A Business Encyclopedia

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 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.

The Schumpeter’s theory of innovation suffers from the following criticisms:

  • It is not only difficult but also unavailing to perform the objective evaluation of Schumpeter’s theory of the business cycle because its arguments are more based on the sociological factors rather than the economic factors.
  • Schumpeter’s theory is not basically different from the over-investment theory; it differs only in the respect of the cause of variation in investment when the economy is in stable equilibrium.
  • Like other theories of the business cycle, this theory also leaves out other factors that cause fluctuations in the economic activities. Innovation is not the sole factor, rather is only one of the factors that cause fluctuations in the economy.

In spite of these shortcomings Schumpeter’s theory of innovation is widely acceptable in the modern economy and is used to determine the economic fluctuations.

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