See Economies of Scope

Notice that the long run average cost (LRATC) curve in Figure 7 falls as output rises and then increases as output rises further.

Economies of scale exist when long run average costs decline as output rises.

Diseconomies of scale occur in the range where long run average costs rise with increases in output.

 

When diseconomies are encountered, reducing the scale of operations allows production at lower average costs.

 

            It might seem that if all resources were expanded by some fixed proportion, output must expand by that same proportion. Gains from specialization, however, may expand output more than proportionally as the scale of operation grows from some small level. These advantages give rise to economies of scale, causing average production costs to fall.

 

            On the other end of the spectrum, diseconomies of scale emerge because of limitations to efficient management. Giant firms encounter diseconomies of scale because managerial control decays as layers are added to any hierarchy. The information that must be digested and acted on snowballs, so coordinating the activities of ever larger groups becomes an ever more formidable task. Another problem is that vertical hierarchies require decision making at many different levels. The principal-agent problem becomes pervasive because monitoring performance is increasingly difficult—not all these decision makers will focus on doing everything with maximum efficiency to realize maximum profits. Organizations may become so large and clumsy that, like dinosaurs, extinction is a real possibility.

 

            To counteract this problem, large bureaucratic firms have recently begun to “reengineer”. Rapid advances in micro computing power coupled with plummeting prices have permitted large firms to reorganize their operations, which has extended economics and improved service.

 

            Between the cases of decreasing and increasing economies of scale is the case of constant returns to scale. Constant returns to scale means that average total cost is constant (flat) and marginal cost equals average total cost. Over some range of output, firms can simply add a plant with essentially the same costs as the previous plant. For example, franchising firms often find this to be the case.