased rents in some cities, showcasing potential negative impacts.
Content Streaming: Streaming platforms like Netflix may experience challenges in content discovery as their libraries grow, making it harder for users to find content of interest.
App Stores: App marketplaces may suffer from overcrowding, making it challenging for new apps to gain visibility and success, despite their quality.

Key takeaways

In economics, economies of scale are achieved when companies can enjoy a higher degree of efficiency, and lowest structural costs as they scale.
Reached a threshold of scale, diseconomies of scale might kick in, and perhaps size rather be an advantage it becomes a risk factor and inefficient. This is what happens when economies of scale kick in.
In the digital world, there is a similar effect thanks to network effects that enable platforms to scale in size.
While many think that platforms business models are immune to scale, and they can grow indefinitely. In reality, also for platform business models, negative network effects can kick in, thus causing a platform to lose value, if not collapse on its own reversed network effects.

Key Highlights on Diseconomies of Scale and Negative Network Effects:

Diseconomies of Scale Defined: In economics, diseconomies of scale occur when a company becomes too large, causing its costs per unit to increase, thereby losing the benefits of scale. This phenomenon can result from various factors, such as coordination issues, management inefficiencies, and communication breakdowns.
Contrasting Economies and Diseconomies of Scale: Economies of Scale refer to cost advantages gained as companies grow and become more efficient in production. In contrast, diseconomies of scale represent the opposite phenomenon, where large companies experience rising costs per unit, diminishing their scale-related benefits.
Causes of Diseconomies of Scale: Several factors can lead to diseconomies of scale, including:
- Coordination issues due to increased organizational complexity.
- Management inefficiencies, leading to slower decision-making.
- Challenges in maintaining smooth communication flows.
- Increased marginal costs for each additional unit of output.
Digital Business and Diseconomies of Scale: While digital businesses often emphasize scalability, they are not entirely immune to diseconomies of scale. Digital business models can experience negative network effects, which are similar to diseconomies of scale.
Digital Business Models Classification: Digital business models can be classified into various levels of digital transformation, from digitally-enabled to platform business models and business ecosystems, depending on the extent of digital integration.
Platform Business Models: Platform business models, like those of Amazon, Airbnb, and Uber, aim to create business ecosystems. These platforms can be highly valuable but are also challenging to build and maintain due to network effects.
Negative Network Effects: In digital platforms, negative network effects can occur as the network grows. These effects include:
- Network congestion, where increased usage reduces platform value.
- Network pollution, where rapid scaling leads to the generation of low-quality or harmful content.
Platform Scalability Challenges: While platforms can scale quickly and achieve significant market share, they may also face scalability challenges related to negative network effects. Excessive growth without addressing these challenges can lead to a decrease in platform value or even collapse.

Case Studies

Company/Situation	Description	Case Study Description
Boeing	Aircraft manufacturing	Boeing faced supply chain and production issues as it expanded production of the 787 Dreamliner, leading to delays and cost overruns.
General Motors	Automotive manufacturing	General Motors experienced organizational complexities and inefficiencies as it expanded its brand portfolio, leading to operational challenges.
Microsoft (Mid-2000s)	Large corporate bureaucracy	Microsoft faced challenges in coordinating its diverse product lines, resulting in delayed product launches and decreased innovation.
U.S. Postal Service	Government organization	The USPS has struggled to maintain efficiency and control costs as its mail volume declined, leading to operational inefficiencies.
Large Financial Services	Financial institutions	Some large banks and financial institutions have faced challenges in managing complex operations, regulatory compliance, and risk, impacting profitability.
Mega Retail Chains	Retail industry	Some mega-retail chains have experienced difficulties in managing vast store networks, supply chains, and inventory control, leading to inefficiencies.
Government Bureaucracies	Public sector	Government agencies can become less efficient as they expand, leading to bureaucracy and slower decision-making.
Large Tech Companies	Tech industry	Some tech giants have faced criticism for stifling innovation and becoming too complex to effectively manage, impacting agility.
Mega-Conglomerates	Diversified holdings	Large conglomerates with diverse business units may struggle to efficiently allocate resources and manage disparate operations.
Airlines (Complex Routes)	Airline industry	Airlines with extensive route networks may experience inefficiencies in scheduling, maintenance, and customer service.

Related Frameworks, Models, or Concepts	Description	When to Apply
Diseconomies of Scale	Diseconomies of Scale refer to the phenomenon where the average cost of production increases as the scale of operation expands beyond a certain point. While economies of scale lead to cost reductions due to increased efficiency and specialization, diseconomies of scale arise from factors such as organizational complexity, coordination challenges, and diminishing returns to scale. As a result, unit costs start to rise, and efficiency decreases, potentially leading to inefficiencies and reduced profitability.	Apply the concept of Diseconomies of Scale to assess the impact of scale on production costs and efficiency. Use it to identify potential inefficiencies and cost increases associated with large-scale operations, and explore strategies to mitigate diseconomies of scale, such as decentralization, process optimization, and organizational restructuring. Implement Diseconomies of Scale analysis as part of strategic decision-making and operations management to optimize scale and maximize profitability in business operations.
Law of Diminishing Returns	Law of Diminishing Returns is an economic principle stating that as the input of one factor of production is increased while other factors remain constant, the marginal productivity of that input will eventually decline. In the context of production, this means that as more resources are added to the production process, the additional output generated will decrease at a certain point, leading to diminishing returns. The law of diminishing returns contributes to diseconomies of scale by causing inefficiencies and increasing production costs as the scale of operations expands beyond the optimal level.	Apply the Law of Diminishing Returns to understand the relationship between inputs and outputs in production processes. Use it to identify the point at which additional inputs no longer lead to proportional increases in output, and marginal productivity starts to decline. Implement the Law of Diminishing Returns as a framework for optimizing resource allocation and production efficiency, and to mitigate the effects of diminishing returns on production costs and profitability.
Complexity Theory	Complexity Theory is an interdisciplinary framework that studies complex systems and their behaviors, emphasizing the emergence of patterns and properties from interactions among individual components. In the context of business operations, complexity theory helps explain how organizational complexity increases as the scale of operations expands, leading to diseconomies of scale. Factors such as increased interdependence, communication overhead, and decision-making complexity contribute to inefficiencies and reduced effectiveness in large-scale organizations.	Apply Complexity Theory to analyze the dynamics of organizational systems and processes at different scales. Use it to understand how interactions among individual components give rise to emergent properties and behaviors in complex systems, and how organizational complexity affects performance and efficiency. Implement Complexity Theory as a framework for managing organizational complexity, identifying bottlenecks, and optimizing processes to mitigate diseconomies of scale and improve operational effectiveness in large-scale organizations.
Principal-Agent Problem	Principal-Agent Problem is a concept from agency theory that describes the conflicts of interest that arise between principals (e.g., shareholders) and agents (e.g., managers) due to divergent goals and incentives. In large organizations, the separation of ownership and control can lead to agency problems, where agents prioritize their own interests over those of the principals, leading to inefficiencies and reduced performance. The principal-agent problem contributes to diseconomies of scale by creating agency costs, such as monitoring and enforcement expenses, and undermining organizational alignment and effectiveness.	Apply the Principal-Agent Problem framework to understand the challenges of aligning incentives and interests in large organizations. Use it to identify agency costs and conflicts of interest between principals and agents, and explore mechanisms to mitigate agency problems, such as incentive alignment, performance monitoring, and corporate governance reforms. Implement the Principal-Agent Problem framework as part of organizational design and governance structures to mitigate the effects of agency costs and improve organizational performance and efficiency at scale.
Coordination Costs	Coordination Costs refer to the expenses incurred in organizing and managing the activities of multiple units or departments within an organization. As the scale of operations expands, coordination costs increase due to the need for more extensive communication, collaboration, and decision-making processes to ensure alignment and integration across diverse functions and teams. Coordination costs contribute to diseconomies of scale by creating inefficiencies and overhead that reduce operational effectiveness and increase production costs.	Apply Coordination Costs analysis to assess the impact of scale on organizational coordination and efficiency. Use it to identify communication bottlenecks, decision-making delays, and coordination challenges associated with large-scale operations, and explore strategies to streamline coordination processes, enhance collaboration, and reduce coordination costs. Implement Coordination Costs analysis as part of operations management and organizational design to optimize coordination and integration across functional areas and mitigate the effects of diseconomies of scale on organizational performance.
Bureaucratic Overhead	Bureaucratic Overhead refers to the administrative and procedural burdens associated with bureaucratic structures and processes within organizations. In large-scale operations, bureaucratic overhead increases due to the need for more complex organizational structures, formalized procedures, and hierarchical decision-making systems to manage coordination and control across diverse functions and units. Bureaucratic overhead contributes to diseconomies of scale by creating inefficiencies, delays, and rigidity that hinder organizational agility and responsiveness.	Apply Bureaucratic Overhead analysis to assess the impact of bureaucratic structures and processes on organizational efficiency and effectiveness. Use it to identify bureaucratic bottlenecks, administrative burdens, and procedural inefficiencies associated with large-scale operations, and explore strategies to streamline bureaucracy, decentralize decision-making, and foster organizational agility. Implement Bureaucratic Overhead analysis as part of organizational redesign and process optimization to reduce administrative overhead and mitigate the effects of diseconomies of scale on operational performance and flexibility.
Communication Overload	Communication Overload refers to the excessive volume of communication and information exchange within organizations, leading to cognitive overload, decision-making delays, and reduced productivity. As the scale of operations expands, communication overload increases due to the proliferation of channels, stakeholders, and information flows across diverse functions and teams. Communication overload contributes to diseconomies of scale by overwhelming employees, impairing decision-making, and hindering effective collaboration and coordination.	Apply Communication Overload analysis to assess the volume and impact of communication within organizations. Use it to identify communication bottlenecks, information overload, and cognitive burdens associated with large-scale operations, and explore strategies to streamline communication, prioritize information, and enhance clarity and effectiveness. Implement Communication Overload analysis as part of communication management and organizational design to reduce cognitive overload and mitigate the effects of diseconomies of scale on decision-making and productivity in large organizations.
Diversification Costs	Diversification Costs refer to the expenses incurred in managing a diversified portfolio of products, services, or markets within an organization. As the scale of diversification increases, diversification costs rise due to the need for more extensive product lines, distribution channels, and market segments to sustain growth and mitigate risk. Diversification costs contribute to diseconomies of scale by increasing complexity, resource requirements, and operational overhead, potentially outweighing the benefits of diversification and reducing overall profitability.	Apply Diversification Costs analysis to assess the impact of diversification on organizational performance and efficiency. Use it to identify the costs and benefits of diversification strategies, including product expansion, market penetration, and geographic expansion, and evaluate the trade-offs between scale and scope economies. Implement Diversification Costs analysis as part of strategic planning and portfolio management to optimize diversification strategies, align resource allocation with strategic objectives, and mitigate the effects of diseconomies of scale on organizational profitability and sustainability.
Technology Constraints	Technology Constraints refer to limitations and challenges associated with technological capabilities and infrastructure within organizations. In large-scale operations, technology constraints may arise from legacy systems, outdated technologies, or inadequate IT infrastructure, limiting the organization’s ability to scale efficiently and leverage digital innovations. Technology constraints contribute to diseconomies of scale by impeding automation, process optimization, and digital transformation initiatives, and increasing reliance on manual processes and workarounds.	Apply Technology Constraints analysis to assess the impact of technology limitations on organizational scalability and performance. Use it to identify technology gaps, bottlenecks, and legacy systems that hinder operational efficiency and innovation in large-scale operations, and explore strategies to modernize technology infrastructure, upgrade systems, and leverage digital solutions to overcome constraints and drive organizational growth. Implement Technology Constraints analysis as part of IT strategy and digital transformation initiatives to optimize technology investments, enhance scalability, and mitigate the effects of diseconomies of scale on organizational competitiveness and agility in the digital age.