Question

4. Explain the concept of “Creative Destruction”. Who came up with it? Does this concept support or oppose subsidies to failing firms? How do you define a failing firm?

Answer 1

Creative destruction refers to the incessant product and process innovation mechanism by which new production units replace outdated ones. This restructuring process permeates major aspects of macroeconomic performance, not only long-run growth but also economic fluctuations, structural adjustment and the functioning of factor markets. Over the long run, the process of creative destruction accounts for over 50 per cent of productivity growth. At business cycle frequency, restructuring typically declines during recessions, and this add a significant cost to downturns. Obstacles to the process of creative destruction can have severe short- and long-run macroeconomic consequences.

Creative destruction refers to the incessant product and process innovation mechanism by which new production units replace outdated ones. It was coined by Joseph Schumpeter (1942), who considered it ‘the essential fact about capitalism’

This concept is in favour of subsidies to failing firms. This, they support by saying, that subsidizing bank loans helped failing firms in the sense, that after the reforms, firms’ exit rates and asset reallocation rise, and are more correlated with performances.

Failing firm is defined if:

• If a firm becomes unprofitable, then it should close down so that resources, (labour and capital) can move into more productive and profitable firms and industries. If this firm doesn't close down, it is a failing firm.
• The threat of going out of business is an incentive for firms to move with the changing market and keep costs low. For example, in an electronic age, newspapers are needing to re-invent themselves with an online presence. IF this innovation is not present, it is a failing firm.