Diseconomies of scale

Economic theory predicts that a firm may become less efficient if it becomes too large. The additional costs of becoming too large are called diseconomies of scale.

Diseconomies of scale result in rising long run average costs which are experienced when a firm expands beyond its optimum scale, at Q.

Economies and diseconomies of scale

Examples of diseconomies include:

  1. Larger firms often suffer poor communication because they find it difficult to maintain an effective flow of information between departments, divisions or between head office and subsidiaries. Time lags in the flow of information can also create problems in terms of the speed of response to changing market conditions. For example, a large supermarket chain may be less responsive to changing tastes and fashions than a much smaller, ‘local’ retailer.

  2. Co-ordination problems also affect large firms with many departments and divisions, and may find it much harder to co-ordinate its operations than a smaller firm. For example, a small manufacturer can more easily co-ordinate the activities of its small number of staff than a large manufacturer employing tens of thousands.

  3. ‘X’ inefficiency is the loss of management efficiency that occurs when firms become large and operate in uncompetitive markets. Such loses of efficiency include over paying for resources, such as paying managers salaries higher than needed to secure their services, and excessive waste of resources. ‘X’ inefficiency means that average costs are higher than would be experienced by firms in more competitive markets.

  1. Low motivation of workers in large firms is a potential diseconomy of scale that results in lower productivity, as measured by output per worker.

  2. Large firms may experience inefficiencies related to the principal-agent problem. This problem is caused because the size and complexity of most large firms means that their owners often have to delegate decision making to appointed managers, which can lead to inefficiencies.  For example, the owners of a large chain of clothes retailers will have to employ managers for each store, and delegate some of the jobs to managers but they may not necessarily make decisions in the best interest of the owners. For example, a store manager may employ the most attractive sales assistant rather than the most productive one.