What are Diseconomies of Scale?

Diseconomies of scale, also known as decreasing returns to scale, is an economic concept used to describe the situation that occurs when economies of scale no longer accrue to a company. In economies of scale, the average cost of producing a product falls as output increases. Diseconomies of scale refers to the point where it begins to cost a firm more to produce each unit of output rather than less. The average cost per unit then ceases to decrease and begins to increase.

The development of this concept was the result of economists asking whether costs could continue to fall indefinitely as the size of a firm increased. That might seem logical, but research indicates that costs frequently do not continue to fall but eventually increase. Generally speaking, this is because the economies of scale that initially accompany expansion of output are either balanced by or exceeded by diseconomies of scale. Economists recognize two types of diseconomies: internal and external.

Internal diseconomies arise from circumstances within the organization. They are largely the result of inefficiencies that might begin to occur as organizations grow in size and become more difficult to manage. Usually, internal issues arise because of the expanding bureaucracy that accompanies growth. Decision making often slows, and firms can no longer respond to market demands and conditions as quickly. As layers are placed between members of the senior management and the organization’s workforce, office culture might become more impersonal and adversely affect the motivation and efficiency of employees.

Diseconomies of scale also might happen as a result of factors external to the firm. For example, as a business increases its output, more pressure might be put on its labor supplies, which would then raise the price of additional output. The availability of raw materials also might cause the cost of production to rise. A mining firm, for example, might first extract minerals that are easy to access. After it is necessary to mine deeper seams to produce more ore, the cost of additional output will rise.

Many companies now incorporate this idea in their expansion plans. When a strategic decision to expand has been made, a company might weigh the overall effects of its decision. A company will typically try to balance the effects of achieving economies of scale through expansion versus the real problem of simultaneously encountering diseconomies.