Internal Diseconomies of ScaleBy

Naeem Akram

Noor College of Business & Sciences

Diseconomies of Scale

The word diseconomies refers to all those losses which accrue to the firm in the industry due to the expansion of their output beyond a certain limit.

Economic theory predicts that a firm may become less efficient if it becomes too large. The additional costs of becoming too large are called diseconomies of scale.

Diseconomies of Scale

Diseconomies of scale result in rising long run average costs which are experienced when a firm expands beyond its optimum scale, at Q.

Examples of Diseconomies of scale

Why it happens?We have seen that increasing output will, at some

point, cause the firm's average cost to start to rise.

This is because variable costs will outweigh the effect of falling fixed costs.

Note that the firm can go on producing well beyond its optimal scale so long as price covers cost.

Even if the price remains fixed, it pays the firm to go on adding capacity –all that happens is that profit per unit decreases.

Reasons of diseconomies of scaleHowever, this is not the only factor causing costs to

rise after the firm has grown beyond its optimum size.

There are a number of disadvantages to large organisations, principally in terms of management diseconomies.

These include:

1. Communication difficulties caused by longer chains of command

2. Delays in responding to market changes because of slow decision-making processes and the need to consult

Reasons of diseconomies of scale

3. Bureaucracy, which results in excessive administration costs

4. Poor morale and motivation as people feel that they do not have a stake in the firm

5. Information overload for managers, who cannot absorb enough detail to make informed decisions.

Large firms can become such heavy users of labourand raw material supplies that they create shortages and drive up wages and prices against themselves.

With a large workforce, trade unions may be able to exert strong influence to achieve wage increases.

Reasons of diseconomies of scale

Managers in market dominating firms grant higher wages easily and accept overmanning because the costs can be passed on to consumers.

Specialisation means that a small number of workers become key personnel who are able to disrupt production –

for example,

a bank’s mainframe

computer operators.

Survival of Small FirmsMost firms in industrialised economies are small,

employing fewer than a hundred people, and the great majority fewer than ten.

Large enterprises exist in those industries where there are significant economies of scale to be had.

These may be technical, as in electricity generation which requires large plants, or it may be that there are significant marketing or buying economies, as in the case of supermarket chains, where the individual plant (the shop itself) is relatively small.

Survival of Small FirmsThe risk-bearing economies may be vital, as in

banking, where a network of small branches operates to gather up a large-quantity of money in small amounts to put it to use in diversified loans.

But even where there are significant technical economies and advantages of size, there are invariably small firms in the same industry.

Small firms do surviveThere are various possible reasons why small firms can

and do survive.

1. Many industries do not require the use of much equipment, so the technical economies are limited and large firms do not have any significant advantage –for example, there are few economies of scale in window cleaning or hairdressing, so the average size of firms in these sectors is low.

2. The size of the market is limited–for example, it may be localised as in the case of house repairs and alterations, so jobbing builders are small firms.

Small firms do survive3. Personal service is important, and this limits the size of

the enterprise so that there are no significant advantages of large scale production and large chains do not appear –for example, hairdressers (again) and solicitors.

4. There are frequent changes in the market so the flexibility and speed of response of small firms makes them more successful than large ones –for example, in the fashion industry where small firms are the norm in the boutique clothing industry.

5. Small firms often fill niches left by large ones which do not want to take on small scale specialist work –for example, car makers like Morgan and Reliant serve markets of no interest to companies like Ford and Fiat.

Small firms do survive6. Individual skills may be of prime importance –for

example in the craft industries. The sole proprietor in this kind of industry often benefits from collective marketing at craft fairs and through craft associations.

7. People simply want to be their own bosses and set up enterprises where this is possible. Often little capital is required, as in writing computer software, yet very large incomes can sometimes be earned, and there is no great value put on expansion and growth.

Growth of Small firmsThere are many instances where small firms can flourish

because they get access to facilities and services which give them the advantages of economies of scale.

Small printing firms can send completed books to specialist binders which have large capacity machinery.

Industry associations, universities and government laboratories offer research and development opportunities to small firms.

Collective marketing and buying provide advantages, for example in farmers' co-operatives and craft industries.

Franchise operatorThe individual who wants to set up in business with as

many advantages of size as possible can turn to a franchise operator.

The franchiser will provide a business plan, specialist equipment and marketing support, and financial help and assistance in finding premises are also usually available.

The franchisee is guaranteed a local market.

There are many franchises on every high street including McDonalds, The Body Shop, photo processing and dry cleaning firms.

There are also industrial franchises.

Change in technologyAs production technology changes towards more and

more assembly of components and as people want more individual products, small firms are likely to flourish just as much in manufacturing as they do in services and retailing.