Chapter No.15

INTRODUCTION

Joseph Alois Schumpeter first presented his theory of economic growth in Theory of EconomicDevelopment published in German in 1911 (its English edition appeared in 1934) which waselaborated and refined but in no way altered in any essential respect in his Business Cycles(1939) and Capitalism, Socialism and Democracy (1942).

THE THEORY

To start with, Schumpeter assumes a perfectly competitive economy which is in stationaryequilibrium. In such a stationary state, there is perfect competitive equilibrium: no profits, nointerest rates, no savings, no investments and no involuntary unemployment. This equilibriumis characterised by what Schumpeter terms the “circular flow” which continues to repeat itselfin the same manner year after year, similar to the circulation of the blood in an animal organism.In the circular flow, the same products are produced every year in the same manner. “For everysupply there awaits somewhere in the economic system a corresponding demand. For everydemand the corresponding supply.” In other words, all economic activities are repetitive in a

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118 The Economics of Development and Planning

timeless economy. To Schumpeter, “The circular flow is a stream that is fed from the continuallyflowing springs of labour-power and land, and flows in every economic period into the reservoirwhich we call income, in order to be transformed into the satisfaction of wants.” Development,according to him, “is spontaneous and discontinuous change in the channels of the circularflow, disturbance of equilibrium, which for ever alters and displaces the equilibrium statepreviously existing.”1 These ‘spontaneous and discontinuous’ changes in economic life are notforced upon it from without but arise by its own initiative from within the economy and appearin the sphere of industrial and commercial life. Development consists in the carrying out ofnew combinations for which possibilities exist in the stationary state. New combinations comeabout in the form of innovations.Innovations. An innovation may consist of: (1) the introduction of a new product; (2) theintroduction of a new method of production; (3) the opening up of a new market; (4) the conquestof a new source of supply of raw materials or semi-manufactured goods; and (5) the carryingout of the new organisation of any industry like the creation of a monopoly. According toSchumpeter, it is the introduction of a new product and the continual improvements in theexisting ones that lead to development.Role of Innovator. Schumpeter assigns the role of an innovator not to the capitalist but to theentrepreneur. The entrepreneur is not a man of ordinary managerial ability, but one whointroduces something entirely new. He does not provide funds but directs their use. Theentrepreneur is motivated by: (a) the desire to found a private commercial kingdom, (b) the willto conquer and prove his superiority, and (c) the joy of creating, of getting things done, orsimply of exercising one’s energy and ingenuity. His nature and activities depend on his social-cultural environment. To perform his economic function, the entrepreneur requires two things:first, the existence of technical knowledge in order to produce new products; second, the powerof disposal over the factors of production in the form of credit. According to Schumpeter, areservoir of untapped technical knowledge exists which he can make use of. Therefore, credit isessential for development to start.Role of Profits. An entrepreneur innovates to earn profits. Profits are conceived “as a surplusover costs: a difference between the total receipts and outlay–as a function of innovation.”According to Schumpeter, under competitive equilibrium the price of each product just equalsits cost of production, and there are no profits. Profits arise due to dynamic changes resultingfrom an innovation. They continue to exist till the innovation becomes general.Breaking the Circular Flow. Schumpeter’s model starts with the breaking up of the circularflow with an innovation in the form of a new product by an entrepreneur for the purpose ofearning profits. In order to break the circular flow, the innovating entrepreneurs are financedby bank-credit expansion. Since investment in innovations is risky, they must pay interest on it.Once the new innovation becomes successful and profitable, other entrepreneurs follow it in“swarm-like clusters.” Innovations in one field may induce other innovations in related fields.The emergence of a motor car industry may, in turn, stimulate a wave of new investments in theconstruction of highways, rubber tyres and petroleum products, etc. But the spread of aninnovation is never 100 percent.The spread of innovation is shown in Fig. 1 where the percentage of firms adopting a particularinnovation is shown on the vertical axis and time taken on the horizontal axis. The curve OI

1. A. Schumpeter, Theory of Economic Development, p. 64. Italics mine.

The Schumpeterian Theory 119

shows that firms adopt an innovation slowly to start withbut soon the adoption of innovation gains momentum.But it never reaches 100 per cent adoption by firms.Cyclical Process. Since investment is assumed to befinanced by creation of bank credit, it increases moneyincomes and prices and helps to create a cumulativeexpansion throughout the economy. With the increase inthe purchasing power of the consumers, the demand forthe products of the old industries increases in relation tosupply. Prices rise, profits increase and old industriesexpand by borrowing from the banks. It induces asecondary wave of credit inflation which is superimposedon the primary wave of innovation. Over-optimism and speculation add further to the boom.After a period of gestation the new products start appearing in the market displacing the oldproducts and enforcing a process of liquidation, re-adjustment and absorption.2 The demandfor the old products is decreased. Their prices fall. The old firms contract output and some areeven forced to run into liquidation. As the innovators start repaying bank loans out of profits,the quantity of money is decreased and prices tend to fall. Profits decline. Uncertainty and risksincrease, the impulse for innovation is reduced and eventually comes to an end. Depressionensues.Schumpeter believes in the existence of the Kondratieff long-wave of upswings and downswingsin economic activity. Each long-wave upswing is brought about by an innovation in the form ofa new product which leads to further innovations in the methods of production, new forms ofbusiness organisation, new sources of supply of raw materials and intermediate products, andnew markets. Thus there is abundance to goods available for the masses.” In the words ofSchumpeter, “mass production means production for the masses.” Once the upswings ends,the long-wave downswing begins and the painful process of readjustment to the “point ofprevious neighbourhood of equilibrium” starts. Ultimately the natural forces of recovery bringabout a revival. Once again equilibrium is restored. Then smite enterprising entrepreneursbegin with a new set of innovations, others follow, and a new boom begins. Schumpeter describesthis process of ‘capitalist development as one of “creative destruction” wherein the old economicstructures of society are being continually destroyed and the new structures are being continuallycreated in their place.This is shown in Fig. 2 where time is taken on the horizontal axisand national output on the vertical axis. The curve YPT showsthe long-run cyclical upswings and downswings. When there isa new innovation, the economy moves upwards from Y andproduction increases upto P. When this innovation ends and anew innovation starts and replaces the earlier one the, outputlevel falls from P to T. In this way, “the creative destruction”process leads to the new equilibrium T of the economy that ishigher than the earlier point Y which shows the development ofthe economy.Schumpeter ’s cyclical process of economic development isillustrated in Fig. 3 where the secondary wave is superimposedon the primary wave of innovation. With over-optimism and speculation, development proceeds

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more rapidly in the prosperity phase. Whenrecession starts, the cycle continues downwardbelow the equilibrium level to the depressionphase. Ultimately, another innovation bringsabout revival.In fine, entrepreneurs are the key figures in theSchumpeterian analysis. They bring abouteconomic development in spontaneous anddiscontinuous manner. And “cyclical swings arethe cost of economic development undercapitalism,” a permanent feature of its dynamictime-path.Secularly, continued technological progress willresult in an unbounded increase in total and percapita output, since historically there are nodiminishing returns to technological progress.As long as technological progress takes place, the rate of the profit will be positive. Hence therecan be no drying up of sources of investible funds nor any vanishing of investment opportunities.“There is therefore no a priori ceiling to the level of per capita income in a capitalist society.Nonetheless, the economic success of capitalism will eventually lead to its decay. For the veryprocess of capitalist development weakens the institutions and values basic to its own survival.”2

“Can capitalism survive? No, I do not think it can,” wrote Schumpeter, as his final appraisal ofthe future of capitalism. To him, the very success of capitalism “undermines the social institutionswhich protect it, and “inevitably” creates conditions in which it will not be able to live andwhich strongly point to socialism as the heir apparent.”3

Process of End of Capitalism. According to Schumpeter, capitalism can maintain itself only solong as entrepreneurs behave like knights and pioneers. But such daring innovators are beingdestroyed by the capitalist system itself which rests on a rational attitude. This enquiring,sceptical and rational attitude permeates the entire capitalist society. As a result, three forces arediscernible that are the beginning of the creeping death of capitalism. They are: (1) the decadenceof the entrepreneurial function; (2) the disintegration of the bourgeois family; and (3) thedestruction of the institutional framework of the capitalist society.In the early stages of capitalism, the driving force came from entrepreneurs who dared toinnovate, to experiment, and to expand. But now innovation is reduced to a routine. Technologicalprogress has become the business of teams of trained specialists. The new ‘lords’ of business arethe managers, depersonalized owners and private bureaucrats. This reduces the industrialbourgeoisie to a class of wage-earners and thus undermines the function and the position of theentrepreneur as the “warrior knight.”There is also the destruction of the bourgeoisie family. Parents adopt a rationalistic attitude intheir behaviour towards children. The traditional family idea is weakened. The desire to founda “private kingdom” , a “dynasty” is no longer there. The will to accumulate wealth graduallydisappears and along with it another important aspect of the capitalist society.

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2. I. Adelman, Theories of Economic Growth and Development, p. 108.3. J.A. Schumpeter, Capitalism, Socialism, and Democracy, p. 61.


Finally, Schumpeter contends that the entrepreneur also tends to destroy the institutionalframework of the capitalist society. The tendency towards concentration into big concernsweakens and destroys the twin institutions of private property and freedom of contract. In thecase of big concerns, the proprietors are the small and large shareholders who are“dematerialized” and “defunctionalized” by the professional, salaried managers. Theproprietors’ role is performed by the latter while the former are totally divorced from activemanagement. According to Schumpeter, it was rationality that had destroyed the royal powerin the past. Now again, it is the rationalistic attitude of the ruling group towards domestic andinternational problems that will be the bane of capitalism. But all these forces are not enough toring the death knell of capitalism. It is, however, the active hostility of the intellectuals which isbringing the day nearer. The intellectuals sow seeds of doubt and discontentment in the mindsof the masses against the social and political framework of the capitalist order. By inciting thewhite-collar groups and the labouring classes they are able to secure anti-capitalist politicalreforms. As a result, the institutional framework upon which capitalism rests starts crumblingand there is a gradual movement towards socialism. Eventually capitalism would fade awaywithout any bang or whimper.

CRITICISMS OF THE THEORY

“Schumpeter’s theory must be ranked as a major performance, one worthy of such greateconomists as Smith, Mill, Marx, Marshal and Keynes.”4 No doubt it is replete with brilliantreasoning and insight of a great theorist, yet it is not free from criticisms.1. The entire process of Schumpeter’s theory is based on the innovator whom he regards asan ideal person. Such persons were to be found in the 18th and 19th centuries. At that timeinnovations were made by entrepreneurs or inventors. But now all innovations form part of thefunctions of a joint stock company. Innovations are regarded as the routine of industrial concernsand do not require an innovator as such.2. Economic development is not the result of the cyclical process. The downswings and theupswings are not essential for economic development. As Nurkse pointed out, economicdevelopment is related to continuous changes.3. Schumpeter’s contention that cyclical changes are due to innovations is also not correct.As a matter fact, cyclical fluctuations may be due to psychological, natural, and financial causes.4. Schumpeter regards innovations as the main cause of economic development. But this isfar from reality because economic development not only depends an innovations but also onmany economic and social changes.5. Schumpeter gives too much importance to bank-credit in his theory. Bank credit may beimportant in the short run when industrial concerns get credit facilities from the banks. But inthe long run when the need for capital funds is much greater, bank credit is insufficient. Forthis, business houses have to float fresh shares and debentures in the capital market.6. Schumpeter’s analysis of the process of transition from capitalism to socialism is not correct.He does not analyse how a capitalist society is transformed into socialism. He simply tells thatthe institutional framework of a capitalist society is transformed with changes in the functionsof the entrepreneur. His analysis of the end of capitalism is emotional rather than real.To conclude with Meier and Baldwin, “Schumpeter’s broad socio-economic analysis of capitalistprocess is generally admired. Yet few seem prepared to accept its conclusions. His arguments

4. G.M. Meier and E. Baldwin, op.cit., p. 95.


are stimulating but not completely convincing.... Although Schumpeter’s analysis is provocative,it seems one-sided and over-emphasized.”5

SCHUMPETER’S ANALYSIS AND UNDERDEVELOPED COUNTRIES

The applicability of Schumpeter’s theory to underdeveloped countries is limited for the followingreasons: 1. Different Socio-Economic Order. Schumpeter’s theory corresponds to a particular socio-economic order that existed in Western Europe and America of the 18th and 19th centuries. Inthat period, some of the prerequisites of growth already existed. In underdeveloped countries,the socio-economic conditions are altogether different and the prerequisites for developmentin the form of economic and social overheads are non-existent.2. Lack of Entrepreneurship. The Schumpeterian analysis depends upon the existence of anentrepreneurial class. However, in underdeveloped countries adequate entrepreneurship islacking. In such economies, there are low profit expectations and low state of technologieswhich do not encourage innovational investments in new plant and equipment. Moreover, thelack of adequate power, transport, skilled personnel, etc. act as disincentives to entrepreneurialactivity.3. Not Applicable to Socialist Countries. Schumpeter’s analysis is not applicable to the majorityof underdeveloped countries which have socialist leanings. For example, the introduction ofsocial security measures and high progressive income taxes are inimical to the development ofan entrepreneurial class because they tend to reduce profits.4. Not Applicable to Mixed Economies. Moreover, Schumpeter’s innovator is a privateentrepreneur who does not fit in the present day mixed economies. In an underdevelopedcountry, government is the biggest entrepreneur. The main impetus for development comesfrom the public and the semi-public sectors. Thus, Schumpeter’s innovator has a limited role toplay in an underdeveloped country.5. Institutional Changes and not Innovations Needed. To start the development process andto make it self-sustaining, it is not innovations alone but a combination of several factors likeorganizational structures, business practices, skilled labour and appropriate values, attitudesand motivations which are required.6. Assimilation of Innovations. According to Henry Wallich, the development process inunderdeveloped countries is based, not on innovation, but on the assimilation of existinginnovations. For entrepreneurs in underdeveloped countries are not in a position to innovate.Rather, they adopt innovations taking place in advanced countries.67. Neglects Consumption. The Schumpeterian process is ‘production oriented’ while thedevelopment process is ‘consumption-oriented’. This appraisal is applied in the current trendtowards the welfare state in which demand and consumption play a leading role.8. Neglects Savings. Schumpeter’s exclusive emphasis on bank credit obscures the role of realsavings in investment. It also undermines the importance of deficit financing, budgetary savings,public credit and other fiscal measures in economic development.9. Neglects External Effects. According to Schumpeter, development is the result of changesthat arise from within the economy. But in underdeveloped countries, changes do not take

5. Ibid., pp. 99 and 101.6. Henry C. Wallich, Some Notes Towards a Theory of Derived Demand, in Aggrawal and Singh (ed),

op.cit., pp. 193-202.


place from within the economy rather they are the outcome of imported ideas, technology andcapital. Backward technology, low saving potential and outmoded social, economic and politicalinstitutions are incapable of leading to development from “within” in underdevelopedeconomies.10. Neglects Population Growth. Further, Schumpeter failed to take into account the impact ofthe growth of population on the economic development of a country. High growth rate ofpopulation tends to lower the growth rate of a developing economy.11. Unsatisfactory Explanation of Inflationary Forces. In Schumpeter’s system, inflationaryimpulses form an integral part of the process of development, but it involves no secular inflation.The long-term price level remains stable. However, in an underdeveloped economy theinflationary forces are very powerful.

Conclusion. All the same, Schumpeter’s theory underlines the importance of inflationaryfinancing and innovations as the main factors in economic development. Inflationary financingis one of the potent methods which every underdeveloped country tries to use at one time oranother. His analysis is relevant to underdeveloped countries from the standpoint of long rangeincrease in productivity and absorption of surplus labour in gainful employment as a result ofinnovations.

Chapter No.15

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