Features of Schumpeter theory of development

Features of Schumpeter theory of development

The two important contributions to theory of economics development by Schumpeter are “entrepreneur” the actors of development and “innovation” the actions of development. The three key features of Schumpeter theory of economic development are:

(i) Circular Flow;

(ii) Innovation;

(iii) Role of Entrepreneur;

(iv) Role of Profit;

(v) Cyclical Development Process and;

(vi) Decay of Capitalism.

(i) Circular Flow

Schumpeter triggered off his analysis of economic development process by introducing the concept of circular flow. The circular flow is based on the premises that economic development is a continuous process, where economic activities produce continuously at constant rate through time. According to Schumpeter “development in our sense………… is change in the channels of the flow as opposed to that movement. It is displacement of the equilibrium state as opposed to the movement towards an equilibrium state”. While supporting the role of circular flow in development, Schumpeter told “development in our sense is a discrete phenomenon, entirely foreign to what may be observed in the circular flow or in the tendency towards equilibrium.

It is spontaneous and discontinuous change in the channels of the flow disturbance of equilibrium, which forever alters and displaces the equilibrium state previously existing”. The economic activities are essentially repetitive and subject to charge in a routine manner. The firms working in the economic system are in a state of competitive equilibrium. All the producers know the aggregate demand for goods and adjust the supply of output accordingly. The equilibrium state circular flow occurs in a static setting. According to Schumpeter, development beings with the breaking up of circular flow by the innovative entrepreneurs with an innovation in the form of a new product.

(ii) Innovations

Innovation is the kingpin of Schumpeter theory of economic development. The  development process remains dynamic and vibrant because of innovations. Innovation is defined as a change in existing production system to be introduced by the entrepreneur with a view to make profits and reduce costs. According to Schumpeter innovation covers five aspects:

(i) The introduction of new good-that is one with which consumers are not yet familiar;
(ii) The introduction of new method of production – that is one not yet tested by experience in the branch of manufacture;
(iii) The opening of a new market – that is a market into which the particular branch of manufacture of the country in question has not previously entered;
(iv) The conquest of a new source of supply of raw materials or half manufactured
(v) The carrying out of the new organization of any industry like the creation of a monopoly.

The combination of these factors are essential for facilitating development. To Schumpeter, “innovation” means “doing things differently in the realm of economic life”. Innovators are the actors of development who are different from capitalists. In order to perform innovations, the innovators have to overcome socio-psychological barriers, besides economic barriers of financing the innovation. Therefore, these group of development actors have to posses the quality of leadership. Sweezy has remarked that “Schumpeter’s analysis is designated to show that without entrepreneurs we have a stationary economy.”

(iii) Role of Entrepreneurs

Entrepreneur is the star of Schumpeterian drama of economic development. He/she is the central figure in Schumpeter’s theory of economic development. He/she is the innovator who does innovation and initiates process of development in an economy and carries it forward. Entrepreneurs are not the capitalists; rather they work under the capitalists. The capitalists furnish the funds, while the entrepreneurs direct the use of these funds.

The two things which are critical to functioning of an entrepreneur to bring economic development are technical know-how and capital resources. Entrepreneurs need technical know-how for introducing new products and new combinations of production factors. Schumpeter considers that these production and production factors are always present in an economy. What an entrepreneur does is only streamline these things. To Schumpeter “it is not part of his function to find or to create new possibilities. They are always present abundantly accumulated by all sorts of people.” The second essential thing which an entrepreneur needs is the capital resource which can enable him/ her to have command over factors of production. He/she acquires capital in the form of credit from banks and other financial institutions.

Thus credit and bank plays vital role in economic development. Schumpeter is of the opinion that the entrepreneur needs credit because credit promotes industrial development which in turn delivers new goods.

(iv) Role of Profit

Profit is the main motivation factor for entrepreneur to go for innovation. Entrepreneurs innovate because they want to increase profit.According to Schumpeter “under competitive equilibrium, the price of each product just equals to its cost of production and there are no profits. Profits arise due to dynamic changes resulting from an innovation. They continue to exist till the innovation becomes general”. Entrepreneurial innovation is the major sources of all profits.

However, as economic development progresses through innovations, the competition to progress among the entrepreneurs rises causing entrepreneurial profit to decline as the economy asymptotically heads towards a stable state.

(v) Cyclical Process of Development

Schumpeter regards economic development as a dynamic, discontinuous and cyclical process. His concept of “creative destruction” where old economic structures of the society are being continually destroyed and new structures are being continually created reveals the cyclical nature of development.

Schumpeter famously claimed that to discuss capitalism without mentioning the process of creative destruction would be like discussing the play Hamlet, without mentioning the Danish prince. According to Diamond (2004) Schumpeter’s central message is that the process of creative destruction describes the form of competition in capitalism that is capable of dramatic improvements in the quantity and quality of our lives. To him the swarm like appearance of entrepreneurs is responsible for cyclical nature of economic growth.

In this situation one entrepreneur follows the other and innovation in one field may induce other innovations in related fields. For example, the emergence of motor industry, may in turn, stimulate a wave of new investments in motor parts industries, tyre industries and petroleum product industries. Schumpeter believes that new units of production enjoy advantages over old units of production when new plants starts turning out production.Entrepreneurs play key role in the Schumpeterian theory of economic development. They bring economic development in a spontaneous and discontinuous manner and “Cyclical saving are the cost of economic development under capitalism”, a permanent feature of its dynamic path.

(vi) Decay of Capitalism

Schumpeter had a pessimistic view about the survival of capitalism. The capitalism will flourish as long as capitalists earn profit and innovations continue and the entrepreneurs
are agile and continue innovation. Schumpeter has sighted three reasons for the downfall of capitalism:

(i) the obsolescence of entrepreneurial function;

(ii) destruction of institutional framework of capitalist and

(iii) destruction of protecting the political strata.

Schumpeter believed that the innovation carried out by the entrepreneurs will not continue
for long and will be turned into routing activity through highly trained managers. This would reduce the position of entrepreneur in a society and undermine their functions and turn them into “warrior knight”.

Another factor responsible for the downfall of capitalism is the weakening of its institutional framework. The tendency towards concentration and increase in the size of the production unit destroy capitalistic institutions like private property and freedom of conflict.

Finally, the destruction of the protecting political strata will give a big blow to capitalist system. With the rise of capitalism not only the institutional frame work will crumble but also the political strata who would have protected capitalism at it’s early stage gets destroyed. The very success of capitalism is destroyed by the royal power. With the progress of capitalism the industrial units and merchants becomes more powerful and pose big threat to political class and virtually dominate them.


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