Diseconomies of scale

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In microeconomics, diseconomies of scale are the cost disadvantages that firms and governments accrue due to increase in firm size or output, resulting in production of goods and services at increased per-unit costs. This typically follows the law of diminishing returns, where further increase in size of output will result in even greater increase in average cost. The concept is the opposite of economies of scale.

The rising part of the long-run average cost curve illustrates the effect of diseconomies of scale. Beyond Q1 (ideal firm size), additional production will increase per-unit costs.

Causes[edit]

Communication costs[edit]

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:

Workers Communication Channels
1 0
2 1
3 3
4 6
5 10
n

The graph of all one-on-one channels is a Complete graph.

The number of one-on-one channels of communication grows more rapidly than the number of workers, thus increasing the time and 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 (e.g. within departments or within geographical locations). This reduces, but does not stop, the increase in unit costs; and also the organisation will incur some inefficiencies due to the reduced level of communication.

Duplication of effort[edit]

An organisation with just one person cannot have any duplication of effort between employees. If there are two employees, there could be some duplication of efforts, but this is likely to be minor, as each of the two will generally know what the other is working on. When organisations grow to thousands of workers, it is inevitable that someone, or even a team, will take on a function that is already being handled by another person or team. In colloquial terms, this is described as "one hand not knowing what the other hand is doing". 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 have had neither the money to allow such expensive parallel developments, nor 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.[citation needed]

Office politics[edit]

"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. In a small company, such behavior could cause the company to go bankrupt, and thus cost the manager his job, so he would not make such a decision. In a large company, one manager would not have much effect on the overall health of the company, so such "office politics" are in the interest of individual managers.

Top-heavy companies[edit]

As an organisation increases in size, it becomes costly to keep control of a sprawling corporate empire, and this 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 increased.

Other effects which reduce competitiveness of large firms[edit]

These do not always increase the cost-per-unit, but do reduce the ability of a large firm to compete.

Cannibalization[edit]

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 the results of their decisions[edit]

If a single person makes and sells donuts and decides to try jalapeño flavoring, they would likely know on the same 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, especially if their research or marketing team fails to respond in a timely manner. By that time, the decision-makers may very well have moved on to another division or company and thus see no consequence from their decision. This lack of consequences can lead to poor decisions and cause an upward-sloping average cost curve.

Slow response time[edit]

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 changes could be made. By this time, the smaller competitors may well have grabbed that market niche.

Inertia (Unwillingness to change)[edit]

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. An example is Polaroid Corporation's delay in moving into digital imaging, which adversely affected the company, ultimately leading to bankruptcy.

Public and government opposition[edit]

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.

Large market share[edit]

A small company with only a 1% market share could relatively easily double market share, and hence revenues, in a year. A large company with 50% market share will find it difficult to do so.

Large market portfolio[edit]

A small investment fund can potentially yield a higher return because it can concentrate its investments in a small number of good opportunities without driving up the purchase price as they buy in, and later sell them without driving down the sale price as they sell off. 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.[citation needed] As the size of the market controlled grows, the results will be closer to market average.

Inelasticity of supply[edit]

A company which is heavily dependent on its resource supply will have trouble increasing production. For instance a timber company cannot 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 are often-cited examples.

Other effects related to size[edit]

Large firms also tend to be old and in mature markets. Both of these have negative implications for future growth. 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[edit]

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[1] 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.[2]

Solutions[edit]

Solutions to the diseconomy of scale for large firms may involve splitting the company into smaller organisations. This can either happen by default when the company, in financial difficulties, sells off its profitable divisions and shuts down the rest, or can happen proactively, if the management is willing.

To avoid the negative effects of diseconomies of scale, a firm must stick to the lowest average output cost and try to recognise any external diseconomies of scale. Moreover, on reaching the lowest average cost, a firm must either expand to other countries to increase demand for its products, or seek new markets or produce new products that do not compete with its original products. However neither of these actions will eliminate communications and management problems associated with large organisations.

A systematic analysis and redesign of business processes, in order to reduce complexity, can counter diseconomies of scale. This leads to increased productivity. Improved management systems and more effective control of labor and operations can lower overhead.

Example[edit]

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. However the whole company incurs the reputational and legal risks arising from each unit.

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. A single, large, centrally controlled firm, on the other hand, 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.

See also[edit]

References[edit]

  1. ^ 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. 
  2. ^ McLean, Timothy A. "Lean for Small and Medium Sized Manufacturing Enterprises". TXM Lean Solutions. 

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