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:
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 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.
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.
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.
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
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.
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.
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.
The idea of a market economy first came from classical economists, including David Ricardo, Jean-Baptiste Say, and Adam Smith. All three of these economists were advocates for a free market. They argued that the “invisible hand” of market incentives and profit motives were more efficient in guiding economic decisions to prosperity than strict government planning.
Positive economics is concerned with describing and explaining economic phenomena; it is based on facts and empirical evidence. Normative economics, on the other hand, is concerned with making judgments about what “should be” done. It contains value judgments and recommendations about how the economy should be.
When there is an increased price of goods and services over a long period, it is called inflation. In these times, currency shows less potential to buy products and services. Thus, general prices of goods and services increase. Consequently, decreases in the purchasing power of currency is called inflation.
Asymmetric information as a concept has probably existed for thousands of years, but it became mainstream in 2001 after Michael Spence, George Akerlof, and Joseph Stiglitz won the Nobel Prize in Economics for their work on information asymmetry in capital markets. Asymmetric information, otherwise known as information asymmetry, occurs when one party in a business transaction has access to more information than the other party.
Autarky comes from the Greek words autos (self)and arkein (to suffice) and in essence, describes a general state of self-sufficiency. However, the term is most commonly used to describe the economic system of a nation that can operate without support from the economic systems of other nations. Autarky, therefore, is an economic system characterized by self-sufficiency and limited trade with international partners.
Creative destruction was first described by Austrian economist Joseph Schumpeter in 1942, who suggested that capital was never stationary and constantly evolving. To describe this process, Schumpeter defined creative destruction as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Therefore, creative destruction is the replacing of long-standing practices or procedures with more innovative, disruptive practices in capitalist markets.
Happiness economics seeks to relate economic decisions to wider measures of individual welfare than traditional measures which focus on income and wealth. Happiness economics, therefore, is the formal study of the relationship between individual satisfaction, employment, and wealth.
An oligopsony is a market form characterized by the presence of only a small number of buyers. These buyers have market power and can lower the price of a good or service because of a lack of competition. In other words, the seller loses its bargaining power because it is unable to find a buyer outside of the oligopsony that is willing to pay a better price.
The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage. Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.
State capitalism is an economic system where business and commercial activity is controlled by the state through state-owned enterprises. In a state capitalist environment, the government is the principal actor. It takes an active role in the formation, regulation, and subsidization of businesses to divert capital to state-appointed bureaucrats. In effect, the government uses capital to further its political ambitions or strengthen its leverage on the international stage.
The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.
The paradox of thrift was popularised by British economist John Maynard Keynes and is a central component of Keynesian economics. Proponents of Keynesian economics believe the proper response to a recession is more spending, more risk-taking, and less saving. They also believe that spending, otherwise known as consumption, drives economic growth. The paradox of thrift, therefore, is an economic theory arguing that personal savings are a net drag on the economy during a recession.
In simplistic terms, the circular flow model describes the mutually beneficial exchange of money between the two most vital parts of an economy: households, firms and how money moves between them. The circular flow model describes money as it moves through various aspects of society in a cyclical process.
Trade deficits occur when a country’s imports outweigh its exports over a specific period. Experts also refer to this as a negative balance of trade. Most of the time, trade balances are calculated based on a variety of different categories.
A market type is a way a given group of consumers and producers interact, based on the context determined by the readiness of consumers to understand the product, the complexity of the product; how big is the existing market and how much it can potentially expand in the future.
Rational choice theory states that an individual uses rational calculations to make rational choices that are most in line with their personal preferences. Rational choice theory refers to a set of guidelines that explain economic and social behavior. The theory has two underlying assumptions, which are completeness (individuals have access to a set of alternatives among they can equally choose) and transitivity.
The peer-to-peer (P2P) economy is one where buyers and sellers interact directly without the need for an intermediary third party or other business. The peer-to-peer economy is a business model where two individuals buy and sell products and services directly. In a peer-to-peer company, the seller has the ability to create the product or offer the service themselves.
The term “knowledge economy” was first coined in the 1960s by Peter Drucker. The management consultant used the term to describe a shift from traditional economies, where there was a reliance on unskilled labor and primary production, to economies reliant on service industries and jobs requiring more thinking and data analysis. The knowledge economy is a system of consumption and production based on knowledge-intensive activities that contribute to scientific and technical innovation.
In a command economy, the government controls the economy through various commands, laws, and national goals which are used to coordinate complex social and economic systems. In other words, a social or political hierarchy determines what is produced, how it is produced, and how it is distributed. Therefore, the command economy is one in which the government controls all major aspects of the economy and economic production.
How do you protect your rights as a worker? Who is there to help defend you against unfair and unjust work conditions? Both of these questions have an answer, and it’s a solution that many are familiar with. The answer is a labor union. From construction to teaching, there are labor unions out there for just about any field of work.
The bottom of the pyramid is a term describing the largest and poorest global socio-economic group. Franklin D. Roosevelt first used the bottom of the pyramid (BOP) in a 1932 public address during the Great Depression. Roosevelt noted that – when talking about the ‘forgotten man:’ “these unhappy times call for the building of plans that rest upon the forgotten, the unorganized but the indispensable units of economic power.. that build from the bottom up and not from the top down, that put their faith once more in the forgotten man at the bottom of the economic pyramid.”
Glocalization is a portmanteau of the words “globalization” and “localization.” It is a concept that describes a globally developed and distributed product or service that is also adjusted to be suitable for sale in the local market. With the rise of the digital economy, brands now can go global by building a local footprint.
Market fragmentation is most commonly seen in growing markets, which fragment and break away from the parent market to become self-sustaining markets with different products and services. Market fragmentation is a concept suggesting that all markets are diverse and fragment into distinct customer groups over time.
The L-shaped recovery refers to an economy that declines steeply and then flatlines with weak or no growth. On a graph plotting GDP against time, this precipitous fall combined with a long period of stagnation looks like the letter “L”. The L-shaped recovery is sometimes called an L-shaped recession because the economy does not return to trend line growth. The L-shaped recovery, therefore, is a recession shape used by economists to describe different types of recessions and their subsequent recoveries. In an L-shaped recovery, the economy is characterized by a severe recession with high unemployment and near-zero economic growth.
Comparative advantage was first described by political economist David Ricardo in his book Principles of Political Economy and Taxation. Ricardo used his theory to argue against Great Britain’s protectionist laws which restricted the import of wheat from 1815 to 1846. Comparative advantage occurs when a country can produce a good or service for a lower opportunity cost than another country.
The Easterlin paradox was first described by then professor of economics at the University of Pennsylvania Richard Easterlin. In the 1970s, Easterlin found that despite the American economy experiencing growth over the previous few decades, the average level of happiness seen in American citizens remained the same. He called this the Easterlin paradox, where income and happiness correlate with each other until a certain point is reached after at least ten years or so. After this point, income and happiness levels are not significantly related. The Easterlin paradox states that happiness is positively correlated with income, but only to a certain extent.
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 organizationscale further.
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.
An economy of scope means that the production of one good reduces the cost of producing some other related good. This means the unit cost to produce a product will decline as the variety of manufactured products increases. Importantly, the manufactured products must be related in some way.
Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
