The Schumpeterian Theory of Economic Growth and Development

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Schumpeter assumes a perfectly competitive economy, which is in stationary equilibrium. In such a stationary state, there is perfect competitive equilibrium, no profits no interest rates, no saving, no investment and no involuntary unemployment. This equilibrium is characterized by what Schumpeter terms as “circular flow” which continues to repeat itself in the same manner year after year. In the circular flow, the same products are produced every year in the same manner. To Schumpeter, “a circular flow is a stream that is fed from continually flowing strings of labour, power and land, and flows in every economic period into the reservoir which we call income, in order to be transformed into the satisfaction of wants”. Development according to him is spontaneous and discontinuous change in the channel of the circular flow, disturbance of equilibrium, which for every alters and displaces the equilibrium state previously existing. These spontaneous and discontinuous changes in economic life are not forced upon it from without but arise by its own initiative from within the economy and appear in the sphere of industrial and commercial life. Development consists in the carrying out of the new combinations for which possibilities exists in the stationary state. New combinations come about in form of innovations. Innovation: This may consist of, the introduction of a new product, a new method of production, opening up of a new market, conquest of a new source of supply of raw materials and carrying out of new organization of any industry like creation of a monopoly. According to Schumpeter, it is the introduction of a new product and the continual improvements in the existing ones that lead to development. Role of innovator: Schumpeter assigns the role of innovators not to the capitalist but to the entrepreneur. An entrepreneur is the one who introduces something entirely new and is motivated by the joy of creating, of getting things done, or simply of exercising one’s energy and ingenuity. Role of profits: An entrepreneur innovates to earn profits. According to Schumpeter, under competitive equilibrium the price of each product just equals its cost of production, and there are no profits. Profits arise due to dynamic changes resulting from an innovation. Breaking the circular flow: Schumpeter’s model starts with the breaking up of the circular flow within innovation in the form of a new product by an entrepreneur for making profits. In order to break the circular flow, innovating entrepreneurs are financed by bank credit expansion. Once the innovation becomes successful and profitable, other entrepreneurs follow it in swarm like cluster. Innovation in one field may induce other innovations in related fields. The speed of innovation is shown in figure below, where percentage of firms adopting a particular innovation is on vertical axis and time taken on horizontal axis. The curve OI shows that firms adopt an innovation slowly to start with but soon the adoption of innovation gain momentum. However, it never reaches 100 per cent adoption by firms.



Cyclical process: since investment is assumed to be financed by creation of bank credit, it increases money incomes and prices and helps to create a cumulative expansion throughout the economy. Hence, increase in purchasing power of consumers raising demand for products of old industries relative to supply. After a period of gestation, new products start appearing in the market displacing old products and enforcing a process of liquidation, re adjustment and absorption. Schumpeter also believes in the existence of Kondratieff long wave of upswings and downswings in economic activity. Each long wave upswing is brought about by an innovation in the form of new product, which leads to further innovation in the methods of production....
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