4 Main Features of Schumpeter’s Theory of Economic Development

The following points highlight the four important features of Schumpeter’s theory of economic development.

They are: 1. Circular Flow 2. Role of Entrepreneur 3. Cyclical Process or Business Cycle and 4. End of Capitalism.

Feature # 1. Circular Flow:

Schumpeter starts his analysis of development process with the concept of circular flow.

It implies a condition where economic activity produces itself continuously at constant rate through time.

Thus, it means a continuous activity and no destruction. It is the characteristic of an economy in stationary state.

The circular flow is similar to circulation in blood in an animal organism. Circular flow is based upon a state of perfect competitive equilibrium in which coasts are equal to receipts and prices to average costs. The Schumpeter, “The circular flow is a stream that is fed from the continually flowing springs of labour power and land and flow in every economic period into the reservoir which we call income, in order to be transformed into satisfaction of wants”.

The main features of circular flow are as under:

(a) All economic activities are essentially repetitive and follow a familiar routine course.

(b) All the producers know the aggregate demand for goods and adjust the supply of output accordingly. This means demand and supply are in equilibrium at each point of time.

(c) The economic system has the optimum level of output and its maximum use and there is no possibility of wastage of resources.

(d) The firms working in a system are in a state of competitive equilibrium.

(e) Under the stationary equilibrium, the prices are equal to the average cost.

Theory of Economic Development:

The above stated features imply that circular flow is used in a static setting. To make it dynamic and consistent with development, changes must take place in flow system. These changes can be brought through innovations.

Innovations:

Innovation may be defined as a change in existing production system to be introduced by the entrepreneur with a view to make profits and reduce costs. The innovation is closely linked with Schumpeterian concept of development.

He 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 take place in the economy, 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.

Any innovation may consist of:

(a) The introduction of a new product

(b) The introduction of a new method of production

(c) The opening up of a new market

(d) The conquest of a new source of supply of raw materials or semi manufactured goods.

(e) The carrying out of the new organisation of any industry like the creation of a monopoly.

The new combinations of these factors are essential for the development process to start. It is to be energised by the development agents and such agents are innovators or entrepreneurs. The entrepreneur is considered as the hero in the Schumpeterian development.

Feature # 2. Role of the Entrepreneur:

Entrepreneur or innovator is the key figure in Schumpeter analysis of the process of development. He occupies the central place in the development process because he initiates development in a society and carries it forward. Entrepreneurship is different from managerial activity.

A manager simply directs production under existing techniques but entrepreneurship, requires the introduction of something new. An entrepreneur is also different from a capitalist. The capitalist simply furnishes the funds while the entrepreneur directs the use of these funds.

As in economic system, there is high degree of risk, thus entrepreneur is motivated:

(a) The desire to find a private commercial kingdom.

(b) The will to conquer and prove his superiority.

(c) The joy of creating, getting things done or simply of exercising one’s energy and ingenuity.

Three things are necessary for the performance of the entrepreneurial function:

(а) Technical know-how should be available to the entrepreneur for introducing new products and new combinations of production factors.

(b) Capital resource can enable the entrepreneurs to have command over factors of production. For this, he needs purchasing power in the form of credit and capital which he can borrow from banks and other financial institutions.

Thus, credit and bank plays a vital role in economic development. Credit enables the entrepreneur to buy producer’s goods which he needs for conducting new experiments and innovations. The invention in one field of the economic activity will induce inventions in the related fields. Thus, credit creation becomes an important part of the development model.

Role of Profits:

An entrepreneur innovates to earn profits. Profits are conceived “as a surplus over costs: a difference between the total receipts and outlay, as a function of innovation”. Profits arise due to dynamic changes resulting from an innovation. They continue to exist till the innovation becomes general.

Breaking the Circular Flow:

Schumpeter regards economic development as a dynamic and discontinuous process. The society progresses through trade cycles. In order to break the circular flow, the innovating entrepreneurs are financed by bank credit expansion. Since investment in innovation is risky, they must be paid bank interest on it.

Once the innovations becomes successful and profitable, other entrepreneurs follow it in “swarm like clusters”. Innovations in one field may induce other innovations in related fields. For example, the emergence of a motor car industry, may in turn, stimulated a wave of new investments in the construction of highways, rubber tyres and petroleum products etc. But the spread is never cent percent.

The spread of innovation can be explained with the help of a figure. 1 where percentage of firm is taken along Y-axis and time is along X-axis. The curve OL represents that firms adopt an innovation slowly to start but soon the adoption of innovation gains momentum but it never reaches 100 percent adoption by firms.

Feature # 3. Business Cycle or Cyclical Process:

The next component of development according to Schumpeter is the business cycle. Schumpeter’s approach to business cycle or crisis is historical, statistical and analytical. He believes that business cycle or crisis is 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”.

After explaining Schumpeter’s approach to business cycle or crisis, we shall now proceed to discuss the working of business cycle. How booms and depression appear and collapse? 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 throughout 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 the high rates of profits stimulate producers to raise investments by borrowing from the banks.

The 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 period. In this stage, the economic activities reach their maximum heights and the idle or unemployed resources are minimised.

During the boom period, the new products start appearing in the market with the entrance of new entrepreneurs. These products displace the old ones and thus decrease their demand 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 and some firms are even forced to run into loss.

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 point. Uncertainty and risk increase. A wave of pessimism sweeps the entire economy and the boom period ends with the appearance of the phase of depression.

Schumpeter believes in the existence of the long wave of upswings (or boom) and downswings (or depression). Once the upswing ends, the long wave of downswing begins and the painful process of readjustment to the “point of previous neighbourhood of equilibrium” starts.

The economic forces of recovery come into operation and ultimately bring about a revival. Once again the economy comes across the equilibrium, and the new boom period starts with a new set of innovations. This process of capitalist development may be regarded as “creative destruction” wherein the old economic structures of society after destruction are ultimately replaced by the new economic structures.

Schumpeter’s cyclical process of economic development has been illustrated in the above diagram where the secondary wave is superimposed on the primary wave of innovation. In the prosperity period, as the above figure reveals, the economic development proceeds more rapidly due to over optimism and speculation.

The business cycle continues to fall below the level of equilibrium with the beginning of the recession and ultimately reaches the point of depression. In the end, the retake of economic activities leads to revival of the economy.

In the Schumpeterian analysis of development entrepreneurs have to play the central role in business cycles. They initiate the economic development in the spontaneous and discontinuous manner. The cyclical swings are the cost of economic development under capitalism.

Feature # 4. The Decay of Capitalism:

The continuous technical progress results in an unbounded increase in total and per capita output. As long as technological progress takes place, the rate of profit is positive. Hence, there can be no drying up of sources of investible funds nor any vanishing of investment opportunities.

“There is, therefore, no prior ceiling to the level of per capita income in a capitalist society. Nevertheless, the economic success of capitalism will eventually lead to its decay”. The very success of capitalism undermines the social institutions which protect it and inevitably creates conditions in which it will not be able to live and which strongly point to socialism as the heir apparent.

Capitalism can maintain itself only so long as entrepreneurs behave like knights and pioneers. Schumpeter holds a very pessimistic view about the survival of capitalism. He advocated capitalist system of production yet he was not unaware of the weakness of this system.

Due to its drawbacks, capitalism disintegrates and yields place to socialism, Schumpeter gives the following reasons for the disintegration of capitalism:

(a) The Obsolescence of Entrepreneurial Function:

Prof. Schumpeter observes that the success of early captains of industry have made innovation a routine activity. It tends to degenerate into a dis-personalised, routine activity carried on in a big business through highly trained managers.

The new lords of business are managers, depersonalised owners and private bureaucrats. This reduces the industrial bourgeois to a class of wage earners and ‘thus’ undermines the function and the position of the entrepreneur as the “warrior knight”.

(b) Destruction of Institutional Frame Work:

Another factor responsible for weakening the foundations of capitalism is the destruction of its institutional frame work. The entrepreneur by his own success tends to destroy not only his economic and social functions but also the institutional framework within which he works.

The tendency towards concentration and increase in the size of production units destroy capitalistic institutions like private property and freedom of contract.

In case of big concerns, the proprietors are small and large shareholders who are dematerialised and de-functionalised by professional and salaried managers and thus, the proprietary interest is replaced by large and small stock holders. These changes tend to weaken the concept of private property and free individual contract.

(c) Destruction of Protecting Political Strata:

The destruction of protecting political strata will administer the last blow to capitalist system. With the progress of capitalism, not only the functions of the entrepreneur and the institutional frame work of capitalism crumble but the group that protected early capitalism politically is also destroyed.

The very success of capitalism is destroyed by the royal power. The progress of capitalism makes industrialists and merchants economically powerful and they begin to dominate in political field.