In this article we will discuss about the innovation theory of business cycles. Also learn about its criticisms.

Joseph Schumpeter offered his own explanation of trade cycles on the basis of the timing of major innovations in a capitalist system. He has suggested an explanation of the business cycle in items of innovations that take place in the economic system of a capitalist country at periodic inter­vals.

By innovations, he means the introduction of new product or a new process (a new method of producing an old product).

In broad sense such innovations may refer to changes the existing methods of production, or all of the following things:


(i) The introduction of a mechanical invention in agriculture like tractors and pump-sets;

(ii) The introduction of a new product like a computer;

(iii) The introduction of a new technique of production such as a laser printing;

(iv) The development of new markets for the existing products;


(v) The development of new sources of raw materials for produc­ing old products;

(vi) The development of new variety of raw materials and at low cost;

(vii) The introduction of changes in the forms of business organisation;

(viii) The introduction of new methods of management in business such as time management, or just-in-time inventory management.


In a free enterprise or capitalist economy, great, though temporary, rewards are received by the successful innovator. Major technological breakthrough or product and processes innovations such as railroads, automobiles and electricity bring bursts of expanding economic activity. In this context, we may cite the examples of some of the major innovations of the mid-twentieth century such as the jet-airliners, nuclear-powered electricity generating stations, automobile plants, etc.

Ultimately, these booms run their course and give way to relative de­clines in business activity as the economy waits for the next burst of innovation to occur. ‘Long waves’ or cycles of economic activity may be traced (after the fact) to major innovations.

In Schumpeter’s scheme of things, innovations are of the two broad categories:

(i) Greater waves of innovations, and

(ii) Smaller waves of innovations.

Only the former tends to cause the long business cycle (long waves).

Schumpeter sought to explain the upswing and the downswing of the business cycle in terms of industrial innovations. According to him, as soon an innovation occurs, it causes a disequilibrium in the existing economic system. Such a disequilibrium persists till there is the required re-adjust­ment so as to restore equilibrium or to take the economy to a new equilib­rium position.

Schumpeter also made the prediction that capitalism would sooner or later be replaced by an alternative economic system. According to Schumpeter, business cycles are simply a part of the capitalist system and cannot be eliminated.

Criticisms of the Theory:

This theory has been criticised on two main grounds. Both the criticisms spring from the unrealistic assumptions on which the theory is based. First, it assumes that the economy is already in a situation of full employment. Now, this assumption is totally wrong.


In general, the capi­talist economy reaches equilibrium at less than full employment, in which case an innovation is unlikely to result in the withdrawal of productive factors from the existing industries. Secondly, the assumption that every innovation in business financed through expansion of bank credit (which ultimately creates an inflationary situation) is also partly baseless.

The innovations are mostly financed by drawing upon the excess reserves specially kept for the purpose rather than through fresh expansion of bank credit. If this is so, business innovations are unlikely to generate inflationary pressures in the economy.


This, however, does not imply that the innovation theory does not have any practical use. There is no doubt that major innovations often provide an important stimulus to business activity. But, as an explanation of business cycle, the theory is not only inadequate, but far from perfect.