Economies of scale and diseconomies of scale are two related – but distinct concepts. As explored further below, economies of scale arise from the cost of production decreasing as the volumes increase. Diseconomies of scale are the opposite – costs increasing as volumes increase.
Economies of scale: Savings that arise from increasing scale
Economies of scale arise from savings that are achieved as the volume of production increases – the more you make of a product, the lower the cost per item.
Common sales economies include:
- Purchasing materials at a better rate: There may be volume discounts in the raw materials, arising from better bargaining power, savings on delivery, or other cost savings relative to small or one-off purchases.
- Fixed costs are spread over a larger number of products: There are likely fixed costs in operating, inured irrespective of the number of products produced. These may include the rent on a facility, the cost of machinery, or the cost of developing the product. When you manufacture a larger volume of products, these costs are spread over a much larger number of products, in turn pulling the fixed cost allocated to each product lower.
- Labor cost per unit declines: Beyond costs that are entirely fixed, there are certain variable costs that may decline the greater volume that you produce. Greater volumes may allow more efficient routines to be implemented, potentially reducing the labor component of each product produced
Diseconomies of scale: Additional costs that arise from increasing scale
Diseconomies of scale arise from savings that are achieved as the volume of production increases – the more you make of a product, the lower the cost per item.
Common sales economies include:
- Coordination difficulties: A key cause of diseconomies of scale is associated with coordination difficulties as the firm grows. While it is easy to manage a small organization, a large organization has a lot of moving parts – each potentially pulling in different directions, with different perceptions of what the firm is, and what it should be doing.
- Extra layers of management: Beyond the coordination difficulties that can occur in large organizations, the extra layers of management add in additional costs. There may be additional layers of management requires to supervise operations, each with associated overhead expenses.
- Lack of focus on small improvements: Another possible source of diseconomy of scale arises because particularly large firms may not be interested in making minor incremental improvements. In part because of coordination difficulties, and in part because of monitoring issues, there may not be the incentives in place to drive managers to pursue small efficiency improvements. Small changes may be thought not big enough to move the needle, with a danger that waste and inefficiencies gradually start to seep in.
The relation between economies of scale and diseconomies of scale
Economies of scale and diseconomies of scale are at odds with one another. Initially, the size of the economies of scale may outweigh any diseconomies, with the net effect being that costs decline as volume increases. However, there comes a point where these effects start to plateau off – savings that come from increasing production volumes may start to decline past a certain point. For example, if you are making 1 million of a particular item, there may only be relatively negligible better bargaining power with suppliers to increase that to 10 million.
This can create a U-shaped relationship between production volumes and costs – initially costs decline as economies of scale outweigh diseconomies, but then past a certain point (the minimum efficient scale), the diseconomies of scale start to dominate, resulting in costs per unit starting to gradually increase.
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