Which of the following contribute to the development of diseconomies of scale?

AO2 You need to be able to: Demonstrate application and analysis of knowledge and understanding Command Terms: These terms require students to use their knowledge and skills to break down ideas into simpler parts and to see how the parts relate: Analyse, Apply, Comment, Demonstrate, Distinguish, Explain, Interpret, Sugges

Answer - Economies and Diseconomies of scale

Definitions

Economies of scale are when the cost per unit of production (Average cost) decreases because the output (sales) increases.

Diseconomies of scale are when the cost per unit of production (Average cost) increases because the output (sales) increases.

Growth brings both advantages and disadvantages to a business. These interact, and depending on the nature of the business and the way it is managed, decide the optimum or most efficient size for the business.

This is the area of economies and diseconomies of scale.

Figure 1: The effect of economies of scale on average cost

Reasons for economies of scale

The most common reason for Economies of scale is that some production costs are fixed (as production increseases these costs stay constant). Therefore since costs per unit (Average Costs) are calculated by dividing the cost by the number of units of output

AC=Costs/quantity

Then any average involving Fixed Costs (Numerator) must decrease as quantity produced (Denominator) increases (make sure you follow this ok)

AFC=FC/Quantity

Fixed Cost economies of scale:

1. Managerial - managers are on a fixed salary

2. Marketing - advertising, endorsements promotional events do not directly depend on quantity produced

3. Techinical - machinery, buildings etc are paid for as a fixed amount

Purchasing economies of scale:

Large firms are able to negotiate more favourable terms when buying raw materials etc.

1. Bulk buying - remember it is the cost per unit of buying in bulk not the total cost (Great example is supermarkets and local shop)

Have you ever wondered what might be the reason why some companies experience higher average costs with increased output while others don’t? What are some of the factors that impact a firm’s average costs and what can a firm do to reduce its costs?

To answer these questions, you would have to know about the diseconomies of scale. This explanation will help you understand diseconomies of scale.

Diseconomies of scale: definition

Diseconomies of scale point out the relationship between the average costs of a firm and its total output.

Diseconomies of scale occur when a firm experiences an increase in its average costs as its total output increases.

Diseconomies of scale usually occur when a firm does no longer experiences economies of scale.

Economies of scale? Yes, economies of scale are the opposite of diseconomies of scale, as the name suggests. They occur when a company experiences a decrease in average cost as the total output increases.

The main difference between the two is that the average cost increases with increases in output when a firm is experiencing diseconomies of scale, and it decreases with an increase in production when experiencing economies of scale.

Diseconomies of scale can be very harmful to a firm. There are many reasons why a firm might experience diseconomies of scale. We will consider some of these reasons later on.

The diseconomies of scale graph

We can depict diseconomies of scale through a diagram, which we can see in figure 1 below.

Fig. 1 - Diseconomies of Scale, StudySmarter Originals

In figure 1, at point C* the firm can produce Q* level of output at the lowest cost possible. After this point, the firm’s cost per additional output produced increases. When the firm moves from producing Q* level of output to Q1, the cost per input increases from C* to C1. When the firm increases its production from Q1 to Q2, the cost per input increases even more, from C1 to C2.

We can further understand how diseconomies of scale work with the example of a coffee shop.

This coffee shop initially has four workers, and all of them can serve 60 customers in an hour. Each employee serves 15 customers in an hour and the coffee shop pays them £10 per hour.

The coffee shop makes a TikTok about their products and it goes viral. This viral video causes 30 more customers to come to the shop in the next hour. Now there are 90 customers waiting to be served.

The coffee shop responds to the increase in demand by quickly hiring two additional workers. These two new workers are also paid £10 an hour.

However, there isn’t enough space for all the workers and the process gets messy and it becomes hard to move around the coffee shop. In the end, the employees are only capable of serving a total of 80 customers.

What has happened to the shop's costs?

Before, the coffee shop was able to serve 60 customers at the cost of £40 per hour, equating to a cost of £0.66 per customer. When the new workers came in, the coffee shop was able to serve 80 customers at the cost of £60 per hour, equating to a cost of £0.75 per customer. So the cost of input has increased for the firm.

Reasons for diseconomies of scale

There are many factors at play when a firm experiences diseconomies of scale. We will look at three of these reasons (Figure 2):

1. Managerial diseconomies of scale.
2. Communication failure.
3. Motivational diseconomies of scale.

Fig. 3 - Reasons for diseconomies of scale

Managerial diseconomies of scale

There are many people in large corporations. There are employees, different managers, and different divisions. The bigger the company, the harder it is to manage the entire personnel.

Some managers could make decisions that are not in the firm's best interest. This is especially true for managers who lack the experience and expertise to run their division. As a result, the firm could see the costs of production rise.

Communication failure

This is also a common case amongst large companies. When a firm grows, the layers between the top management and the staff grow. Workers in production may be far from management, and there might not be too much communication between them.

This often makes ordinary workers feel unappreciated and unattended, which discourages them from working. As a result, they are less productive in work, which contributes to an increase in the cost of production.

Imagine the workers in Amazon that work in warehouses and make sure that the goods are delivered on time to Amazon customers. What are the chances they get to meet or communicate with Jeff Bezos, and how does this contribute to productivity and cost per input?

Motivational diseconomies of scale

Some companies are unable to keep their workers’ motivation up. That could be for many reasons. Firstly, it is costly for a company to offer bonuses and incentives to all workers. Moreover, it is hard for companies to pay competitive wages to every worker. This results in the firm attracting less-skilled workers and reduced productivity. As a result, the firm incurs higher costs per input.

Types of diseconomies of scale

There are two main types of diseconomies of scale (Figure 3): internal diseconomies of scale and external diseconomies of scale.

Fig. 4 - Types of diseconomies of scale

Internal diseconomies of scale

Internal diseconomies of scale are types of diseconomies of scale caused by factors in the firm. There are two main reasons for internal diseconomies of scale (Figure 4): organisational or technical.

Fig. 5 - Internal diseconomies of scale

Internal diseconomies of scale arising from organisational issues are common because it becomes inefficient to manage a large number of workers. The communication between management and workers becomes more challenging, resulting in workers not receiving the proper instructions.

This contributes to an increase in the diseconomies of scale. Another reason why a firm might face organisational diseconomies of scale could be due to lack of motivation of workers as, usually, in large businesses, ordinary workers feel more isolated.

Technical issues also contribute to a firm’s internal diseconomies of scale. This involves the amount of machinery a firm chooses to include in the production process. If a firm chooses to add 20 more pieces of machinery in the factory, it might increase the cost per input as the production process becomes inefficient.

External diseconomies of scale

External diseconomies of scale occur due to external factors independent of a firm’s production process (Figure 5). The environment and the industry in which a firm operates significantly influence the cost per input a firm faces. The reason for that is that the industry in which the firm is provides an additional constraint in the firm’s production process. Therefore, the firm has limited resources to operate and produce. Some industries might face the cost per input going up because there is a shortage in raw materials.

Fig. 6 - External diseconomies of scale

The supply chain is one of the causes of external diseconomies of scale. The reason for that is that the firm is dependent on other factors to move its goods around. One of those aspects is traffic. If the routes that a company uses to deliver or their goods are always congested, that might cause delays, especially when dealing with distant markets.

Inputs with price inelasticity of supply are also a reason for external diseconomies of scale. Imagine a firm experiences significant growth in demand, and as a result, it needs to produce more output. However, those supplying the input for the firm can’t increase the total output by as much as the price increases. This means that the firm will be paying more but not getting as many inputs, which then causes diseconomies of scale.

Imagine that a firm is located close to another firm that is producing and selling the same thing. The market experiences growth, which causes them both to generate more sales.

However, as they are both located in the same location and compete with one another, they both will be looking to find the labour to match the increase in production. As there are not as many locals in their area, they would have to bid up the salary they pay in order to attract workers. This, in turn, contributes to diseconomies of scale.

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