Do Diseconomies of Scale Impact Firm Size and Performance? A Theoretical and Empirical Overview

Icfai Journal of Managerial Economics, Vol. 4, No. 1, pp. 27-70, 2006

40 Pages Posted: 16 Sep 2008 Last revised: 2 Jan 2011

Staffan Canback

EIU Canback

Phillip Samouel

affiliation not provided to SSRN

David Price

University of Reading - Henley Business School

Date Written: 2006

Abstract

This article tests Oliver Williamson's proposition that transaction cost economics can explain the limits of firm size. Williamson suggests that diseconomies of scale are manifested through four interrelated factors: atmospheric consequences due to specialization, bureaucratic insularity, incentive limits of the employment relation and communication distortion due to bounded rationality. Furthermore, Williamson argues that diseconomies of scale are counteracted by economies of scale and can be moderated by adoption of the multidivisional organization form and by high internal asset specificity. Combined, these influences tend to cancel out and thus there is not a strong, directly observable, relationship between a large firm's size and performance.

A review of the relevant literature, including transaction cost economics, sociological studies of bureaucracy, information-processing perspectives on the firm, agency theory, and studies of incentives and motivation within firms, as well as empirical studies of trends in firm size and industry concentration, corroborates Williamson's theoretical framework. The framework translates into five hypotheses: (1) Bureaucratic failure, in the form of atmospheric consequences, bureaucratic insularity, incentive limits and communication distortion, increases with firm size; (2) Large firms exhibit economies of scale; (3) Diseconomies of scale from bureaucratic failure have a negative impact on firm performance; (4) Economies of scale increase the relative profitability of large firms over smaller firms; and (5) Diseconomies of scale are moderated by two transaction cost-related factors: organisation form and asset specificity.

The hypotheses were tested by applying structural equation models to primary and secondary cross-sectional data from 784 large US manufacturing firms. The statistical analyzes confirm the hypotheses. Thus, diseconomies of scale influence the growth and profitability of firms negatively, while economies of scale and the moderating factors have positive influences. This implies that executives and directors of large firms should pay attention to bureaucratic failure.

Keywords: diseconomies of scale, bureaucratic failure, transaction cost economics, structural equation modeling

JEL Classification: L14, L25

Suggested Citation

Canback, Staffan and Samouel, Phillip and Price, David, Do Diseconomies of Scale Impact Firm Size and Performance? A Theoretical and Empirical Overview (2006). Icfai Journal of Managerial Economics, Vol. 4, No. 1, pp. 27-70, 2006. Available at SSRN: https://ssrn.com/abstract=1267964

Staffan Canback (Contact Author)

EIU Canback ( email )

210 Broadway
Suite 303
Cambridge, MA Massachusetts 02139
United States
6173991300 (Phone)

HOME PAGE: http://canback.com

Phillip Samouel

affiliation not provided to SSRN ( email )

David Price

University of Reading - Henley Business School ( email )

Greenlands
Henley-on-Thames
Oxfordshire RG9 3AU, England
United Kingdom

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