Let us make an in-depth study of Schumpeter’s innovation theory of trade cycle.
Joseph Schumpeter considered trade cycles to be the result of innovation activity of the entrepreneurs in a competitive economy.
In his view trade cycles are an inherent part of the process of economic growth of a capitalist society.
Schumpeter develops his model of the trade cycle as consisting of two stages.
The first stage deals with the initial impact of the innovation which entrepreneurs introduce in their production process. The second stage follows as a result of the reactions of competitors to the initial impact of the innovation.
Schumpeter starts his analysis by assuming the equilibrium state of the economic system where all the factors of production are fully employed. Every firm is producing efficiently with average costs equal to price. Product prices are equal to both average and marginal costs.
Profits in the Schumpelerian sense are zero. There is no net saving and no net investment. Schumpeter calls this equilibrium state of the economy as a “circular flow” of economic activity which just repeats itself period after period like the circulation of blood in the animal organism.
The circular flow of economic activity gets disturbed when an entrepreneur successfully carries out an innovation. According to Schumpeter, the primary function of an entrepreneur is innovation activity which yields him real ‘profit’. By an innovation he means “such changes in the production of goods as cannot be effected by infinitesimal steps or variations on the margin.”
An innovation may consist of:
(1) The introduction of a new product;
(2) Adoption of a new method of production;
(3) The opening up of a new market; food
(4) The conquest of a new source of raw materials or semi-manufactured goods; and
(5) Re-organisation of production processes within a firm. Innovations are the commercial applications of inventions by entrepreneurs.
An entrepreneur is not a man of ordinary ability in that he introduces in his business something which is entirely ‘new’ to the existing economic system. He is not a capitalist but an organizer who can mobilise the needed cash for introducing his innovation.
The innovator-entrepreneur requires two things to perform his function; one, technical knowledge for the introduction of innovations, and two finance for the completion of his task. In Schumpeter’s view, a reservoir of untapped technical knowledge exists in a capitalist society on which he can draw for shaping his innovation. Regarding funds, Schumpeter believes that an entrepreneur can attract bank credit easily.
Introduction of an innovation spells a start for the business cycle. As the innovator-entrepreneur begins bidding away resources from other industries, money incomes increase and prices begin to rise thereby stimulating further investment. As the innovation steps up production, the circular flow in the economy swells up. Supply exceeds demand. The initial equilibrium is disturbed.
There is a wave of expansion of economic activity. This is what Schumpeter calls the “primary wave”. This primary wave is followed by a “Secondary wave” of expansion. This is due to the impact of the original innovation on the competitors.
As the original innovation proves profitable, other entrepreneurs follow it in “swarm-like clusters.” Innovation in one line induces innovations in related lines. Money incomes and prices rise. There is a cumulative expansion of economic activity. Since the purchasing power of consumers increases, the demands for the products of the non-innovating industries also go up and their prices are pushed up.
As potential profits in these industries increase, a wave of expansion in the whole economy follows. This is the secondary wave of credit inflation that gets superimposed on the primary wave of expansion. Over optimism and speculation add to the enthusiasm for expansion under boom conditions.
The period of prosperity ends as soon as ‘new’ products induced by the waves of innovations replace old ones. Since the demand for old products goes down, their prices fall and consequently their producer-firms are forced to contract their output.
Some of them may be forced into liquidation. When the innovators begin repaying their bank loan out of the newly-earned profits, the quantity of money in circulation is reduced as a result of which prices tend to fall and profits decline.
In this atmosphere, uncertainty and risks increase. Depression sets in. The impulse for further innovation is sapped up. The painful process of readjustment to the point of “previous neighbor-hood of equilibrium” begins. The economy is on its way downward into depression.
The economy cannot continue in depression for long. Innovation-minded entrepreneurs continue their search for profitable innovations. The natural forces of recovery bring about a revival. Schumpeter points out that the deflationary forces generated by depression are gradually offset by certain other forces one of which is the ‘dilution or diffusion of effects’.
This is the effect of bankruptcies, shut-downs and collapses of individual markets on general economic activity.
The impact of these events goes on falling as these occur. Another factor reducing the effect of depression is that the collapse of some firms enables remaining firms to expand their operations to eater to the market fed by the collapsing firms.
These offsetting influences have a restorative effect. Further, the decline in aggregate consumption throughout the downswing will be less than that in income which results in the depletion of inventories to the point where there is a need to replenish them.
As fresh investments take place, some of the more adventurous entrepreneurs will start innovating. Others follow and investment surges up again in a spurt and another boom are on the way. This completes the phases of a full trade cycle.