Unit 3 Micro: Diseconomies of Scale

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

“In automobiles as in many industries, economies of scale are technological, the diseconomies of scale human. Human factors in business are generally more influential than technological ones in determining the long run fate of a company.” Source: John Kay, Financial Times, December 2008

The potential diseconomies of scale a firm may experience relate to:

1. Control – monitoring the productivity and the quality of output from thousands of employees in big corporations is imperfect and costly – 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. Traditionally this has been seen as a problem experienced by the larger state sector businesses, examples being the Royal Mail and the Firefighters, the result being a poor and costly industrial relations performance. However, the problem is not concentrated solely in such industries. A good recent example of a bitter industrial relations dispute was between Gate Gourmet and its workers.

Avoiding diseconomies of scale

A number of economists are skeptical about diseconomies of scale. They believe that proper management techniques and appropriate incentives can do much to reduce the risk of industrial strife. Here are three of the reasons to doubt the persistence of diseconomies of scale:

1. Developments in human resource management (HRM). HRM describes improvements that a business might make to procedures involving worker recruitment, 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. Recruitment and retention of the most productive and effective employees makes a sizeable difference to corporate performance in the long run.

2. Performance related pay schemes (PRP) can provide financial incentives for the workforce leading to an improvement in industrial relations and higher productivity. Another aim of PRP is for businesses to reward and hang onto their most efficient workers. 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.

3. Increasingly companies are engaging in out-sourcing of manufacturing and distribution as they seek to supply to ever-distant markets. 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