Diseconomies are the result of decreasing returns to scale and lead to a rise in average cost

Diseconomies of scale in a large business may be due to:

1. Control – monitoring the productivity and the quality of output from thousands of employees in big, complex corporations is imperfect and expensive – this links to the concept of the principal-agent problem i.e. the difficulties of shareholders monitoring the performance of managers.
2. Co-ordination - it can be difficult to co-ordinate complicated production processes across several plants in different locations and countries. Achieving efficient flows of information in large businesses is expensive as is the cost of managing supply contracts with hundreds of suppliers at different points of an industry’s supply chain.
3. Co-operation - workers in large firms may develop a sense of alienation and loss of morale. If they do not consider themselves to be an integral part of the business, their productivity may fall leading to wastage of factor inputs and higher costs

Big organisations often suffer from the debilitating effects of internal politics, information over-load, complex bureaucracy, unrealistic expectations among managers and cultural clashes between senior people with inflated egos.

The result can be that hidden costs increase quickly – expense accounts, a slump in productivity, a deadweight loss of time in slow-moving big businesses. This is the essence of internal diseconomies of scale.

Avoiding diseconomies of scale

1. Human resource management (HRM) focuses on improvements in recruitment, communication, training, promotion, retention and support of faculty and staff. This becomes critical to a business when the skilled workers it needs are in short supply.
2. Performance related pay schemes (PRP) can provide financial incentives for the workforce leading to an improvement in industrial relations and higher productivity. The John Lewis Partnership is often cited as an example of how a business can empower its employees by giving them a stake in the financial success of the organization. Each partner gets a share of the firm’s profits each year,
3. Out-sourcing is a tried and tested way of reducing costs whilst retaining control over production although there may be a price to pay in terms of the impact on the job security of workers whose functions might be outsourced overseas.

The best way to avoid diseconomies of scale is to make business organization less complex and more transparent.

Effects of Diseconomies of Scale

Diseconomies of scale mean that

• A business has moved beyond their optimum size
• Businesses are suffering from productive inefficiency
• Higher unit costs will reduce total profits
• Businesses may then have to charge higher prices in order to cover their increased costs
• Lost competitiveness could lead to declining market share and also a fall in their share price

Diseconomies of scale and the effect on total profits

Consider the diagram below - producing an output beyond the minimum efficient scale e.g. at Q2 leads to lower total profits. Diseconomies of scale cause unit costs to be higher than at output Q1.