What are areas where economies of scale do not hold up?

My answer on Quora:

Economies of scale are not always true for ever-increasing levels of production. Sometimes, a company can get too big and begin to experience diseconomies of scale where the cost of producing an extra unit begins to rise.

Economies of Scale

Most companies start off with economies of scale, where they get more efficient (i.e. have a lower cost per unit) as they begin producing more goods or delivering more services. For example, it might cost a lot to produce your first, say, generic widget because you needed to invest in some start-up equipment and rent out a factory or space. Your second widget will then cost less to produce than the first. The more widgets you produce, your average cost of producing a widget will decline because you are spreading the earlier up-front costs and other recurring fixed costs across a larger number of widgets. Economies of scale are often greatest in high fixed-cost markets.

Diseconomies of Scale

At a certain point, however, such economies of scale can turn into diseconomies of scale, where the company gets too big or too complex and coordination costs start to rise, management becomes more difficult, and other challenges associated with running larger and larger operations start to chip away at the efficiencies associated with scale. The result, then, is that average costs start to rise with each additional unit.

(For those who have taken any microeconomics course, you may recall that most Average Cost Curves have a U-shape — the first (declining) part of the curve is where economies of scale exist, the bottom point of the curve tends to be where profits are maximized, and the later (rising) part of the curve is where diseconomies of scale exist).

So, it might not always be the case that systems and processes improve with scale (as the question suggests) at any level of production. In fact, systems and processes can start to get increasingly complex and result in higher costs per unit of production due to the costs and inefficiencies associated with added complexity.

Now, some markets or firms may have increasing returns to scale. This is where the benefits of scale grow indefinitely or nearly indefinitely. This tends to be seen in “winner-take-all” markets, of which digital technologies are making more common. However, organizations in these markets could also have practical, operational limits, but it is hard to use the traditional microeconomic toolkit to analyze these markets because marginal costs (the cost of producing an additional unit) are often zero. Herein lies a major area of research today (measuring the digital economy, analyzing its properties, etc.), and herein lies the end of the scope of this answer!

 

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