Diseconomies of scale

A diseconomy of scale is the opposite of an economy of scale. If some cost of a business rises with an increase in size, by a greater proportion than the increase in size, it is a diseconomy of scale.

A more precise definition is that long run average cost per unit rises with an increase in output.

Diseconomies of scale are rarer than economies of scale and they are often offset by economies of scale that exist in the same business. This can make it hard to decide which will have more effect.

For example, there is evidence that diseconomies of scale exist in pharmaceutical companies' research and development. There are undoubtedly economies of scale in manufacturing and marketing. The latter are also important costs. They will usually outweigh R & D combined, and often alone, but R & D is a growth driver and its efficiency has a strategic importance they lack.

Causes of diseconomies of scale usually relate to the difficulties of managing a larger organisation. A larger organisation is harder to monitor, it is more complex and therefore co-ordination between different departments and divisions becomes more difficult. As well as making management less effective, and therefore indirectly imposing costs, the systems designed to cope with the extra complexity may also directly impose costs (that is usually less important as it can be quantified and managed). People working within a larger organisation may also feel less committed to it.

Diseconomies of scale can also occur for reasons external to a firm. For example, as a business becomes larger it may put pressure on its supplies of raw materials and labour, raising input prices.

In certain industries, regulation can be tighter on large firms as a result of competition law or industry specific regulation. Usually, however, there are economies of scale in dealing with regulation - this is one of the advantages large pub chains have over small chains and (even more) independent pubs.

In general economies of scale are more significant and important for investors, but diseconomies of scale can occur and are worth considering especially when dramatic expansion or acquisitions are being considered.

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