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.

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.

business-platform-theory

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:

  1. 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.
  2. 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.

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. 

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!

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 Economic Concepts

Market Economy

market-economy
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 and Normative Economics

positive-and-normative-economics
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.

Inflation

how-does-inflation-affect-the-economy
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

asymmetric-information
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

autarky
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.

Demand-Side Economics

demand-side-economics
Demand side economics refers to a belief that economic growth and full employment are driven by the demand for products and services.

Supply-Side Economics

supply-side-economics
Supply side economics is a macroeconomic theory that posits that production or supply is the main driver of economic growth.

Creative Destruction

creative-destruction
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

happiness-economics
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.

Oligopsony

oligopsony
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.

Animal Spirits

animal-spirits
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

state-capitalism
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.

Boom And Bust Cycle

boom-and-bust-cycle
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.

Paradox of Thrift

paradox-of-thrift
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.

Circular Flow Model

circular-flow-model
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 Deficit

trade-deficit
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.

Market Types

market-types
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

rational-choice-theory
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.

Conflict Theory

conflict-theory
Conflict theory argues that due to competition for limited resources, society is in a perpetual state of conflict.

Peer-to-Peer Economy

peer-to-peer-economy
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.

Knowledge-Economy

knowledge-economy
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.

Command Economy

command-economy
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.

Labor Unions

labor-unions
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.

Bottom of The Pyramid

bottom-of-the-pyramid
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

glocalization
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

market-fragmentation
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.

L-Shaped Recovery

l-shaped-recovery
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

comparative-advantage
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.

Easterlin Paradox

easterlin-paradox
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.

Economies of Scale

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.

Diseconomies of Scale

diseconomies-of-scale
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.

Economies of Scope

economies-of-scope
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

price-sensitivity
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.

Network Effects

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. 

Negative Network Effects

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. 

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