Diseconomies of Scale in Employment Contracts

Abstract

A central question in industrial organization is what determines the size of firms. This question is closely linked to a central assumption in microeconomics generally, that managerial diseconomies of limit the size of firms. If such diseconomies of scale did not exist, many industries would be natural monopolies because average cost declines with output for any technology with a fixed cost and constant marginal cost. This was noted by Sraffa and Kaldor, who concluded that perfect competition was unrealistic. Modern textbook theory, rejecting the premise of constant marginal cost, notes that if marginal cost rises with output, then a large firm is inefficient and a competitive market is feasible. The combination of rising marginal cost and a fixed cost generates the Vinerian U-shaped average cost curve, not natural monopoly. The commonly given reason for increasing long-run marginal cost, a reason mentioned as far back as Kaldor, is that a larger firm is harder to manage.