Encyclonomic WEB*pedia: DISECONOMIES OF SCALE

DISECONOMIES OF SCALE:
Increasing long-run average cost that occurs as a firm increases all inputs and expands its scale of production. Diseconomies of scale result from decreasing returns to scale and are graphically illustrated by a positively-sloped long-run average cost curve. Diseconomies of scale usually occur for relatively large levels of production and overwhelm economies of scale that occurs at relatively small production levels. Together, economies of scale and diseconomies of scale create a U-shaped long-run average cost curve.
Diseconomies of Scale
Diseconomies of scale exist when the expansion of all inputs, especially labor and capital, result in an increase in long-run average cost. In effect, as a firm increases in the scale of operations by not only adding more workers to a given factory but also by building a larger factory, average production cost rises.
Diseconomies of scale are the result of: (1) decreased management control and (2) increased resource prices.
Decreased Management Control
As the scale of operation expands, control over production tends to decline. This is often seen by an increase in the number of layers of managers and an increased separation between owners and workers.
Consider, for example, the production of Wacky Willy Stuffed Amigos (those cute and cuddly armadillos and tarantulas). A relatively small scale of production might consist of one worker (the owner William J. Wackowski) using one sewing machine in a small corner of his basement. However, larger scale production might involve a 100,000 square foot factory with 5,000 sewing machines being operated by three shifts of workers 24 hours a day.
With the smaller scale, William J. Wackowski has complete control over all facets of production. William J. Wackowski, the employee, knows exactly what William J. Wackowski, the owner, wants done because they are one and the same. There is no chance that the worker misunderstands the instructions of the owner. There is no chance that a mid-level manager will pursue personal objectives at the expense of company goals.
With the larger scale, however, William J. Wackowski issues directives from his plush penthouse office through an assortment of vice presidents, a contingent of department heads, a plethora of managers, and a passel of shop supervisors. This extensive chain of command is likely to raise the average cost of producting Wacky Willy Stuffed Amigos for three reasons.
One, the likelihood of misunderstanding increases for each additional layer of management. President and Chairman of the Board of Directors, William J. Wackowski, might issue a directive to his vice presidents that the new product line of stuffed scorpions will be blue and test marketed in New Mexico. By the time this information filters to the shop supervisors, workers, sales representatives, and others it might come out as the new product line will be blue whales produced in Mexico. Any mistakes and misunderstandings will simply add to the average cost of production.

Two, each vice president, department head, manager, and shop supervisor expects to be paid. And their payment is part of the average cost of production. This in itself is not a big deal. However, as the scale of operation expands, the layers of management also tend to expand. With the one-worker, one-machine operation, William J. Wackowski is his own boss. With an expanded operation of a dozen employees, Wackowski might hire someone to supervise the other employees. An operation with a hundred or so employees is likely to see a production manager who oversees a dozen shop supervisors. As the operation grows, the structure of management is inclined to expand like a pyramid, the bigger the base, the higher the top, and the more layers in the middle.

Three, with additional management layers separating production from ownership, the propensity for each employee to pursue personal agendas increases. The department head in the middle of pyramid might be more interested in office size, number of employees supervised, and size of the department's budget than actually producing and selling Stuffed Amigos. In some cases the profitable production of Stuffed Amigos might conflict with the personal goals of this department head. To the extent that these managers circumvent the primary production goal of the firm, average cost increases. And with a larger scale of operation, the opportunity for such counter-productive activity also increases.
Increased Resource Prices
As the scale of production increases from small to large, some resource prices are likely to decline as suppliers provide volume discounts and take advantage of their own decreasing average cost. However, with additional expansion of the scale, resource prices might very well increase. Higher resource prices raise average cost.
When William J. Wackowski produces Stuffed Amigos all by himself in his basement, the materials that he purchases are but a small fraction of sales by his suppliers. An expanded operation might induce some suppliers to offer The Wacky Willy Company volume discounts and lower prices. However, should the scale of Stuffed Amigos production continue to expand, some of these resource suppliers might find themselves with rising production cost and thus be forced to charge higher prices to Wacky Willy.
The best example might be labor. If The Wacky Willy Company is the major employer of labor in Shady Valley, that is, most workers in Shady Valley work at the Wacky Willy Stuffed Amigos factory, then expanding the scale of Stuffed Amigos production forces the wage higher, essentially moving up a positively-sloped labor supply curve.
The key is that when the scale of production becomes so large that the operation is a major part of the overall market for a particular resource, the resource moves up its supply curve and the price rises.
Not the Short Run
In the long run, when all inputs under the control of the firm are variable, average cost increases, resulting in a positively-sloped long-run average cost curve. In the short run, when at least one input is fixed and at least one input is variable, average total cost increases, resulting in a positively-sloped short-run average total cost curve. The increase of average total cost in the short run exists for different reasons than the increase of average cost in the long run.
The Short Run: In the short run, average total cost increases due to decreasing marginal returns and the law of diminishing marginal returns. The addition of a variable input to a fixed input causes decreasing marginal returns and increasing marginal (and average) cost. However, this decrease in average total cost only occurs in the short run.

The Long Run: In the long run, there are no fixed inputs. As such, the law of diminishing marginal returns does not operate and marginal returns do not guide production in the long run. Instead increasing long-run average cost results from management control and resource prices.
Check Out These Related Terms...
     | economies of scale | long-run total cost | long-run average cost | long-run marginal cost | minimum efficient scale | planning horizon |
Or For A Little Background...
     | returns to scale | decreasing returns to scale | long-run production analysis | long-run, microeconomics | average cost | opportunity cost | fixed input | variable input | marginal returns | marginal analysis | microeconomics |
And For Further Study...
     | long-run average cost curve, derivation | long-run, macroeconomics | average total cost curve | law of diminishing marginal returns | short-run production analysis | U-shaped cost curves | opportunity cost, production possibilities | ownership and control | firm objectives |
Recommended Citation:
     DISECONOMIES OF SCALE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: November 23, 2024].