Question

How does Schumpeter explain both the long run evolution of the capitalist system and fluctuations in economic activity (business cycles) in terms of a theory of innovation? In your answer carefully explain the key features of innovation including how it represents the source of capitalist profits according to Schumpeter. How is Schumpeter’s prediction of the eventual end to capitalism and transition to socialism different from Marx’s? try to be detailed.

Answer 1

Schumpeter’s Theory of Innovation :-

Definition: Schumpeter’s Theory of Innovation is in line with the other investment theories of the business cycle, which asserts that the change in investment accompanied by monetary expansion are the major factors behind the business fluctuations, but however, Schumpeter’s Theory posits that innovation in business is the major reason for increased investments and business fluctuations.

According to Schumpeter, the cyclical process is almost exclusively the result of innovation in the organization, both industrial and commercial. By innovation he means, the changes in the methods of production and transportation, production of a new product, change in the industrial organization, opening up of a new market, etc. The innovation does not mean invention rather it refers to the commercial applications of new technology, new material, new methods and new sources of energy.

Schumpeter has developed a model in two stages, i.e. first approximation, and second approximation, in order to further explain his business cycle theory of innovation. The first approximation lays emphasis on the primary impact of innovatory ideas while the secondary approximation deals with the subsequent responses obtained from the application of the innovations. Let’s study these stages in detail:

• First Approximation: This stage begins with the economic system in equilibrium in which there is no involuntary unemployment, firm’s mc = mr (marginal cost is equal to marginal revenue) and price = Average Cost (AC). In the situation of complete equilibrium in the economy, if the firm decides to undertake a new technique of production, then the same needs to be financed through bank credit. Since the economy is in equilibrium, there are no surplus funds to finance the new venture.

  With the additional funds from the banking system, the firm keeps on bidding higher prices for the inputs with a view to withdrawing them from the other less important uses. With an increased expenditure in the economy, the price begins to rise. This process further expands, when other firms try to imitate the innovation and raise additional funds from the banking system. As the innovation gets widely adapted the output begins to flow in the market. This marks the beginning of prosperity and expansion.

  But after a certain level, with an increase in the level of output the price and profitability decreases. This is because the further innovation does not come by quickly and thus, there will be no additional demand for the funds. Instead, the firms which borrowed the funds from the bank start paying it back. This results in the contraction in money supply and hence the prices fall further. The process of recession begins and remains until the equilibrium in the economy is restored.

• Second Approximation: The second approximation deals with the waves generated by the first approximation. The speculation is the main element of the second approximation. As the primary wave of expansion begins, the investor, particularly in capital goods industries, expects this upswing to remain permanent and hence borrows heavily.

  Even the consumers expecting the prices to increase in future go into debt to acquire durable consumer goods. This heavy indebtedness turns out to be havoc when prices begin to fall. Both the investors and consumers find it difficult to meet their obligations, and this situation leads to a panic and then depression.

• Schumpeter's prediction of the eventual end to capitalism and transition to socialism different from Marx’s:

Schumpeter devoted to an analysis of Marxian thought and the place within it for entrepreneurs. Noteworthy is the way that Schumpeter points out the difference between the capitalist and the entrepreneur, a distinction that he claims Marx would have been better served to make. The analysis of Marx is broken down into four roles that Schumpeter ascribes to the writer (prophet, sociologist, economist, and teacher). The section Marx the Prophet explains that if nothing else Marx would have been received well by people who needed a theory to explain what was happening in their society. The section Marx the Sociologist focuses on how Marx's theory of class fits in with the larger intellectual traditions of the day and how it superseded them in at least its ability to synthesize sociological thought. The section Marx the Economist focuses on Marx's economic theory and judges it excessively "stationary" . He also deals with the concept of crisis and business cycle, two economic theories that Marx pioneered. Marx the Teacher, evaluates the usefulness of Marx's thought to interpret the events of his time and those between his death and Schumpeter's time. Schumpeter claims that any theory of crisis gains support when crises occur, and points to some areas where Marx's theories have failed to predict.