diseconomies-of-scale

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.

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.

Are platform business models immune from diseconomies of scale?

platform-vs-linear-business-models
Source: Applico Inc.
 

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 a 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.

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. In short, while Diseconomies of Scale might affect linear businesses, platform business models, might, in most cases, be immune to that.

However, there is a catch.

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.

Just like diseconomies of scale take hold of more traditional, physical businesses. Reverse network effects can create substantial damages 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!

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.

Connected Business Concepts

economies-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.
pirate-metrics
Venture capitalist, Dave McClure, coined the acronym AARRR which is a simplified model that enables us to understand what metrics and channels to look at, at each stage for the users’ path toward becoming customers and referrers of a brand.
north-star-metric
A north star metric (NSM) is any metric a company focuses on to achieve growth. A north star metric is usually a key component of an effective growth hacking strategy, as it simplifies the whole strategy, making it simpler to execute at high speed. Usually, when picking up a North Start Metric, it’s critical to avoid vanity metrics (those who do not really impact the business) and instead find a metric that really matters for the business growth.
marketplace-business-models
A marketplace is a platform where buyers and sellers interact and transact. The platform acts as a marketplace that will generate revenues in fees from one or all the parties involved in the transaction. Usually, marketplaces can be classified in several ways, like those selling services vs. products or those connecting buyers and sellers at B2B, B2C, or C2C level. And those marketplaces connecting two core players, or more.
network-effects
network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.
platform-business-models
A platform business model generates value by enabling interactions between people, groups, and users by leveraging network effects. Platform business models usually comprise two sides: supply and demand. Kicking off the interactions between those two sides is one of the crucial elements for a platform business model success.
negative-network-effects
In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 
virtuous-cycle
The virtuous cycle is a positive loop or a set of positive loops that trigger a non-linear growth. Indeed, in the context of digital platforms, virtuous cycles – also defined as flywheel models – help companies capture more market shares by accelerating growth. The classic example is Amazon’s lower prices driving more consumers, driving more sellers, thus improving variety and convenience, thus accelerating growth.
amazon-flywheel
The Amazon Flywheel or Amazon Virtuous Cycle is a strategy that leverages on customer experience to drive traffic to the platform and third-party sellers. That improves the selections of goods, and Amazon further improves its cost structure so it can decrease prices which spins the flywheel.

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Gennaro Cuofano

Gennaro is the creator of FourWeekMBA which reached over a million business students, executives, and aspiring entrepreneurs in 2020 alone | He is also Head of Business Development for a high-tech startup, which he helped grow at double-digit rate | Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy | Visit The FourWeekMBA BizSchool | Or Get The FourWeekMBA Flagship Book "100+ Business Models"

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