Economic Ideas of Joseph Alois Schumpeter

The following points highlight the top six economic ideas of Joseph Alois Schumpeter. The economic ideas are: 1. Methods of Study 2. Role of Entrepreneur 3. Innovations 4. Schumpeter’s Innovation Theory 5. Capital 6. Capitalism and Socialism.

Economic Idea # 1. Methods of Study:

Schumpeter believed that both inductive and deductive methods are necessary for the study of economic science. Deductive method was effective in price theory and inductive method was suitable for the study and analysis of economic organisation.

He followed statistical method in his study of business cycles and later he realised that it was not useful. Historical method was the most important one for him. At the same time, he accepted mathematics as an important tool in the science of economics.

Economic Idea # 2. Role of Entrepreneur:

According to Schumpeter in economic development, entrepreneur played a key role. The credit for innovations and outburst of economic activity belonged to the entrepreneur. Innovation consisted in the introduction of a new good, new method of production, opening of a new market, the discovery of a new source of supply of raw materials or semi-manufactured goods and introduction of a new organisation in an industry.

In a world full of risk and uncertainty, only exceptional entrepreneurs succeed by introducing innovations. The main motivating factor behind an innovating entrepreneur was profit expectations. Thus entrepreneur played an important role in determining the rate of economic growth. In his absence, the growth rate is bound to be slow.

Economic Idea # 3. Innovations:

Schumpeter developed his own system in which he analysed the effects of various changes occurring with the introduction of a new technique of production. In his initial model, Schumpeter eliminated profits and interest from general equilibrium theory. He assumed that all values were created by demand and that all costs were opportunity costs and as there was no surplus, there was no profit.

Interest would not arise as the entrepreneur had perfect knowledge of future. He then studied the effects of innovations on the working of economic system. He defined innovation as “an introduction into economic use of an invention”. After the introduction of innovation, cost falls below the competitive level and profit appears.

He concluded that profit arises only in a dynamic society. Then Schumpeter proceeded to analyse long-run processes of business cycles. In the long run, prosperity and inflation led to the introduction of innovations since capital was in abundance. These innovations depended upon the expectation of profit and financed by credit creation.

According to Schumpeter, the innovator borrowed money from the bank and moved into the market to outbid others. Other entrepreneurs followed until a new equilibrium is reached. Schumpeter’s model is limited to the economic changes introduced by innovations. However, Schumpeter did not analyse the inter-relationship of various causes leading to economic changes.

Schempeter’s theory is not comprehensive as he did not analyse the relationship between public policy and economic change. Further, he did not take into account the degree of competition and its effects as he assumed a state of perfect competition. He also did not study the economic changes introduced by innovations from the point of view of an individual firm.

Economic Idea # 4. Schumpeter’s Innovation Theory:

Joseph A. Schumpeter has developed innovation theory of trade cycles. An innovation includes the discovery of a new product, opening of a new market, reorganization of an industry and development of a new method of production. These innovations may reduce the cost of production and may shift the demand curve. Thus innovations may bring about changes in economic conditions.

Suppose, at the full employment level, an innovation in the form of a new product has been introduced. Innovation is financed by bank loans. As there is full employment already, factors of production have to be withdrawn from others to manufacture the new product. Hence, due to competition for factors of production costs may go up, leading to an increase in price.

When the new product becomes successful, other entrepreneurs will also produce similar products. This will result in cumulative expansion and prosperity. When the innovation is adopted by many, supernormal profits will be competed away. Firms incurring losses will go out of business. Employment, output and income fall resulting in depression.

Schumpeter’s theory has been criticised on the following grounds. Firstly, Schumpeter’s theory is based on two assumptions, viz., full employment and that innovation is being financed by banks. But full employment is an unrealistic assumption, as no country in the world has achieved full employment. Further innovation is usually financed by the promoters and not by banks. Secondly, innovation is not the only cause of business cycle. There are many other causes which have not been analysed by Schumpeter.

Economic Idea # 5. Capital:

Schumpeter did not identify capital with concrete goods; but regarded it as a separate agent or factor representing a fund of purchasing power. In this respect he departed from the economic ideas developed by Bohm-Bawerk and F.A. Von Hayek. Capital became significant only when economic development took place.

It explained the emergence of interest during the process of economic development. Interest did not arise in a static state and therefore it was an aspect of dynamic analysis. Capital was a price paid for the new productive forces accrued under innovation. It arose in the money market which was a creation of economic development.

Economic Idea # 6. Capitalism and Socialism:

Schumpeter agreed with Marx that capitalism was sowing the seeds of its own destruction, due to inner contradictions. Capitalism was killed by its own achievement. Schumpeter had infinite faith in the potentiality of capitalism but he believed in a Marxian fashion. The very success of capitalism would breed the germs of its ultimate decay. It was not economic barriers but social factors which undermine capitalism.

According to Schumpeter, the economic and social foundations of capitalism crumbled on account of the destruction of the industrial framework the decay of the entrepreneurial function and the disintegration of the protecting political framework. Innovation thus degenerated into a depersonalized routine activity.

The concentration of business and the growth of monopolies destroyed the institutions of private property and freedom of contract. The social class that used to protect capitalism also lost its political power and unwilling to support the established trade and industry. The educated unemployed was another group of ‘have-not’s against the capitalist class of ‘haves’.

Labour also organised itself to fight against capital and the intellectuals supplied the leadership. All these new forces led to the gradual decay of capitalism and strengthen the movement towards socialism. Capitalism could not function in this new atmosphere.

To conclude in the words of Seligman that Schumpeter was not a reformer. He was not interested in public policy. He was neither a Marxist nor a socialist. Instead he was an objective scientific investigator, with no particular axe to grind. He was no man’s pupil, and he founded no school.

In her review of Schumpeter’s capitalism, socialism and democracy, Joan Robinson wrote, “Professor Schumpeter, as many fast phrases reveal, has little love for socialism, and none at all for socialists. His natural sympathy is all with the heroic age of expanding capitalism. But yet he regards capitalism as doomed and socialism as inevitable”.

As an economist, Schumpeter occupies a unique position. He founded no school and hardly had any follower. He was a class by himself. He possessed mastery over all branches of economics. He was independent in his ideas and style.

Despite the originality of ideas and expression, his writings suffer from ambiguity and lack of coherence. “The result of complexity, diversity and universality of his mind was that he could not fully integrate his ideas”, and that is why he could not gain that position which was held by his contemporaries, especially Keynes.