Question

What is Schumpeter theory & what is the innovation theory by Joseph Schumpter? in depth explaination

Answer 1

Schumpeter's Theory of Innovation states that business innovations are an important factor for the increase in investments and any fluctuations in business. Schumpeter stated that innovation results in growth of the organization. Under innovation he included changes in production methods, changes in transportation methods, new product development, entering new markets, etc. Innovation doesn't necessarily need to include innovation but more integrated and efficient way to apply technology, utilize new materials and more productivity from new energy sources. Schumpeter's model is developed under two stages,

1. first approximation which emphasizes on the impact of ideas involving innovations. Under this stage, the economy is in equilibrium and there is no involuntary unemployment. Under these conditions, when the firm gets involved in innovations in production techniques it would need to raise funds. As the economy is under perfect equilibrium, there are no funds available in surplus. Hence, the firm borrows from the bank which would result in an increase in the total expenditure in the economy. With the rise in expenditure, the prices would increase. As the innovation starts getting adapted by other firms in the economy, the output would rise, hence resulting in market expansion. However, after a certain stage the output in the economy along with the increased profitability would start to fall. This is because further innovations take longer periods of time and the demand for funds start to decline. The firms are also liable to start paying back for the funds borrowed. This would result in money contraction and the prices start to fall. As a result the economy starts to fall under recession until the original equilibrium of the economy is reached.

2. The secondary approximation stage includes any further responses that come after the application of the innovation. With the increase in prices, the investors start speculating that the rise in prices and profit would be permanent and they borrow in huge amounts. With the expectation that prices would continue to rise, the consumers start borrowing funds too. This results in indebtedness in the economy which would result in a fall in prices. It gets difficult for the consumers as well as the investors to pay back funds which can further lead the economy into a state of depression.

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.