Many people believe that the bigger the business, the better for the owners. It is not entirely true. The business can become too large, and when it reaches that tipping point, we are going to have a problem.
A business that grows too large in size at some point is going to lose the benefits of economies of scale. When the business becomes outsized (too big), therefore inefficient, those inefficiencies are going to lead to higher cost of production, therefore economies of scale can no longer be exploited.
Instead, the business is going to experience the opposite – when the scale of operation is increased too much, the average cost of producing one unit of output will begin to rise which will then lead to less profit.
So, diseconomies of scale are those factors that increase unit costs as a firm’s scale of operation increases beyond a certain size where the average cost of production is the lowest.
Two different types of diseconomies of scale
Internal diseconomies of scale are diseconomies of scale that occur inside the firm and are within its control.
External diseconomies of scale are diseconomies of scale that occur within the industry (outside the firm) and are largely beyond an individual firm’s control.
Examples of diseconomies of scale
Internal diseconomies of scale are mainly related to problems associated with managing a business that is very large in size, e.g. businesses that have hundreds of thousands of workers, operate around the world in many countries, have several divisions targeting many different market segments with multiple products, etc.
Examples of internal diseconomies of scale include: poor coordination, poor communication, poor control, demotivation of workers, complacency, alienation of workforce and bureaucracy.
External diseconomies of scale are diseconomies of scale that occur due to problems that affect the whole industry, e.g. there too many firms producing the same product, there is not enough land and other factors of productions, etc.
Examples of external diseconomies of scale of scale include: scarcity of land, increasing rents, transportation problems, higher recruitment costs and higher wages.
What would happen without diseconomies of scale?
If there were no disadvantages to large-scale business operations, many industries would be dominated by only a few huge corporations causing markets to experience the creation of monopolies and monopolistic practices.
The large-scale production would be so dominant that smaller firms would find it increasingly difficult to operate profitably, therefore will have to shut down.
So, the negative impact of diseconomies of scale prevents one or just a few firms from completely dominating the market.
Can a business continue growing without experiencing diseconomies of scale?
One of the ways to grow the business to a very large scale without experiencing diseconomies of scale is through franchising.
A franchise is a unique type of business where a famous company such as McDonalds, KFC, Subway, Burger King, Pizza Hut, Starbucks, Costa Coffee or 7-Eleven allows other individual people or businesses the right to sell products using its name in return for some form of payment, usually a license fee and a certain percentage of sales revenue.
This growth method allows an inexperienced franchisee to set up a new retail store from scratch with a franchisor’s help which has reputation for its branded products. These franchisees are strictly monitored to ensure that the standard is maintained.
Multinational companies are able to use this growth strategy to expand their businesses internationally, raise brand awareness and sell to hundreds of millions of customers without having to face higher unit costs of being too large.
