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?

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 attribute to platforms business models the ability to scale at 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.

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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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