Diseconomies of scale
Definition
Internal diseconomies of scale: the rise in long-run average cost (LRAC) that occurs when a single firm grows too large to manage well.
External diseconomies of scale: the rise in LRAC every firm suffers when the whole industry becomes overcrowded in one area.
Key Idea
- Internal diseconomies push a firm back up its own LRAC curve as it outgrows its management.
- External diseconomies shift the whole industry's LRAC curve upwards as the cluster becomes congested.
Internal diseconomies
- Communication: as more layers of management are added, information travels slowly and is distorted, so decisions are delayed and costly errors rise.
- Coordination and control: a large workforce spread across many sites is harder to monitor, so extra supervisors are needed and average cost rises.
- Motivation: workers feel remote from decisions in a huge firm, so effort and productivity fall and cost per unit rises.
Example
- Adding a regional tier of 50 managers on £40,000 each raises costs by £2,000,000 a year, yet adds no extra output, so average cost climbs.
- In a sprawling firm such as a global carmaker, senior managers lose touch with the factory floor, so faults are caught late and rework costs rise.
External diseconomies
- Factor-price pressure: as an industry concentrates in one area, firms bid up local wages and rents, raising costs for every firm there.
- Congestion: overloaded transport and infrastructure slow deliveries, so logistics costs rise across the whole cluster.
- Input scarcity: heavy competition for scarce raw materials or skilled labour pushes input prices up for all producers.
Example
- In a booming tech hub, firms bidding for the same engineers can push salaries up by tens of thousands of pounds, raising every firm's wage bill.
- Clogged local roads add hours to deliveries, so haulage and storage costs rise for all producers in the cluster.
Effect on the LRAC curve
- Diseconomies raise long-run average cost once output grows past the minimum efficient scale.
- They create the upward-sloping section of the LRAC curve.
- It depends on the firm: strong management or new technology can delay diseconomies, so the flat section of the LRAC curve is longer in some industries than others.
Do diseconomies of scale inevitably cap a firm's size?
- This holds because a firm that expands past its minimum efficient scale meets communication, coordination and motivation problems that raise long-run average cost, so unchecked growth can leave a giant less efficient than a smaller rival.
- But many firms hold average cost roughly flat over a wide range of output, giving an L-shaped LRAC curve; delayering, decentralised divisions and digital monitoring can push diseconomies far to the right or offset them for years.
- It also depends on whether the pressures are external, such as congestion and rising local wages, since a firm that spreads its sites or relocates can escape costs that trap rivals stuck in one crowded cluster.
- On balance, diseconomies limit efficient size only where management fails to adapt, so whether they bind depends on the quality of management, the technology available and how far the pressures are internal rather than external.
Exam technique
- Say whether a diseconomy is internal or external before explaining it.
- Tie the rising cost to the upward-sloping part of the LRAC curve.
Common Mistake
- Do not confuse diseconomies of scale with diminishing returns.
- Diseconomies are long run with all factors variable, while diminishing returns are short run with at least one fixed factor.
Self review
- Define diseconomies of scale.
- Distinguish internal from external diseconomies.
- Name the three main sources of internal diseconomies.
- Which part of the LRAC curve do they explain?
