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.

Let’s first understand the difference between economies and diseconomies of scale.

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 they 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.

Platform business models and economies 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 to 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 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.
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Gennaro Cuofano

Gennaro is the creator of FourWeekMBA which he brought to reach over half a million business students, professionals, and entrepreneurs in the last year | Gennaro is also Head of Business Development at a tech startup, he helped grow at double-digit rate and become profitable | Gennaro is an International MBA with emphasis on Corporate Finance | Subscribe to the FourWeekMBA Newsletter | Or Get in touch with Gennaro here

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