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What are diseconomies of scale? Diseconomies of scale can be defined as the increase in average cost per unit in a firm when the company output grows above a certain point. So, how can they impact businesses? Let's find out.
Diseconomies of scale are the increase in average cost per unit when the output of a firm increases above a certain point.
Diseconomies of scales can be observed in firms when it grows or produces output beyond a certain point. This means that, beyond this particular point, economies of scale do not work for this firm, and the average cost increases per increase in output.
Let us have a look at the diseconomies of scale graph, it occurs when the average cost of a unit starts to increase.
Figure 1. Diseconomies of scale occur to the right of point 'X', StudySmarter
Figure 1 shows when the output volume exceeds 'X', (moves to the right of 'X'), economies of scale stop working for a firm and gradually turn into diseconomies of scale, ie, the average cost per unit increases for an increase in output volume.
Economies of scale are the decrease in average cost per unit as the output volume increases.
This can be observed when the production becomes efficient. This is mainly seen in large companies, as they have a high output volume. Having a high output volume helps companies to distribute their fixed costs among the produced units, thereby decreasing the average cost per unit.
This is why small to medium-sized companies charge more for products, as they have fewer units to distribute the costs, thereby increasing the average cost per unit. Factors affecting the economies of scale are:
Learning
Efficient capital
Specialization
Negotiation power
It should be noted that the increase in output volume stated here should not exceed a certain amount, as this will then lead to diseconomies of scale.
The increase in average cost of production per unit due to constraints on economic and other resources imposed on a company by the external environment in which it works is called external diseconomies of scale.
As demand increases, the costs per unit increase. This is because as production increases with demand, the resources become scarce, and the cost to obtain them increases. This leads to an increase in the fixed costs, thereby increasing the cost of production for each unit. For example, when land becomes scarce, the rent (fixed cost) increases, or a decrease in the number of qualified labourers leads to an increase in their wages. All such factors increase the cost of production. Such factors are caused by the external environment, and therefore the management does not have any control over these factors.
There are mainly three types of external diseconomies of scale - diseconomies of pollution, limited natural resources, and infrastructure diseconomies s.
When firms grow and set up factories, they impose costs on the local population in the form of pollution in the local surroundings, as this can lead to several health issues. Poor health is one of the main results of this type of diseconomy.
Poor health: Pollution caused by factories have long-lasting damaging effects on different human organs, causing innumerable health issues.
Natural resources ranging from labourers to other physical resources such as oil and coal are required by all companies. As the form grows in size, the number of resources required also becomes more. As the demand for such limited resources increases, it becomes hard to gain them, making them more expensive. Higher prices and higher salaries are the results of this type of diseconomy.
High prices: Prices of the end product increase as the resources to produce the product becomes higher due to its scarcity.
Higher salaries: Laborers that possess a talent or skill not known to a lot of others can negotiate for a higher salary.
Infrastructure diseconomy is when a company grows to the point that it puts a strain on the local infrastructure. For example, if all the companies were to increase the number of trucks to decrease the delivery, this would lead to traffic blocks on roads, putting a strain on the local infrastructure. Moreover, this increases the delivery time due to traffic, leading to more costs, as costs increase as the delivery time increases.
Internal diseconomies of scale are the increase in the average cost of production due to factors within the company. These factors are directly controlled by the management.
Technical, organizational, purchasing, competitive / monopoly, and financial diseconomies are the types of internal diseconomies of scale.
This is observed when a company grows faster than it can adapt, and is seen in the production process. It happens when a firm overcrowds its offices beyond capacity and ultimately results in an increased cost of production. Technical diseconomies of scale lead to overcrowding and scalability.
Overcrowding: This is the increase in production beyond reasonable capacities. This could be having too many factory workers or employees in a store. Too many employees end up duplicating each other's work and increasing the company's overall cost.
Scalability: When a firm is functioning very efficiently in some locations and decides to expand but the new outlets turn out to be inefficient. This also increases the overall cost of production drastically.
This occurs when the management is unable to cope up with the growth of the company. It becomes increasingly difficult for management to manage the growing workforce. Communication, demotivation, and employee health are effects of organizational diseconomies of scale.
Communication: If the firm's communication management can not adapt as fast as the company's growth, this can cause diseconomies of scale. Inefficient communication among employees and the management can lead to confusion and misunderstandings, creating problems in the workplace.
Demotivation: this can be caused as a result of managers overlooking individual employee success. It becomes increasingly difficult for managers to keep track of their employees' success in a rapidly growing company and this results in underperforming employees.
Employee health: feeling isolated and insignificant are common psychological effects that can have on employees when their company quickly expands. This is because before, they were maybe an integral part of a few hundred people, but now feel not as important among 100,000 people. This can lead to a fall in employees' mental health, making them inefficient.
In most cases, big firms end up paying more money than a small company would have, for assets or resources. This is because now the company has a higher level of cash flow and spends more on purchases simply because they can. These results in higher costs, greater waste, and deadlock.
Higher cost: the tendency to overspend on items results in increasing the overall cost and expenses of the form.
Greater waste: due to the communication gap between the managers and employees that are created due to the rapid growth, managers are unaware of the resources needed by employees and invest in unwanted resources.
Deadlock: as a result of overspending, future purchase decisions might have to go through many levels of approval, just to get rejected at the end (due to the drastic increase in expenses caused by the purchases). This will stop or halt the company's progress.
Monopolies have no pressure to increase quality or decrease cost, as they do not have the threat of going out of business. Competition is important to keep a business running efficiently. Higher cost and more competition are the effects of a competitive / monopoly diseconomy.
Higher cost: such companies usually have a high number of employees, and having a strong market position does not present the management with many incentives to implement efficiencies within the firm. This leads to higher costs.
More competition: new forms seize the opportunity to enter the market when a monopolistic firm becomes inefficient.
Financial diseconomies occur when a business overspends. Firms tend to invest in real estate as they grow. But if the cost of buying and maintaining them is not proportional to the growth of the company, the company will require funding from external sources and will, in turn, have to pay interest rates. An expanded workforce and high levels of interest are the results of financial diseconomies.
Expanded workforce: the workforce will expand as more staff is required to look over the newly bought assets and its finances.
High levels of interest: If the funding to purchase the asset were not organically funded by the company and the firm borrows from external sources, it will then have to pay high levels of interest to the banks and lenders, as the company is at a higher financial risk.
Figure 2. Five Types of External Diseconomies of Scale, StudySmarter
The following are a few examples of diseconomies of scale.
Higher cost of materials. As companies grow as their demand for resources increases. Firms in the same industry have similar resource requirements and the resources become scarce as their demand increases. This, in turn, increases the cost of materials.
Poor communication is yet another but important example of diseconomies of scale. As the company grows and employs more people, communication among the staff can become very difficult and inefficient. You might not know who the right contact person is in an international organization. Sending emails rather than direct communication becomes a usual practice, which can sometimes cause important details to be overlooked.
Inefficient management is a result of rapid growth in an organization. The management fails to understand that the rapid growth in a company can lead to a decrease in employee morale due to the increase in employees and workload. The lack of training does not allow managers to look properly after their employees as a result of which, they do not perform as much as they can.
Diseconomies of scale are defined as the increase in average cost per unit in a firm when the company output grows above a certain point.
Diseconomies of scales can be observed in firms when it grows or produces output beyond a certain point.
Economies of scale are the decrease in average cost per unit as the output volume increases. This can be observed when the production becomes efficient.
The increase in average cost of production per unit due to constraints on economic and other resources imposed on a company by the external environment in which it works is called external diseconomies of scale.
There are mainly three types of external diseconomies of scale - diseconomies of pollution, limited natural resources, and infrastructure diseconomies.
Poor health is one of the main results of diseconomies of pollution.
Higher prices and higher salaries are the results of limited natural resources.
Infrastructure diseconomy is when a company grows to the point that it puts a strain on the local infrastructure.
Internal diseconomies of scale are the increase in the average cost of production due to factors within the company.
Technical diseconomies of scale lead to overcrowding and scalability.
Communication, demotivation, and employee health are effects of organizational diseconomies of scale.
Higher costs, greater waste, and deadlock are the results of purchasing diseconomies.
Higher costs and more competition are the effects of a competitive / monopoly diseconomy.
An expanded workforce and high levels of interest are the results of financial diseconomies.
Higher cost of materials, poor communication and inefficient management are some examples of diseconomies of scale.
Diseconomies of scale are defined as the increase in average cost per unit in a firm when the company output grows above a certain point. Diseconomies of scales can be observed in firms when it grows or produces output beyond a certain point. This means that, beyond this particular point, economies of scale do not work for this firm, and the average cost increases per increase in output.
The above graph shows when the output volume exceeds ‘X’, (moves to the right of ‘X’), economies of scale stop working for a firm and gradually turn into diseconomies of scale, i.e., the average cost per unit increases for an increase in output volume.
Diseconomies of scale can be caused by internal and external factors. The internal factors can be controlled by the management, whereas, the external factors can not.
Internal diseconomies of scale are the increase in the average cost of production due to factors within the company. These factors are directly controlled by the management. Technical, organisational, purchasing, competitive/monopoly, and financial diseconomies are the types of internal diseconomies of scale.
The increase in average cost of production per unit due to constraints on economic and other resources imposed on a company by the external environment in which it works is called external diseconomies of scale.
There are mainly three types of external diseconomies of scale - diseconomies of pollution, limited natural resources, and infrastructure diseconomies.
Higher cost of materials, poor communication and inefficient management are some examples of diseconomies of scale.
There are mainly 5 approaches followed by organisations to manage diseconomies of scale.
Diseconomies of scale are defined as the increase in average cost per unit in a firm when the company output grows above a certain point. Diseconomies of scales can be observed in firms when it grows or produces output beyond a certain point. This means that, beyond this particular point, economies of scale do not work for this firm, and the average cost increases per increase in output.
Economies of scale are the decrease in average cost per unit as the output volume increases. This can be observed when the production becomes efficient. This is mainly seen in large companies, as they have a high output volume. Having a high output volume helps companies to distribute their fixed costs among the produced units, thereby decreasing the average cost per unit. Learning, efficient capital, specialisation, and negotiation power are factors affecting economies of scale.
The above graph shows when the output volume exceeds ‘X’, (moves to the right of ‘X’), economies of scale stop working for a firm and gradually turn into diseconomies of scale, i.e., the average cost per unit increases for an increase in output volume.
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