Steve Bain

Diseconomies of Scale
(Definition & Examples)

Diseconomies of scale is a term that applies to anything which causes a firm's average cost of production to increase as its total output increases. In practice it tends to apply to businesses that offer goods/services that are more tailored to the particular needs of each customer, e.g. a local hairdresser, rather than to industries that mass produce a standardized product for many customers.

The key distinction there is the ability (or not) to replicate the same product again and again. For businesses that need to tailor their product, there are often significant extra costs when expanding output beyond a level that allows for a personalized product to be offered.

Ultimately, however, all firms and industries will reach a point beyond which they start to experience diseconomies of scale, and the reasons for that usually fall into one of four main causes.

Causes of Diseconomies of Scale

  1. Management Costs - The most commonly cited cause of diseconomies of scale is that of management diseconomies. As firms get bigger they get disproportionately more complex and hard to run. Simple communication of new ideas and new problems that may once have been easily conducted between a small group of managers, at a single location, become exponentially more difficult as extra business premises are added and extra layers of management are needed. There may even be some emergence of principal-agent problems if a business owner retires and hands over the running of the business to its employees.
  2. Regulatory Overview - If a firm grows to a point that it supplies a significant share of a market, it will start to be noticed by industry regulators. This will usually necessitate the recruitment of a legal team to protect the firm from any sort of legal action to restrict it. In the US it is common for such firms to start spending large amounts of money for lobbying government representatives for favorable treatment. I've given two examples of regulatory overview problems below, relating to Twitter and Microsoft. 
  3. Supplier Limitations - When a firm is small it will likely be a small buyer of its merchandise, raw materials and other factors of production. As it grows it may well benefit from an ability to negotiate cheaper bulk prices for these inputs. However, continued growth may well start to present the opposite problem whereby some inputs become scarce e.g., an oil well may be easy to extract oil from in the early stages of operation, but it will get more expensive and difficult at some point.
  4. Geography - Some firms build their competitive advantage by securing the best locations from which to serve their customers, but once the market becomes saturated it becomes harder to find additional viable locations. The major food retailers are a good example of this, because a given location can only support so many retail outlets before adding more of them merely results in poaching customers from existing outlets.

Diseconomies of Scale Examples

Twitter

Twitter went public in 2013 and since that time has struggled to make consistent profits. Profits are not the same as average costs and so we shouldn't immediately deduce that diseconomies of scale are at play, but it does seem like a reasonable assumption. Revenues are primarily made from advertising services, and these are unlikely to have fallen meaning that costs have probably risen - but why?

Twitter is the classic example of regulatory burden; its growth has come with significant political influence, and that has brought it under close regulatory scrutiny. Regardless of where you stand on the free speech vs disinformation divide, any wrong move by Twitter could see it prosecuted, and significant numbers of its advertisers desert it. In light of that, Twitter has taken on the huge costs of mitigating this threat by employing a vast army staff to police what is tweeted on its platform.

Microsoft

In the 1990s Microsoft was a rapidly expanding company and enjoying great success in the software industry. This was the early days of the internet and the race was on to develop the best web browser for users to access the net. By the late 90s there were many competing browsers that customers could use, and typically they came with a subscription fee. The dominant browser at that time was Netscape Navigator, and until 1998 it was only available to its customers for a fee. Why the change in 1998?

The reason for the change was because Microsoft had introduced Internet Explorer as a free web browser, and made it a standard part of its Windows operating system. The results were devastating to Netscape Navigator and Internet Explorer quickly dominated the web browser market. That might sound like good news for Microsoft, but it led to a huge lawsuit with many competitors alleging that Microsoft's dominance in the software industry allowed it to unfairly squeeze out its rivals.

The Department of Justice got involved, and ultimately Microsoft was found to have violated the Sherman Act (although it did win its appeal). The case cost Microsoft a fortune and is thought to have contributed to its founder, Bill Gates, early retirement. A settlement with the DOJ was agreed whereby restrictions were placed on the company that not only affected its core software market, but also its web browser market. By the early 2000s Internet Explorer was a shadow of its former self. If Microsoft had not held such a large and dominant position in the software and web browser markets, there would have been no antitrust violation, and no costly regulation of its business.

More Examples of Diseconomies of Scale

In the opening section of the article I gave the example of a local hairdresser as being likely to experience diseconomies of scale at a relatively low level of production. This is true and, as stated, it is due to the personalized nature of the service offered. However, I don't want to give the impression that it is only small high street shops that experience such problems.

There are a huge number of small specialized businesses that can only operate efficiently at a low level of output because their service is somewhat unique. The Digital & Creative industry is a good example of this. Film and audio services are often highly skilled and sometimes unique. Clearly, it is quite impossible for a songwriter to mass produce lyrics, even if the end result is a performance that can be posted online and instantly accessed by millions of fans.

There is a virtual army of micro-businesses in the digital and creative sector who contribute towards the production of a film. Anything from make-up artists, 3D imaging companies, digital special effects creators, camera technicians, lighting experts, and so on all tend to operate on a small scale. They do so because their services are so highly-skilled and specialized that the diseconomies of scale they face make mass production impossible.

Related Pages:

Show / Hide