Diseconomies of scale
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Diseconomies of scale are the forces that cause larger firms and governments to produce goods and services at increased per-unit costs. The concept is the opposite of economies of scale.
- 1 Causes
- 2 Other effects which reduce competitiveness of large firms
- 2.1 Cannibalization
- 2.2 Isolation of decision makers from results of their decisions
- 2.3 Slow response time
- 2.4 Inertia (unwillingness to change)
- 2.5 Public and government opposition
- 2.6 Large market share
- 2.7 Large market portfolio
- 2.8 Inelasticity of supply
- 2.9 Other effects related to size
- 2.10 Impact on Smaller Firms
- 3 Solutions
- 4 See also
- 5 References
- 6 External links
Ideally, all employees of a firm would have one-on-one communication with each other so they know exactly what the other workers are doing. A firm with a single worker does not require any communication between employees. A firm with two workers requires one communication channel, directly between those two workers. A firm with three workers requires three communication channels between employees (between employees A & B, B & C, and A & C). Here is a chart of one-on-one communication channels required:
The graph of all one-on-one channels is a Complete graph.
The one-on-one channels of communication grow more rapidly than the number of workers, thus increasing the time, and therefore costs, of communication. At some point one-on-one communications between all workers becomes impractical; therefore only certain groups of employees will communicate with one another (salespeople with salespeople, production workers with production workers, etc.). This reduced communication slows, but doesn't stop, the increase in time and money with firm growth, but also costs additional money, due to duplication of effort, owing to this reduced level of communication.
Duplication of effort
A firm with only one employee can't have any duplication of effort between employees. A firm with two employees could have duplication of efforts, but this is improbable, as the two are likely to know what each other is working on at all times. When firms grow to thousands of workers, it is inevitable that someone, or even a team, will take on a project that is already being handled by another person or team. General Motors, for example, developed two in-house CAD/CAM systems: CADANCE was designed by the GM Design Staff, while Fisher Graphics was created by the former Fisher Body division. These similar systems later needed to be combined into a single Corporate Graphics System, CGS, at great expense. A smaller firm would neither have had the money to allow such expensive parallel developments, or the lack of communication and cooperation which precipitated this event. In addition to CGS, GM also used CADAM, UNIGRAPHICS, CATIA and other off-the-shelf CAD/CAM systems, thus increasing the cost of translating designs from one system to another. This endeavor eventually became so unmanageable that they acquired (and then eventually sold off) Electronic Data Systems (EDS) in an effort to control the situation. Smaller firms typically choose a single off-the shelf CAD/CAM system, with no need to combine or translate between systems.
"Office politics" is management behavior which a manager knows is counter to the best interest of the company, but is in his personal best interest. For example, a manager might intentionally promote an incompetent worker knowing that the worker will never be able to compete for the manager's job. This type of behavior only makes sense in a company with multiple levels of management. The more levels there are, the more opportunity for this behavior. At a small company, such behavior would likely cause the company to go bankrupt, and thus cost the manager his job, so he would not make such a decision. At a large company, one bad manager would not have much effect on the overall health of the company, so such "office politics" are in the interest of individual managers.
As a firm becomes too large, it becomes costly to keep control of a sprawling corporate empire and so often results in bureaucracy as executives implement more and more levels of management. As firms increase in size, managers will initially provide a net benefit to the firm and increase productivity, however, as a firm grows and covers a larger geographical area and/or employs more people, a principal agent problem arises, leading to lower productivity. To counter this, executives introduce standards and controls in order to maintain productivity and this necessitates the hiring of more managers to apply these standards and controls, hence the proportion of managerial to working class begins to lean towards managerial and the company becomes "top-heavy". However, these additional managers are not providing additional output, they are spending their time implementing standards and carrying out supervision that is unnecessary in smaller firms, hence the cost-per-unit has decreased
Other effects which reduce competitiveness of large firms
These don't always increase the cost-per-unit, but do reduce the ability of a large firm to compete.
A small firm only competes with other firms, but larger firms frequently find their own products are competing with each other. A Buick was just as likely to steal customers from another GM make, such as an Oldsmobile, as it was to steal customers from other companies. This may help to explain why Oldsmobiles were discontinued after 2004. This self-competition wastes resources that should be used to compete with other firms.
Isolation of decision makers from results of their decisions
If a single person makes and sells donuts and decides to try jalapeño flavoring, they would likely know that day whether their decision was good or not, based on the reaction of customers. A decision maker at a huge company that makes donuts may not know for many months if such a decision worked out or not. By that time they may very well have moved on to another division or company and thus see no consequences from their decision. This lack of consequences can lead to poor decisions and cause an upward sloping average cost curve.
Slow response time
In a reverse example, the smaller firm will know immediately if people begin to request other products, and be able to respond the next day. A large company would need to do research, create an assembly line, determine which distribution chains to use, plan an advertising campaign, etc., before any change could be made. By this time smaller competitors may well have grabbed that market niche.
Inertia (unwillingness to change)
This will be defined as the "we've always done it that way, so there's no need to ever change" attitude (see appeal to tradition). An old, successful company is far more likely to have this attitude than a new, struggling one. While "change for change's sake" is counter-productive, refusal to consider change, even when indicated, is likewise toxic to a company, as changes in the industry and market conditions will inevitably demand changes in the firm in order to remain successful. A recent example is Polaroid Corporation's refusal to move into digital imaging until after this lag adversely affected the company, ultimately leading to bankruptcy.
Public and government opposition
Such opposition is largely a function of the size of the firm. Behavior from Microsoft, which would have been ignored from a smaller firm, was seen as an anti-competitive and monopolistic threat, due to Microsoft's size, thus bringing about government lawsuits.
A small company with only a 1% market share could potentially double market share, and hence revenues, in a year. A large company with 90% market share will find it difficult to do so well, as this would require that they control 180% of the original market. Unless the total market size is increasing rapidly, this isn't possible.
Large market portfolio
A small investment fund can potentially return a larger percentage because it can concentrate its investments in a small number of good opportunities without driving up the price of the investment securities. Conversely, a large investment fund like Fidelity Magellan must spread its investments among so many securities that its results tend to track those of the market as a whole.
Inelasticity of supply
A company which is heavily dependent on its resource supply will have trouble increasing production. For instance a timber company can not increase production above the sustainable harvest rate of its land. Similarly service companies are limited by available labor, STEM (science, technology, engineering, and mathematics) professions being an often cited example.
Large firms also tend to be old and in mature markets. Both of these have negative implications for future growth, as well. Old firms tend to have a large retiree base, with high associated pension and health costs, and also tend to be unionized, with associated higher labor costs and lower productivity. Mature markets tend to only offer the potential for small, incremental growth. (Everybody might go out and buy a new invention next year, but it is unlikely they will all buy cars next year, since most people already have them.)
Impact on Smaller Firms
While Diseconomies of Scale are typically associated with large mature firms, similar problems have been observed in the growth phase of small and medium sized manufacturing companies. Mclean has observed that this can occur once the workforce exceeds around 20 employees. At this point business complexity grows more rapidly than revenue. The business experiences falling productivity leading to rising variable costs along with rapidly rising overheads.
Solutions to the diseconomy of scale for large firms involve changing the company into one or more small firms. This can either happen by default when the company, in bankruptcy, sells off its profitable divisions and shuts down the rest, or can happen proactively, if the management is willing. Returning to the example of the large donut firm, each retail location could be allowed to operate relatively autonomously from the company headquarters, with employee decisions (hiring, firing, promotions, wage scales, etc.) made by local management, not dictated by the corporation. Purchasing decisions could also be made independently, with each location allowed to choose its own suppliers, which may or may not be owned by the corporation (wherever they find the best quality and prices). Each locale would also have the option of either choosing their own recipes and doing their own marketing, or they may continue to rely on the corporation for those services. If the employees own a portion of the local business, they will also have more invested in its success. Note that all these changes will likely result in a substantial reduction in corporate headquarters staff and other support staff. For this reason, many businesses delay such a reorganization until it is too late to be effective.
For smaller firms Lean Manufacturing has been demonstrated as an effective technique to counter the diseconomies of scale. This is because lean manufacturing allows for a systematic analysis and redesign of business processes in order to reduce complexity. This leads to increased productivity. Improved management systems based on Lean Leadership also leads to more effective control of labour and operations and lower overheads.
Independently controlled donut firms may choose to offer higher wages and charge higher prices if they are in an affluent area. In October, when fresh apple cider is available at bargain prices from local farmers, they may choose to market a cinnamon donut/hot apple cider combo promotion. A single, large, centrally controlled firm may lack the flexibility to offer such customizations. However, if each donut shop within the large firm is allowed to operate independently, this flexibility may be restored.
The real solution for diseconomies of scale is that a firm must stick to the lowest average cost of its output and must make huge efforts to sense any external diseconomies of scale. Moreover, on reaching the lowest average cost a firm must either open new factories in other countries resulting in larger demand for firm products and in case of inability of such behaviour then firms must wisely seek new markets or attempt to produce new products that do not compete with its original products to achieve risk economies.
- McLean, Timothy A. (December 2014). Grow Your Factory, Grow Your Profits: Lean for Small and Medium Sized Manufacturing Enterprises. New York: Productivity Press. ISBN 978-1-4822-5585-0.
- McLean, Timothy A. "Lean for Small and Medium Sized Manufacturing Enterprises". TXM Lean Solutions.