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The Schumpeterian theory:
Introduction:
Joseph Alois Schumpeter, a great admirer of the capitalist system has provided a
penetrating analysis of the origin, evolution, operation and downfall of capitalism and
its replacement by socialism. He accumulated experience as a legal practitioner,
manager of the financial affairs of a princess, economist, advisor, finance-minister,
president of a private bank, and as a professor of economics at Harvard in 1932. He
wrote on a variety of subjects. Schumpeter’s ideas about economic development first
appeared in the book ‘theory of economic development’ published in German in 1911,
and its English edition appeared in 1934. later, he refined and published his ideas and
gave a complete version of his theory of economic development in his works ’business
cycles’ (1939) and ‘capitalism, socialism and democracy’(1942). Irma Adelman asserts
that,” the main problem which Schumpeter addressed himself throughout his work
was how to explain the process of economic development.
Main features of Schumpeter’s theory:
The main features of Schumpeter’s theory of economic development are as follows:
1. Circular flow
2. The role of entrepreneur
3. Business cycle or cyclical process.
4. End of capitalism
1. Circular flow:
Schumpeter devotes the first chapter of his book ’theory of economic development’ to
the study of the concept of circular flow. According to him, “in a circular flow, from
which we always start, the same products are produced every year in the same way.
For every supply there awaits somewhere in the economic activities are repetitive “. It
means that the supply and demand are in equilibrium at each point of time and the
economy is in its stationary state. Circular flow is based upon a state of perfect
competitive economy which is in stationary state, there is perfect competitive
equilibrium.
The costs of the firms are equal to the receipts; the prices are equal to average costs.
There are no profits no interest rates, no savings, no investment and no unemployment.
According to Schumpeter this stationary equilibrium is characterized by the circular
flow which continues to revive itself every year in the same system as the blood
circulates in a human body.
As regards economic development Schumpeter in his theory states that,” the
development is spontaneous and discontinuous change in the channels of the circular
flow, disturbance of equilibrium which forever displaces the equilibrium state
previously existing”. Schumpeter theory of development is the key element of dynamic
process which basically consists of new resource combinations, so called innovations or
technological changes. When innovations or changes (economic, social, political and
technical) take place in the economy, the stationary equilibrium or circular flow is
displaced and the process of development starts
The main features of circular flow are as follows:
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1. All economic activities are essentially repetitive and follow a familiar and routine
course.
2. All the producer knows the demand for goods in an economy, and adjusts the supply
of the output accordingly. In other words, the demand and supply are in equilibrium
at each point of time.
3. The economic system has the optimum level of output and its maximum uses. There
is no possibility of wastages of resources.
4. The firms working in the system are in the state of perfect competitive equilibrium,
that is, the firms are of optimum size. The factors of production are paid according to
their marginal product.
5. Under the stationary equilibrium of the economy, the prices everywhere are equal to
the average cost of production. In other words, the profits are zero or the profits
opportunities do not exist at all. Interest rates tend to be zero and there is no
possibility of involving unemployment of resources.
The above features imply that the circular flow is used in static setting. To make it
dynamic and consistent with development, changes must take place in the economic
system. These changes can be brought through innovations.
Innovations:
Innovations may be defined as a change in the existing production system introduced
by the entrepreneur with a view to making profits and reducing costs. The innovation
is closely linked with Schumpeter defined development as a,” spontaneous and
discontinuous change in the channels of flow, disturbance of equilibrium which,
forever alters and displaces the equilibrium state previously existing”.
When changes (economic, social, political or technological) take place in the economy,
the circular flow is disturbed and the development process starts. He assumed that
change is the basic element of dynamic process and those changes come in the form of
innovations. The innovations may consist of the following aspects:
1. The discovery of the new source of raw-materials.
2. The presentation of a new product.
3. The implementation of the modern method of production.
4. The search of new markets.
5. The creation of monopoly or establishment of a new type of industrial organisation.
Schumpeter, thus, lays emphasis on the introduction of new products through the
improvements in the technological and other economic and non-economic resources
which lead to economic development.
2. The role of the entrepreneur as an innovator:
Entrepreneur is the key figure in Schumpeter’s analysis of the process of development.
Schumpeter’s model starts with the breaking of circular flow with an innovation in the
form of a new product. He occupies the central place in the development process
because he initiates development in a society and carries it forward. As a matter of
fact, entrepreneurship is different from the functions of a manager. A. manager simply
manages the affairs of an enterprise whereas the entrepreneur also takes high degree of
risk. The role of an entrepreneur has been glorified by Schumpeter on the basis of
functional abilities. According to him, entrepreneurs is to
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a. Appreciate the possibilities of innovation
b. Overcome the socio-psychological barriers against the introduction of new things,
c. Direct the means of production into new channels
d. Persuade the banker to provide him with necessary finance for innovations.
e. Induce other producers in his branch of activity for taking risk.
f. Create an environment conducive to the satisfaction of wants as the normal motive.
g. Provide leadership and
h. Take high degree of risk in the economic world.
Though Schumpeter has given a comprehensive explanation about the role of
entrepreneur, but it cannot be considered an adequate explanation of the general
theory of capitalistic development. For entrepreneur himself is a product of social
environment, which compels him to innovate or get eliminated, because, of the forces of
competition. Despite this fact, credit goes to Schumpeter who has emphasized the role
of an entrepreneur in the capitalist development.
The entrepreneurs require two things to perform his functions.
Firstly, there must exist technical knowledge with which the entrepreneur can
introduce new products or new combinations of factors of production. This according
to Schumpeter does not pose a problem because there always exists the reservoir of
unused technical inventions, which can be explored and exploited by the prospective
entrepreneurs; secondly, in order to carry out the new inventions the entrepreneur
requires the services of the factors of production. For this he needs purchasing power
in the form of credit and capital, which can be provided by banks and other financial
institutions. Thus credit and banks play an important role in the economic
development of a country.
Role of Profits:
An entrepreneur innovates so as to earn profits. Profits are conceived, ‘as a surplus
over costs- a difference between the total receipts and outlay- as a function of
innovations’. According to Schumpeter under competitive equilibrium the price of
each produce just equals its cost of production and, thus, there are no profits.
According to him, profits arise on account of dynamic changes resulting from
innovation. They continue to exist till the innovation becomes general.
Breaking the circular flow:
The central theme of the Schumpeterian theory of economic development lies in the
breaking up of the circular flow with innovation in the form of a new product by an
entrepreneur raising the level of investment in the economy. The bank credit can help
largely in this context. Since investment in innovations is risky, the entrepreneurs must
pay interest on it. Once the new innovations prove to be more profitable and quite
successful, other entrepreneurs also follow them in ‘swarm like clusters’. Innovations
in one field may stimulate innovations in other allied fields. But the trend of the
expansion of innovations in other firms is never found to be 100%.
Business Cycle or Cyclical process:
The next component of development according to Schumpeter is the business cycle. To
analyse the business cycle is to analyse the economic process under capitalism.
Schumpeter’s approach to business cycle or crisis is historical, statistical and
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analytical- he believes that business cycles are not merely the result of economic
factors but also of non-economic factors. Schumpeter concludes that crisis is the
“process by which economic life adapts itself to the new economic conditions”.
Bank credit is an essential element of Schumpeter’s model, according to Schumpeter,
the creation of bank credit is assumed to accelerate money incomes and prices in the
economy. It creates a cumulative expansion through out the economy, with the
increase in the purchasing power of the consumers, the demand for the products
increases in relation to supply. The rising prices and high rates of profits stimulate
producers to raise investments by borrowing from the banks. The secondary wave of
credit inflation starts with the entrance of new entrepreneurs in the field of production
which superimposes on the primary wave of innovations. This may be called ’boom’ or
‘prosperity’. Extreme optimism and speculation in business also further enhance
prosperity.
During prosperity new products start appearing in the market with the entrance of
new entrepreneurs. These products displace the old ones and thus decrease their
demand and in the market. Consequently, the prices of old products fall, with a view
to liquidating their stocks, the old firms start selling their goods at a low price and
hence most of the firms incur losses. Investment declines and unemployment starts,
leading to a fall in the aggregate demand. As the entrepreneurs start repaying bank
loans, the quantity of money in circulation is reduced and prices start falling. Profits
too decline and come to zero, uncertainty and risk increases. A wave of pessimism
sweeps the entire economy, boom ends, and phase of depression starts.
Schumpeter believes in the existence of the long wave of upswings (boom) and
downswings (depression). Once the upswing begins, ultimately, the economic force of
recovery comes into operation and brings about a revival, once again the economies
come across new equilibrium, and the new boom period starts.
End of capitalism:
Like Karl Marx, Schumpeter also believes that capitalism is self-destructive. He
stated, ”there is inherent in the capitalist system a tendency towards self destruction,
those factors make not only for the destruction of the capitalist system but for the
emergence of socialist civilization”.
Schumpeter agrees with the Marxian thesis that capitalism has itself the seeds of its
own destruction and ultimately it will come to an end. The very success of capitalism
will bring about its decay. According to Schumpeter,” capitalism cannot survive; it
will die on its own accord”. It will ultimately give place to socialism”.
A Critical appraisal:
Schumpeter theory of economic development has a ring of greatness. And within the
assumptions of the model, it may be regarded as a major analytical achievement. His
analysis of the process of capitalist development is appreciable and outstanding. He
has very cleverly enlightened the role of entrepreneurs in the progress and
development of the capitalist order. Schumpeter’s steers clear of such inhibiting
factors of classical and neo-classical theories like dimishing returns, over population
and mal-distribution of incomes. Moreover, in place of pessimistic forebodings of
classical that the economy is doomed to a stationary state or stagnation, the theory
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visualizes ever-rising levels of real income with Ofcourse temporary interruptions.
Though Schumpeter’s theory is replete with brilliant reasoning and the insights of a
great theorist, yet it suffers from the following weaknesses and criticisms.
1. Role of entrepreneur over-emphasized:
Schumpeter’s theory of economic development has unduly highlighted the role of an
entrepreneur. An entrepreneur is the prime mover of economic development. It was
true almost in the 18th and 19th centuries when entrepreneur used to perform the
functions of an innovator. However, in the modern economic world, the act of
entrepreneurship and innovation is not the work of an individual. It is carried out by
companies and that too through a group of individuals, with its membership changing,
as a result no single or particular individual or entrepreneur is identified as responsible
for introducing innovations. Even the inventions now-a-days is the product of team
work and not of an individual.
2. Analysis of capitalist process not convincing:
According to Meir and Baldwin,” Schumpeter’s broad socio-economic analysis of
capitalist process is generally admired. Yet few seem prepared to accept his
conclusions. His arguments are stimulating but not completely convincing”.
3. Emergence of socialism got based on sound reasoning:
Schumpeter has not convincingly explained as to how capitalism will eventually be
replaced by socialism. His unawareness about this factor is evident from these words,”
we know nothing as yet about the precise way by which socialism, may be expected to
come, except that there must be a great many possibilities ranging from gradual
bureaucratization to the most picturesque revolution”. As a matter of fact,
Schumpeter’s analysis of the end of capitalism is emotional and not real.
4. Analysis of cyclical process is wrong:
Schumpeter’s idea that the economic development is the result of the cyclical process is
wrong. According to Nurkse,” economic development is related to continuous
changes”.
5. Undue importance to bank credit:
Schumpeter has given undue importance to bank credit. Bank credit may be
important in the short run when the industrial concerns get credit facilities from the
banks. However, in the long run when the need of capital funds is greater or long term
capital is required bank credit is insufficient. For this, business houses, have to float
new shares, debentures etc in the market.
6. Innovation is not the main cause of economic development:
Schumpeter regards innovations as the main cause of economic development.
However, this view is far from real, because economic development of a country does
not depend on innovations only but also on many economic and social factors.
7. Little Relevance for underdeveloped countries:
When viewed from the point of view of an underdeveloped country, Schumpeter’s
theory is found to be grossly inadequate.
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