Analysis of Joseph Schumpeter’s ‘Theories of Economic Development’

At the turn of the century, a period of strengthening the role of monopolies, increasing property differentiation of the population and the deepening of cyclical crises appeared the concept of an Austrian economist and sociologist Joseph Schumpeter.

Joseph Schumpeters Theories of Economic Development
Joseph Schumpeter

Joseph Schumpeter was an economist and sociologist, he came into the history of economic science as a profound scholar of theoretical problems of entrepreneurship and evolution of socio-economic systems, as the historian of economic theory. His broad vision of the evolution of socio-economic processes still has influence on modern economic thought. He presented his understanding of the subject of economics and tried to combine economic theory, economic sociology and the history of economic analysis. He tried to create a coherent system of believes that explains new phenomena and processes. According to his theoretical views, J. Schumpeter does not belong to any known economic schools. He was involved in many issues, focusing on the development of a holistic view of the mechanism of operation and prospects of development of the capitalist economy. One of his major works is called “Theories of Economic Development.”

Schumpeter undertook a multidimensional study of contemporary society, its past and future, trying to explain in his theory the principles of operation and the laws of evolution of the economy at all levels. At the same time he sought to create a “synthesized” theoretical system, taking the best from existing modern and past economic thoughts. In this connection, Schumpeter’s contemporaries called him the “Western Marx.”

The focus of this article is his theory of economic development, its main provisions and its relation to new emerging markets. This article will explore Schumpeter’s theories regarding economic development and compare it with other theories of economic growth to illustrate his influence to modern economics.

Economic Views of Schumpeter

Schumpeter was an outstanding economist of his time, who put forth many new ideas and thus left a significant contribution to the development of economic thought and economic theory. According to Schumpeter, the economic theory is definitely a tool of analysis, and in this regard he considers the development of economic thought and describes the history of economic doctrines as the evolution of hypotheses and methods of research of the market economy, by which scientists try to understand the economic reality and explain.

The apex of economics Schumpeter believed to be the neoclassical theory, which brilliantly explained the movement of prices in a market system. However, he considered its static approach in the study of economic processes as a serious disadvantage, and phenomena of development and system dynamics was left not explained. In this connection, Schumpeter, when analyzing the market economic system, which is based on private property, division of labor and free competition, has introduced a clear distinction between the two levels of investigation: statics and dynamics. In his view, the static model considers the behavior of separate economic units, based on the theory of marginal utility and marginal productivity; describes the economic activities as circuit, in which all firms are in a state of sustainable equilibrium, when revenues are equal to costs. Schumpeter explained that in the economic system where dominate free competition, price can not exceed the cost of production because the presence of profits would attract other competitors in this industry, would lead to supply increase and disappearance of profits. Static model, according to Schumpeter, is untrue, and economic life, as a dynamic and constantly changing process, must be studied in development. In this regard, in contrast to the orthodox approach, Schumpeter center of his analysis made the very development of the system and the internal factors that give rise to this development.

Special role in Schumpeter’s theory take monetary relations: credit and money connect economic statics (cycling) and dynamics (development), providing a breakthrough to a new stage of growth. The scientist emphasizes the role of monetary form of capital as a basis for economic development. He notes that innovation need to employ additional funds that it receives from the bank for credit.

Schumpeter also worked on the theory of effective competition, in which the market mechanism in the era of “big business” is considered as a fruitful interaction between the forces of monopoly and competition based on innovation. Scientists emphasize that the reality of the markets there is a “hybrid” models of “pure monopoly” and “pure competition”. On the one hand, the desire to gain a monopoly position is the main stimulus of competition, on the other hand, the monopoly power to spur competition, while the industry which receives monopoly profits, attracts other manufacturers. Consequently, the monopoly is a powerful stimulus of growth of competition. However, Schumpeter notes that competition is not always effective, as it is sometimes accompanied by inappropriate use of resources, the deformation of demand.

Dynamic competition based on lowering costs and improving product quality through innovation, Schumpeter refers to effective competition, which is a potent stimulus for the expansion in output, productivity, lowering prices, expanding the product range.

The dynamics of capitalism, in Schumpeter’s point of view, goes due to technological progress. The main factor for growth is innovation — changes in the modes of production and sale of goods. They can ruin the balance, that leads to a change in the existing system of prices, costs, revenues. As a result, the circuit is broken, stops the work of unprofitable production, that stimulates the innovative mechanism that supports the market process in a continuous development.

Theory of Economic Development and Dynamism of the Economy

 In 1911, Joseph Schumpeter in “The Theory of Economic Development” has spoken of the new side of economic life (except static) as dynamic, which represents a new cycle of innovations and development. Schumpeter considered the cycle as an important pattern of economic growth.

In the cyclical development of the economy, Schumpeter pointes long waves, which resulted in an increase in production volumes, productivity, product quality, lower prices and increase in real incomes; although in short periods of time this trend may be accompanied by recessions. Schumpeter called cyclic development as “creative destruction”, during which there is a continuous updating of the productive apparatus and the transition to a higher stage of development.

While working on dynamic model of economic development, Schumpeter introduced the concept of “effective competition” and “effective monopoly” by associating them with the process of innovation and entrepreneurial function. Innovations, according to Schumpeter, is the basis of a new type of competition, which is much more effective than price competition. Innovations represent an opportunity to change not only the technology and products, but also influence the structure of demand, conditions of formation costs and prices. And competition, which is stimulated by the desire to profit from the advantages in production costs and quality of the product itself, Schumpeter called the “effective competition”.

In Schumpeter’s concept of modernity is connected and the monopoly of a new type, different from those forms of monopoly, which are based on special rights and privileges, the ownership of scarce resources and scarce goods. Monopoly, which is a consequence of innovation, Schumpeter called effective because it is formed in a highly competitive, and in his opinion, incompatible with the stagnation and exploitation through the price mechanism. Monopoly profits derived innovator, is an incentive and reward for innovation. At the same time it is — a transient phenomenon for a particular company, as the disappearing under the same mechanism of competition, which owes its existence to a monopoly, that is due to specific innovations. Thus, in theory, Schumpeter’s “effective monopoly” is a natural part of economic development.

Innovations as Driving Force of Economic Development

Schumpeter’s important contribution to economic theory lies precisely in that he explores the factors that “blow up” the balance of the market system from the inside. These internal factors become new production combinations, which determine the dynamic changes in the economy. Schumpeter identifies several types of innovative combinations of factors of production:

  • Creation of a new product,
  • The use of new technologies of production,
  • Use the new organization of production,
  • Opening new markets and sources of raw materials.

New combinations of factors of production are called “innovations”. It should be emphasized that, in the terminology of Schumpeter “innovation” is not synonymous with the word “invention”, as entrepreneurial activity is associated with the use of existing resources rather than creating new ones. Possibility of a new application of funds in excess are “dead” opportunities. The entrepreneur overcomes technological and financial difficulties, and opens new avenues for profit that should be considered as excess over the income established in the circuit. And it is the entrepreneur, the person whose role is to implement a new combination of production factors, plays in the concept of economic development of Schumpeter a particularly important role.

Schumpeter ties the innovative activities with the problem of recurrence, as it believes that the process of innovation does not flow evenly, it is characterized by leaps and bounds of various duration’s. The reason for fluctuations is that an entrepreneur seeks to opening up new ways of making a profit, and so he tends to innovate. Initial innovations are followed by a series of innovations introduced by other entrepreneurs, which determines the rapid growth of investment and leads of long-term prosperity. Schumpeter admits that the phases of recovery may be interrupted by negative phases of shorter cycles, superimposed on this basic model. Attenuation of long waves Schumpeter explains with the exhaustion of the capacity of innovation, decreasing profits, increasing number of bankruptcies of old and inefficient items. Thus, Schumpeter considers the cycle as an important pattern of economic growth.

The Role of Entrepreneur as Innovator

An important characteristic of Schumpeter’s theory was that, when analyzing the causes of the dynamic changes, he emphasized the “human factor”. Therefore, Schumpeter was the first in economics who distinguished between the concepts of “capitalist” and “entrepreneur.”

The driving force of the development in his theory was the entrepreneur as an economic entity, which is different from the capitalist and the worker. It should be stressed that entrepreneurship, according to Schumpeter, is a special gift, a characteristic feature of human nature, which does not depend on class or social status. This type of character includes the following features:

  • Self-reliance,
  • Preference for risk,
  • The value of own independence,
  • Focus on own opinion,
  • The need to achieve success, despite the fact that the intrinsic value of money for entrepreneur is not high,
  • A key quality of the entrepreneur is the desire for innovation.

In the pursuit of profit, the entrepreneur carries out a new combination of production factors, contributes to the emergence of new products, introduces new methods of production, expands into new markets, provides new forms of management. As a result of this initiative the entrepreneur gets a profit, and the economy as a whole gets a boost to development. So the entrepreneur is considered the main subject of economic development. His activity helps to promote technological progress, creates a surplus value, brakes the “static situation” and the economy has an incentive to development.

It is interesting to see how Schumpeter in the theory of entrepreneurship analyses the concept of rational (economic) and real (“irrational”) rights, the object of research of economists of institutional direction. Speaking about the theme of economic activity in a static state, Schumpeter distinguishes the motive of needs on the basis of rational behavior (maximizing utility or profits). When considering the dynamic model, Schumpeter believes that the motives of business are irrational, because the main motives become self-development, success and joy of creativity. Entrepreneur is driven by his desire to win. Also the entrepreneur, according to Schumpeter, is not burdened by an excess of intelligence, and in this case it is a positive quality, as it is the relative limitations of outlook does not give him an opportunity to compare many different options to achieve goals and to hesitate too much. Schumpeter points that the theory of entrepreneurship is one area where economics and psychology have found a common language, that leads to the emergence of new science called “economic psychology”.

The concept of the entrepreneur as a key figure of the market economy lies at the heart of Schumpeterian interpretations of capital, profits, interest and money.

Financing of Innovations and Economic Development

An important role in the study of the internal factors of economic growth Schumpeter gave to credit, seeing it as an essential condition for the use of existing factors for the establishment of new production combinations. For innovative entrepreneurs could get means of production, they must use a bank loan, since banks “create” money for innovators, and from this starts the redistribution of the flow of resources, that is of the social capital. Thus, a banks, according to Schumpeter, are special phenomenon of development which, acting on behalf of the national economy, give possibilities for implementation of new industrial combinations. They act as necessary intermediaries between the desire to implement the innovation and the ability to do this. The fee for such opportunities is a percentage rate, that is the price paid for the acquisition of new productive forces. According to Schumpeter, it is the development in the truest sense of the word that requires a loan.

An entrepreneur when obtaining a loan, he goes on the market of production factors, which, by assumption, is in complete equilibrium of supply and demand, and violates it. He needs an additional amount of resources and he suggests higher price for them. It leads to violation of the system of equilibrium prices, changes in the direction of resource flows, and the flow of consumer goods- in such a way breaks down the entire rhythm of the circuit, the whole system of prices, costs and revenues. According to Schumpeter, this process is a normal state, rather than the equilibrium cycle. And that is why there is always the entrepreneurial profit, and for these reasons capitalism is not static, but is constantly evolving.

Schumpeter argues that the increase of money in circulation through the use of bank credit leads to a general rise in prices, primarily for production resources, including labor costs. But according to Schumpeter, it is not just inflation as it is considered in the quantitative economic theory. As a result of this initial inflation the whole economic cycle is changing: companies that work traditionally go bankrupt (as in the new conditions incomes do not cover the costs), but entrepreneurs-innovators, by contrast, make a profit. That is why bank loans lead not just to higher prices, but to changes in the whole economic structure, transition to a new round of spiral development. Thus, bank credit appears to be closely associated with the phenomenon of economic development, and money function not just as a mean of circulation, but act as a catalyst for economic growth, including through the profit and interest.

Process of Economic Development

With the innovative activities Schumpeter connects the cyclic form of economic development, and to the study of this issue he devotes his paper “Economic Cycles” (1939). Highlighting and establishing a link between the three types of cycles (long, short and classic), Schumpeter takes the existence of economic cycles from the period of implementation of inventions, which are carried out in spurts, when one invention “pulls” a series of innovations. Schumpeter wrote that “every innovation is a wave of imitations, diverging in all directions.”

The set of such waves diverge simultaneously, they overlap each other and such a movement (in summation of all waves) can not be smooth; it generates a total recovery periods that can be followed by periods of general decline. This is the essence of Schumpeter approach to the analysis of economic cycles. The reason of the economic crisis he sees in a panic associated with the termination of an economic boom, highlighting the psychological motive as central in explaining this economic phenomenon.

It should be noted that Schumpeter’s ideas about innovations and entrepreneurship lie in the principle of development of many emerging markets. That is, the emergence of new markets in developing countries and countries with economies in transition in many ways has the features and principles described by Schumpeter. First of all, this is the main place of innovation in economic development and economic system, as well as the important place of entrepreneurs as subjects of innovation activity.

Difference of Schumpeter’s Views from other Economic Theories and his Contribution to Modern Economics

Works of Joseph Schumpeter differ from the scientific work of the majority of his contemporaries. In his writings on economics, he integrated the lessons of diverse knowledge of the history, politics and mathematics. Methodology of Schumpeter differs from the conceptual foundation of the neoclassical, and his ideas of innovation, entrepreneurship and economic cycles are no less important than, for example, ideas of free competition of A. Marshall.

In “The Theory of Economic Development” Schumpeter, unlike many representatives of economic theory of his time who studied the conditions of static equilibrium, was developing a theory of economic development, with focus on the analysis of internal factors that cause development of the economic system. The word “development” has already been new for the neoclassical theory, which considered only the state of equilibrium in the economy.

J. Schumpeter believed that his “theory of economic development better explained the origin and development of emerging markets and new forms of economic organization.

Schumpeter also made analysis of monopoly and competition from the standpoint of economic processes, which is opposed to the neoclassical theory, which traditionally considered the functioning of the market only through the prism of static efficiency, that is the economy’s ability to provide customers the most complete satisfaction of the demand from existing resources. Schumpeter develops a new criterion for evaluating economic efficiency — the ability to increase the satisfaction of consumer demand due to the introduction of innovations, in terms of increased efficiency per unit of resources used. Innovations form the core of a new type of competition, which makes economic processes more dynamic, as a process of creative destruction equilibrium situations, the acceleration changes the very terms of the formation of production costs, prices, quality goods.

Joseph Schumpeter also proposed an entirely new way of defining business functions. He proposed an innovative feature of entrepreneur, who with his innovative character differs from the manager: he is not the inventor, but the person who realizes innovations, and his activity is associated with certain personality characteristics of a “typical entrepreneur”.

Schumpeter has a great influence on the history of economic thought. His contribution lies in development of a comprehensive theory of dynamics of the economic system. This theory later became the basis for developing and implementing a special innovation policy at the level of individual firms and national economies, as a fundamental element of theory of entrepreneurship and economic growth policy.

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