Schumpeter’s Theory of Economic Development

Schumpeter’s theory of development assigns paramount role to the entrepreneur and innovations introduced by him in the process of economic development. According to Schumpeter, the process of production is marked by a combination of material and immaterial productive forces. The material productive forces arise from the original factors of production, viz., land and labour, etc., while the immaterial set of productive forces are conditioned by the ‘technical facts’ and ‘facts of social organization’. The Schumpeterian production function can, therefore, be written as –

Q = ƒ [k, r, I, u, ν) …(1)

Where, Q stands for the output, k for the Schumpeterian concept of “produced means of production”, r for natural resources, l for the employed labour force.

The symbol u represents the society’s fund of technical knowledge and ν represents the facts of social organization, i.e., the socio-cultural milieu within which the economy operates.

The above function shows that the rate of growth of the output depends upon the rate of growth of productive factors, the rate of growth of technology and the rate of growth of investment friendly socio-cultural environment. Schempeter held that the alterations in the supply of productive factors can only bring about gradual, continuous and slow evolution of the economic system. On the other hand, the impact of technological and social change calls for spontaneous, discontinuous change in the channels of output flow.

Thus taking into account these two types of distinct influences Schumpeter distinguished two components in the dynamic evolution of the economy –

(a) the “growth component” which brings about gradual, continuous and slow evolution due to the changes in the factor availability,

(b) the “development component” which brings about spontaneous and discontinuous change in the channels of output flow due to changes in the technical and social environments.

Schumpeter regarded land to be constant. The growth component will, therefore, include only the effects of changes in population and of increase in the producer goods. But Schumpeter further maintains that there does not exist any a priori relationship between the changes in population and the changes in the flow of goods and services. In other words, Schumpeter considers the population growth to be exogenously determined. Now, the increase in producer goods results from a positive rate of net savings. The major part of savings and accumulations are attributed by Schumpeter to profits. But, according to him, the profits can arise if innovations such as new techniques of production are employed or if new product is introduced. Hence ultimately it is the change in the technical knowledge (i.e., variable u) which is responsible for any change in the stock of producer goods, i.e., the rate of capital accumulation directly depends on the rate of technical change.

Regarding the historical development, Schumpeter subscribed to Marx’s materialistic interpretation of history and he maintained that the economic state of people emerges only from the preceding total situation. However, the most important point of Schumpeter’s theory is that the expansion of output depends upon the history of technological development. In simple words, we can say, according to Schumpeter, the growth of output is geared to the rate of innovations.

No doubt, Schumpeter holds that the trend of economic growth shall be fixed by the exogenous variable of population growth, yet according to him, the process of economic development is synonymous with discontinuous technical change, i.e., innovations. The agent which brings about innovations is called by Schumpeter as entrepreneur. Thus, entrepreneur becomes the pivot of Schumpeter’s model.

Role of Entrepreneur as an Innovator:

In economic development as outlined by Schumpeter, the entrepreneur plays a key role. The credit for innovations and the outburst of economic activity goes entirely to the entrepreneur.

Innovation consists in:

(i) Introduction of anew good,

(ii) Introduction of a new method of production,

(iii) The opening of a new market,

(iv) The discovery of a new source of supply of raw materials or semi-manufactured goods, and

(v) Introduction of a new organisation in an industry.

In a world characterised by a high degree of risk and uncertainty, only businessmen of exceptional ability and daring will be able to undertake innovations and launch enterprises and exploit opportunities for profit. But these entrepreneurs are not only lured by profit but are also motivated with a desire to found a dynasty in the business world or a desire for conquests in the competitive world or have the joy of creating. Thus, in the Schumpeterian analysis, the role of the entrepreneur is a determining factor of the rate of economic growth. In his absence the growth rate is bound to be slow.

The supply of entrepreneurs depends not only on the rate of profits (which is obvious) but also on the favourable social climate. They will appear and continue only in a society which honours them, where prestige is attached to them and the social rewards or recognition they are able to earn. In short, the conditions or social values in which they have to operate must be favourable. The rate of profit is an unfailing thermometer of the favourable climate. Any tendency to squeeze profits, increase taxes, intensify welfare programmes, strengthening of the trade union movement or measures of redistribution of income will deteriorate the climate for investment and so for economic development.

Development Cycle-The Circular Flow and the Process of Creative Destruction:

Schumpeter’s starting point in the “circular flow” is a stationary equilibrium in which there is no investment, population growth is at a standstill position and there is full employment. But there are numerous opportunities in business which the entrepreneurs are quick to exploit and innovations are undertaken. The success of the original innovators attracts ‘swarmlike’ many others who follow them. Economic activity becomes more and more brisk and the boom gathers momentum with the result that prices and money incomes rise. There is then the secondary economic wave ‘imitative investment’ superimposed upon the earlier one, i.e., ‘innovational investment’.

But soon follows the process of creative destruction. The boom gives way to slump or recession. Completion of innovations brings in a large supply of goods which cannot be marketed at profitable price. There are forced bankruptcies since the banks call back loans. The repayment of bank loans accentuates deflationary forces. Business risks scare away the prospective entrepreneurs. In this unfavourable climate, the innovational activity comes to a halt. After this painful process of adjustment in which weak enterprises are liquidated, the businessmen find conditions again ripe for a further spurt of entrepreneurial activity. The economic activity is resumed at a higher equilibrium. This is how the circle of development process is completed. There is a new wave of innovations and the development cycle repeats itself.

Role of Credit:

Another new point introduced by Schumpeter in this analysis of economic development is the important role that credit plays in economic development. It is not the saving out of current income which supplies funds for investment, but the credit creation by the banking system. The classical and the neoclassical economists thought in terms of given supply of money or the supply coming forth to match the increased supply of goods and services, so that the price level is not affected. To them “money is a mere veil which tends to hide the behaviour of the basic forces at work”.

But Schumpeter makes credit creation an integral part of the development, process. In this analysis the entrepreneurs expand their business merely by borrowing from banks who will lend not because some persons have made savings and deposited in the banks. But the banks just create credit themselves to accommodate the business borrowers. This pushes up the prices. “Thus credit- creating facilities tend to free investors from the voluntary abstinence routine of the savers. Forced savings become an important means of capital accumulation.”

Two points are worth mentioning in regard to Schumpeter’s analysis of development process in a capitalist society. In the first place, the dominance of the entrepreneur or the producer limits and reduces correspondingly the sovereignty of the consumer. The producer does not passively produce the goods as dictated by consumers’ tastes and preferences. By his dynamic role, through high pressure of salesmanship, he attempts and succeeds fairly in changing even the tastes of consumers or in creating in them new wants and desires.

This again emphasises the crucial role of the entrepreneur in giving new directions and dimensions to the development process. Secondly, unlike the neoclassical economists who believed that the process of economic development was gradual and harmonious, Schumpeterian analysis brings out the uneven and disharmonious nature of economic growth. It proceeds by spurts and leaps and bounds. “The essence of development is a discontinuous disturbance of the circular flow.” This disturbance appears in the form of innovations. This arises from the fact that the world is dynamic and not static. In the static world rational calculations are possible and reasonable forecasting is feasible, but the dynamic world is full of risk and uncertainty mainly arising from the innovational activity of the entrepreneur who is able to exploit new investment horizons.

Capitalism- Its Potentialities and its Degeneration:

The classical economists were depressed by the inexorable law of diminishing returns and the irresistible growth of population. Schumpeter does not share their pessimism. He also does not believe in the inherent tendency towards a maldistribution of incomes resulting in ever-recurring severe crises as Marx did. Nor does he agree with the stagnationists that there is persistent lack of investment opportunities together with institutional rigidities making for an equilibrium at less than full employment. Schumpeter, on the other hand, has faith in the capacity of the capitalist system in attaining ever increasing levels of national output and income. He is prepared to admit, however, that there might be temporary setbacks.

Although Schumpeter has infinite faith in the potentialities of capitalism, but he also believes in a Marxian fashion that the very success of capitalism will breed the germs of its ultimate degeneration which will pave the way for socialism. In Schumpeter’s view, it is not failure of capitalism which will spell its doom, but its very success that would result in killing the goose that lays the golden egg. He thus says – “The actual and prospective performance of the capitalist system is such as to negative the idea of its break-down under the weight of economic failure, but its very success undermines the social institutions which protect it, and inevitably create conditions in which it will not be able to live and which strongly point to socialism as the heir apparent.” In other words, it is not the economic barriers but social factors which will undermine capitalism.

According to Schumpeter, the economic and social foundations of capitalism will crumble on account of:

(a) The decay of the entrepreneurial function,

(b) The destruction of the institutional framework, and

(c) The disintegration of the protecting political framework.

The entrepreneurs make their business grow so big that innovation itself becomes a routine and is in the charge of salaried persons and technological progress now becomes the province of specialists; marketing and administration become automatic. “Innovation thus degenerates into a depersonalised routine activity carried on in big business through a bureaucracy of highly trained managers.”

This is how the entrepreneurial function is rendered obsolete. The concentration of business and the growth of monopolies destroy the institution of private property and freedom of contract. Whereas ‘bigness’ contributes to more rapid economic progress, it also weakens the concepts of private property and freedom of contract. In a big business corporation, the proprietary interest is replaced by shareholders, big and small, none of whom is particularly interested in the business. The part that the proprietor used to play is now played by professional salaried managers.

The social class that used to protect capitalism also loses its political power which is captured by a new group of politicians who are ill-equipped to rule and unwilling to support the established trade and industry. They adopt policies inimical to capitalists’ interest. This is what we are witnessing in India. The common people and many politicians are now positively hostile to big business like the Birlas, Tatas and Ambanis. The intellectuals who derived freedom and power from capitalism now lead the anti-capitalist groups. The educated unemployed is another group of ‘have-nots’ against the capitalist class of ‘haves’. Labour also organises itself for fight against capital and the intellectuals supply the leadership. All these new forces lead to the gradual degeneration of capitalism and strengthen the movement towards socialism. Capitalism cannot function in this new atmosphere.

Apart from differences in emphasis, three major differences may be noted between the Classical School of Marx and the Schumpeterian analysis:

(a) Schumpeter introduces interest rate as a determinant of savings which is an important factor in economic development’,

(b) He separates the autonomous investment from the induced investment and emphasises innovations as the factor affecting autonomous investment; and

(c) He regards entrepreneurship as the vital force which shapes an economy.

Evaluation of Schumpeter’s Theory of Development:

Schumpeter has been a great ‘theorist’ whose writings contain brilliant thoughts and a deep insight into the working of an economy. However, his analysis of the entrepreneurial innovations is not applicable to modern conditions in which the act of invention and innovation is carried on not by individual entrepreneurs but by large corporations as a routine affair. It is not possible to identify entrepreneurs who introduced many actual innovations. He himself recognises the tendency towards obsolescence of the entrepreneur.

It has been pointed out by critics that what Schumpeter gives is the theory of business cycles and not an analysis of economic development. Even Schumpeter’s analysis of business cycles can be accepted only with some modifications to suit modern economic conditions. According to Shumpeter, crisis in capitalism is brought about by maladjustment caused by waves of innovations. But big businesses in modern times can absorb these waves and produce steadier and larger expansion of the total output. Further, the main cause of business cycles is fluctuations in aggregate demand as pointed out by J.M. Keynes.

The assumption that innovations are financed by borrowing from credit creation by the banks is also not very realistic. It is a well-known fact that most of the bank loans are short-term loans whereas the implementation of innovations requires long-term finances. The long-term projects are financed by retained profits or by the issue of shares and debentures by the companies concerned.

Schumpeter’s socio-economic analysis of the capitalist process is also not fully convincing. He seems to overemphasise the influence of economic factors on social culture. It is not one-way link between rationalism in economic matters and rationalism in other fields, social and political. Not many would agree that capitalism was about to crumble and socialism was round the corner.

Capitalism in countries like the U.K. and the U.S.A. which were its traditional homes too strongly established themselves to yield place to socialism. Only, we can say with him that the nature of capitalism has changed. There is no doubt that the political strata protecting the old type capitalism are weakening and the traditional entrepreneurship too is becoming obsolete, as Schumpeter said. But it does not mean that capitalism is about to collapse and socialism is coming.

On the contrary, it is socialism that collapsed in eighties of the 20th century. In both Soviet Russia and Republic of China socialism came to end and in its place free-market economy came into existence. Meier and Baldwin rightly write- “Although Schumpeter’s analysis is provocative, it seems one-sided and overemphasised. To recognise that history involves perpetual change is quite different from concluding that a socialist form of society will emerge from an equally inevitable decomposition of capitalist society.”

Relevance of Schumpeter’s Theory for Developing Countries:

The conditions obtaining in Western Europe and America after the First World War presented a capitalist system in full swing, wherein the innovator acted as the initiator and controller of economic development. Schumpeter’s observant eye got the clue to formulate a theory of development presenting a unified view of the whole economic process. Schumpeter viewed “development” as a distinct phenomenon which, he says, “is spontaneous and discontinuous change in the channels of flow, disturbance of equilibrium, which forever alters and displaces the equilibrium state previously existing.”

This springs from changes in the economic life due to endogenous factors (initiated from within) and not exogenous factors which are forced upon it. Explaining his contention further, he holds that “Should it turn out that there are no such changes arising in the economic system itself, and that the phenomenon that we call economic development is in practice simply founded upon the fact that the data change and the economy continuously adapts itself to them, then we should say that there is no economic development.” This concept wherein endogenous changes in the economy act as the sole prime mobile of development restricts the relevance of Schumpeter’s theory to the growth problems of developing economies.

Rigid and outmoded socio-economic institutions, low saving potential and laggard technology are completely incapable to generate developmental impulses from “within” in the underdeveloped countries. They have to take recourse to imported capital, technology and skill to initiate and propel their developmental wheels. For instance, India made a big stride forward in growth and it has sought foreign capital to help in its economic development. It has also gone for foreign collaboration in terms of loan, equipment, skill and technical know-how. Since factors from ‘without’ are responsible for initiating and operating development projects, they cannot, according to Schumpeter, be regarded as embodiments of India’s genuine process of economic development. This contention of Schumpeter is unsustainable and unconvincing.

It cannot be gainsaid that every such plant has generated a developmental wave in the Indian Economy. Thus, Alfred Bonne remarks, “Exclusion from Schumpeter’s definition would not make the new plant cease to be a case of development, having in view precisely those goods which are the essential objectives of development activities in economically backward countries.” In this view, therefore, Schumpeter’s theory of development is incongruent with the conditions prevailing in the developing world.

Further, Schumpeter’s preoccupation with only the endogenous factors and his insistence on development as embodying only the spontaneous and discontinuous changes makes him oblivious of the role of population growth as an economic force in the developmental process. He regarded population as exogenously determined and held that there does not exist any deterministic a priori relationship between population growth and variations in the flow of goods and services. But it is precisely the excessive population pressure that is responsible for revolutionising the methods and techniques of agricultural production in the presently overpopulated developing countries.

In fact, some of the post-Keynesian theories regard population growth as a stimulant for autonomous investment. By failing to take proper cognisance of one of the most vital phenomena operating in the presently underdeveloped economies, Schumpeter rendered his theory almost ineffectual to such countries.

Further, the existence of a business elite, i.e., the entrepreneurial class, is fundamental to Schumpeter’s theory of economic development. The carrying out of innovations and using new production functions is the prerogative of this elite group of private entrepreneurs. However, there are serious doubts about the effectiveness of this social group in the development of the developing countries. The contemporary history of economic development of these countries provides ample evidence to reveal that it is not only the private entrepreneurial class, but also the national governments that are responsible for preparing and launching programmes of industrialisation.

With the development process of these countries being rapidly imbued with the socialistic hues, their governments have increasingly assumed the role of a national entrepreneur. Not the innovations of the private entrepreneur but the “government action and mass impulses today seem to be the most characteristic motive forces of economic development.” So much so that even in the private sector of these economies the entrepreneurs cannot fulfill their functions without the active and substantial assistance from the government and semi-public bodies. Moved by such a un-Schumpeterian economic landscape in the developing countries, Prof. Gunnar Myrdal remarks that “it represents, indeed, an attempt at a complete reversal of what once happened in the now developed countries as described by the Schumpeterian model.”

In developing economies, a number of factors such as the outmoded socio-economic institutional framework, tradition-ridden investment horizon and unreliable attitude for undertaking of new ventures, have all contributed in denigrating the pivotal role assigned to the Schumpeterian entrepreneur in his functional aspects. The governments of these countries under such conditions cannot afford to remain an idle and passive spectator. It is incumbent for them to come forward and become the herald of industrialization by playing the role of a unified national entrepreneur.

Furthermore, the governments of the developing countries are committed to the rapid creation of ‘social overheads’ or what is now called infrastructure in order to fulfill the popular demand for higher standards of living. The private capital fails to come forward because of the lumpy nature of such investments and the long gestation periods involved. On the other hand, an agency like the government has sufficient means to mobilize the capital resources of the economy through various fiscal and monetary measures and by borrowing from abroad.

The very exigency of the situation in the developing economies compels their governments to shoulder the responsibility of initiating and steering the gigantic task of economic development. Thus, the Schumpeterian model of development which assigns the primary and central role to the private entrepreneur and only a secondary and passive function for the government is a misfit to the conditions obtaining in the developing countries.

Besides, the entrepreneurial innovation so pivotal to the working of Schumpeter’s model has no significance to the process of development in the developing countries. Henry C. Wallich and H.W. Singer have held that due to the demonstration effect on an international plane, the businessmen in the developing countries are prone to import and assimilate the already known technology and methods of production from the developed countries rather than undergo the risks of innovating anew (some of which in any case may prove to be abortive). Hence the development process in the developing countries is increasingly becoming a process of derived development, being based on assimilation of existing innovations made elsewhere rather than on the Schumpeterian type of indigenous innovations.

In the Schumpeterian model, by its very nature and approach, inflationary pressures are bound to operate as the development process gathers momentum. The entrepreneurs’ innovational activity being financed by the credit-creating banking system, credit-creation assumes a vital role in his model. The creation of credit leads to a rise in purchasing power of the community without a corresponding increase in production. Increased purchasing power results in an increased demand for production services and consumer goods. The increased demand coupled with the increased volume of money in circulation results in a general price rise.

But in the consumption-oriented development process of a developing economy, the inflationary tendencies are very powerful, persistent and cumulative in nature. “It is not only development and associated investment that are responsible for inflationary tendencies, but the entire social climate of demand-oriented economy.” They become a serious drag on the development process itself. Thus, the production-oriented Schumpeterian vision of development process fails to realise the hurdles like secular inflation that characterise the consumption-oriented development of the developing economies. What in fact is needed is a totally different framework of analysis and theory that is realistic to the circumstances of these economies.

However, certain aspects of Schumpeter’s model retain universality of application. Irrespective of the type of economy and its stage of development, the importance of innovations as one of the major factors in economic development remains unassailable. ‘Technological possibilities are an uncharted sea’, and in this Apollo age, we can safely assume that the developing countries can hardly afford to remain mere imitators and assimilators.

Even if mere transfer of ready-made and proven techniques of production is sought, there remains the problem of adaptation of foreign technology in the domestic economy. It calls for a certain amount of pioneering spirit and entrepreneurial skill in so far it is new to the country in which it is to be adapted. Further, the risks of transplanting such technology in underdeveloped economics would be considerable. Hence the entrepreneurs in these countries should possess at least some of the basic qualities of the Schumpeterian entrepreneur.

From the point of view of successful development in developing countries Schumpeter’s theory highlights the urgency of bringing about drastic transformation of the tradition-ridden socio­economic institutions and reshaping of the inimical attitudes to develop a favourable climate for the growth of entrepreneurship. Adequate entrepreneurship is one of the prerequisites for sparking off a take-off stage in these countries.

Further, once the process of industrialisation sets apace in the developing countries, Schumpeter’s theory can undoubtedly throw considerable light on the problems associated with the long-run increase in productivity. It shall also provide clues to the problem of absorption of ‘surplus labour’ in gainful employment as a result of innovations. In this way Schumpeter’s theory of development can provide some valuable lessons to the countries for avoiding waste and extra hardships that are liable to attend an unplanned and uncoordinated development.

Criticisms of Schumpeter’s Theory of Economic Development

1. Role of innovator emphasized: Schumpeter theory highlights the role of innovator as the prime mover of economic development. The analysis of the entrepreneurial innovation is highly useful in the development of capitalism. Innovations are only one of many factors causing cyclical fluctuations in a capitalistic economy. But it is difficult to differentiate their innovating activity from their ordinary business activity. The innovational activities have become a matter of routine these days and there is no need of special agent like innovator for carrying on such activities. Thus Schumpeter has over glorified the place of innovator in his model.

2. Role of savings ignored: Schumpeter assumed that innovations are financed by the bank credit and this assumption is not much convincing. Banks usually grant short term loans. He assumes that innovations are financed by the borrowings from credit creating banks. This actually happened in Germany, but in many other countries, this sort of financing does not occur. In this way this theory ignores the important sources of real savings such as deficit financing, budgetary savings, public borrowings and other fiscal measured.

3. Analysis of capitalist process not convincing: According to Schumpeter broad socio-economic analysis of capitalist process is generally admired. Yet few seem prepared to accept its conclusions. His arguments are stimulating but not completely convincing. This theory explains that rational behaviour of innovators and intellectual class is responsible for the success of capitalism.The Schumpeter’s Hero i.e. innovator or entrepreneur is a forward looking man in the economic matters and he is an adaptable individual who can overcome all sorts of difficulties and obstacles. But in social and political field, he may be quite weak. The entrepreneur may not be capable of adjusting to political changes. The success of capitalism does not depend only on the personality and behaviour of the innovator but on the non economic factors too. It is therefore, not convincing that capitalist process always works on the basis of rationality and dispassionate ideas.

4. Emergence of socialism not based on sound reasoning: Schumpeter’s analysis about the emergence of socialism is provocative yet it seems to be one sided and over emphasized. He himself is not quite sure about the way in which socialism will take place of capitalism. His unawareness about this factor is clear from these words, “We know nothing as yet about the precise way by which socialism may be expected to come, except that there must be a great many possibilities ranging from gradual bureaucratization to the most picturesque revolution.” So it is very difficult to conclude that the decomposition of capitalism will eventually lead to composition of socialism.

5. Circular flow based on Say’s law of markets: Circular flow is the first component of the Schumpeterian analysis of economic growth and its features reveal that this concept is very much similar to Say’s- Law of Markets. The circular flow or Say’s law is valid in a stationary society which is not in tune with development process which is dynamic one. It is the dynamic setting which is more conducive to economic development. Hence the assumptions of circular flow are incompatible with the development process.

6. Analysis of cyclical process is wrong: Schumpeter’s view that the economic development is the result of the cyclical process is wrong. According to Nurkse, “Economic development is related to continuous changes”.

7. Undue importance to bank credit: Schumpeter has given undue important to bank credit. Bank credit may be important in the short run when industrial concerns get credit facilities from the banks. However, in the long run when the need of capital funds is greater but bank credit is insufficient. For this, business houses have to float new shares, debentures etc. in the market.

8. Innovations is not the main cause of economic development: Schumpeter regards innovations as the main cause of economic development. However, this view is far from reality because economic development of a country does not depend on innovations only but also on many economic and social factors.

9. Little relevance for underdeveloped countries: In the context of underdevelopment, the Schumpeter theory is found to be inadequate. In underdeveloped counties, the class of innovators is very small because of the small extent of the market, and the low expectation of profits. Schumpeter has talked of a private innovators as the prime mover of economic growth, but in most of the poor countries, the government is the biggest innovator. Again Schumpeter believes that development is the result of domestic forces. But underdeveloped economies depends on imported technology, foreign capital joint collaboration etc. Thus the development process in the backward countries is very much influenced by the exogenous forces in the initial stages of development. Again the underdeveloped countries are under a constant strain of population growth. This factor has not been considered by Schumpeter in his analysis. Population growth creates so many economic, social and political problems, and retards the pace of development process.