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# Diseconomy of scale

Diseconomies of scale are the forces that cause larger firms to produce goods and services at increased per-unit costs. They are less well known than what economists have long understood as "economies of scale", the forces which enable larger firms to produce goods and services at reduced per-unit costs.

Research that focused explicitly on the forces behind corporate diseconomies of scale is Canbäck (2002)

## Causes

Some of the forces which cause a diseconomy of scale are listed below.

### Cost of communication

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 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 $frac\left\{n\left(n-1\right)\right\}\left\{2\right\}$

The one-on-one channels of communication grow more rapidly than the number of workers, thus increasing the time, and therefore 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 (salespeople with salespeople, production workers with production workers, etc.). This reduced communication slows, but doesn't stop, the increase in time and money with firm growth, but also costs additional money, due to duplication of effort, owing to this reduced level of communication.

### Duplication of effort

A firm with only one employee can't have any duplication of effort between employees. A firm with two employees could have duplication of efforts, but this is improbable, as the two are likely to know what each other is working on at all times. When firms grow to thousands of workers, it is inevitable that someone, or even a team, will take on a project that is already being handled by another person or team. 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 neither have had the money to allow such expensive parallel developments, or 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 Electronic Data Systems (EDS) in an effort to control the situation. A smaller firm would have chosen a single off-the shelf CAD/CAM system, with no need to combine or translate between systems.

### Top-heavy companies

The more employees a firm has, the larger percentage of the workforce will be "management". A company with a single worker doesn't need any managers (this refers to managers of people, as opposed to managers of other resources). A firm with five employees might employ one as a manager and the other four as workers. If that manager does nothing other than manage the workers under them, then the productivity of the firm has been reduced by 20%. A firm with 21 employees might have 16 workers, 4 supervisors, and 1 manager. If neither the manager nor supervisors do anything but manage the people under them, then we now have reduced productivity by 5/21 or 23.8%. Thus, the larger the firm, the lower the percentage of "line workers". To be sure, companies with higher worker-to-manager ratios and that have "working managers" (who perform other important tasks in addition to managing the people under them) will have their productivity less negatively impacted by growth, but the effect is still there. Managers are necessary to manage a large, complex company, but should be considered a "necessary evil" as they also reduce overall productivity. Also note that higher level managers get higher level pay, often despite poor performance, and thus cost the company more than their numbers would indicate. For example, a company with 16 workers at \$10/hr, 4 supervisors at \$20/hr and 1 manager at \$30/hr is spending \$270/hr, \$110/hr (41%) of which is on management.

### Isolation of decision makers from results of their decisions

If a single person makes and sells donuts, and decides to try jalapeño flavoring, they would likely know that day whether their decision was good or not, based on the reaction of customers. A person at a huge company that makes donuts may not know for many months if such a decision worked out or not. By that time, they may very well have moved on to another division or company, and thus see no consequences from their decision. This lack of consequences can lead to poor decisions. This causes an upward facing marginal cost curve.

### Slow response time

In a reverse example, the single worker donut firm will know immediately if people begin to request healthier offerings, like whole grain bagels, 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 change could be made. By this time smaller competitors may well have grabbed that market niche.

### Inertia (unwillingness to change)

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 toxic to any company, as inevitably changes in the industry and market conditions will demand changes in the firm, in order to remain successful. A recent example is Polaroid Corporation's refusal to move into digital imaging until after this lag adversely affected the company, ultimately leading to bankruptcy.

### Cannibalization

A small firm only competes with other firms, but larger firms frequently find their own products are competing with each other. A Buick is just as likely to steal customers from another GM make, such as an Oldsmobile, as it is 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.

### Large market share / portfolio

A company with only 1% of the market share could easily double sales in a year. A company with 90% market share can't hope to do so well. They can diversify into other markets or industries, but this means they will lose many of the economies of scale specific to the old market or industry.

A small investment fund can potentially return a larger percentage because it can concentrate its investments in a small number of good opportunities without driving up the price of the investment securities. 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.

### Public and government opposition

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 public opposition and government lawsuits.

### Other effects related to size

Large firms also tend to be old and in mature markets. Both of these have negative implications for future growth, as well. 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 (due to inability to fire incompetent employees). 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.

## Solutions

Solutions to the diseconomy of scale for large firms involve changing the company into one or more small firms. This can either happen by default when the company, in bankruptcy, sells off its profitable divisions and shuts down the rest, or can happen proactively, if the management is willing. Returning to the example of the 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.

### Examples

The independently controlled donut firm locations 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 promotion. A single large, centrally controlled firm may lack the flexibility to offer such customizations.