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The Schumpeterian theory:

Introduction:
Joseph Alois Schumpeter, a great admirer of the capitalist system has provided a penetrating
analysis of the origin, evolution, operation and downfall of capitalism and its replacement by
socialism. He accumulated experience as a legal practitioner, manager of the financial
affairs of a princess, economist, advisor, finance-minister, president of a private bank, and as
a professor of economics at Harvard in 1932.
He wrote on a variety of subjects.
Schumpeters ideas about economic development first appeared in the book theory of
economic development published in German in 1911, and its English edition appeared in
1934. later, he refined and published his ideas and gave a complete version of his theory of
economic development in his works business cycles (1939) and capitalism, socialism and
democracy(1942). Irma Adelman asserts that, the main problem which Schumpeter
addressed himself throughout his work was how to explain the process of economic
development.
Main features of Schumpeters theory:
The main features of Schumpeters theory of economic development are as follows:
1. Circular flow
2. The role of entrepreneur
3. Business cycle or cyclical process.
4. End of capitalism
1. Circular flow: Schumpeter devotes the first chapter of his book theory of economic
development to the study of the concept of circular flow. According to him, in a circular
flow, from which we always start, the same products are produced every year in the same
way. For every supply there awaits somewhere in the economic activities are repetitive . It
means that the supply and demand are in equilibrium at each point of time and the economy
is in its stationary state. Circular flow is based upon a state of perfect competitive economy
which is in stationary state, there is perfect competitive equilibrium.
The costs of the firms are equal to the receipts; the prices are equal to average costs. There
are no profits no interest rates, no savings, no investment and no unemployment. According
to Schumpeter this stationary equilibrium is characterized by the circular flow which
continues to revive itself every year in the same system as the blood circulates in a human
body.
As regards economic development Schumpeter in his theory states that, the development is
spontaneous and discontinuous change in the channels of the circular flow, disturbance of
equilibrium which forever displaces the equilibrium state previously existing. Schumpeter
theory of development is the key element of dynamic process which basically consists of new
resource combinations, so called innovations or technological changes. When innovations or
changes (economic, social, political and technical) take place in the economy, the stationary
equilibrium or circular flow is displaced and the process of development starts
The main features of circular flow are as follows:
1. All economic activities are essentially repetitive and follow a familiar and routine course.
2. All the producer knows the demand for goods in an economy, and adjusts the supply of the
output accordingly. In other words, the demand and supply are in equilibrium at each point
of time.
3. The economic system has the optimum level of output and its maximum uses. There is no
possibility of wastages of resources.
4. The firms working in the system are in the state of perfect competitive equilibrium, that
is, the firms are of optimum size. The factors of production are paid according to their
marginal product.
5. Under the stationary equilibrium of the economy, the prices everywhere are equal to the
average cost of production. In other words, the profits are zero or the profits opportunities
do not exist at all. Interest rates tend to be zero and there is no possibility of involving
unemployment of resources.

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The above features imply that the circular flow is used in static setting. To make it dynamic
and consistent with development, changes must take place in the economic system. These
changes can be brought through innovations.
Innovations: Innovations may be defined as a change in the existing production
system introduced by the entrepreneur with a view to making profits and reducing costs.
The innovation is closely linked with Schumpeter defined development as a, spontaneous
and discontinuous change in the channels of flow, disturbance of equilibrium which, forever
alters and displaces the equilibrium state previously existing.
When changes (economic, social, political or technological) take place in the economy, the
circular flow is disturbed and the development process starts. He assumed that change is
the basic element of dynamic process and those changes come in the form of innovations.
The innovations may consist of the following aspects:
1. The discovery of the new source of raw-materials.
2. The presentation of a new product.
3. The implementation of the modern method of production.
4. The search of new markets.
5. The creation of monopoly or establishment of a new type of industrial organisation.
Schumpeter, thus, lays emphasis on the introduction of new products through the
improvements in the technological and other economic and non-economic resources which
lead to economic development.
2. The role of the entrepreneur as an innovator: Entrepreneur is the key figure in
Schumpeters analysis of the process of development. Schumpeters model starts with the
breaking of circular flow with an innovation in the form of a new product. He occupies the
central place in the development process because he initiates development in a society and
carries it forward. As a matter of fact, entrepreneurship is different from the functions of a
manager. A. manager simply manages the affairs of an enterprise whereas the entrepreneur
also takes high degree of risk. The role of an entrepreneur has been glorified by
Schumpeter on the basis of functional abilities. According to him, entrepreneurs is to
a. Appreciate the possibilities of innovation
b. Overcome the socio-psychological barriers against the introduction of new things,
c. Direct the means of production into new channels
d. Persuade the banker to provide him with necessary finance for innovations.
e. Induce other producers in his branch of activity for taking risk.
f. Create an environment conducive to the satisfaction of wants as the normal motive.
g. Provide leadership and
h. Take high degree of risk in the economic world.
Though Schumpeter has given a comprehensive explanation about the role of entrepreneur,
but it cannot be considered an adequate explanation of the general theory of capitalistic
development. For entrepreneur himself is a product of social environment, which compels
him to innovate or get eliminated, because, of the forces of competition. Despite this fact,
credit goes to Schumpeter who has emphasized the role of an entrepreneur in the capitalist
development.
The entrepreneurs require two things to perform his functions.
Firstly, there must exist technical knowledge with which the entrepreneur can introduce new
products or new combinations of factors of production. This according to Schumpeter does
not pose a problem because there always exists the reservoir of unused technical inventions,
which can be explored and exploited by the prospective entrepreneurs; secondly, in order to
carry out the new inventions the entrepreneur requires the services of the factors of
production. For this he needs purchasing power in the form of credit and capital, which can
be provided by banks and other financial institutions. Thus credit and banks play an
important role in the economic development of a country.
Role of Profits:
An entrepreneur innovates so as to earn profits. Profits are conceived, as a surplus over
costs- a difference between the total receipts and outlay- as a function of innovations.
According to Schumpeter under competitive equilibrium the price of each produce just

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equals its cost of production and, thus, there are no profits. According to him, profits arise
on account of dynamic changes resulting from innovation. They continue to exist till the
innovation becomes general.
Breaking the circular flow:
The central theme of the Schumpeterian theory of economic development lies in the
breaking up of the circular flow with innovation in the form of a new product by an
entrepreneur raising the level of investment in the economy. The bank credit can help
largely in this context. Since investment in innovations is risky, the entrepreneurs must pay
interest on it. Once the new innovations prove to be more profitable and quite successful,
other entrepreneurs also follow them in swarm like clusters. Innovations in one field may
stimulate innovations in other allied fields. But the trend of the expansion of innovations in
other firms is never found to be 100%.
3. Business Cycle or Cyclical process: The next component of development
according to Schumpeter is the business cycle. To analyse the business cycle is to analyse
the economic process under capitalism. Schumpeters approach to business cycle or crisis is
historical, statistical and analytical- he believes that business cycles are not merely the
result of economic factors but also of non-economic factors. Schumpeter concludes that
crisis is the process by which economic life adapts itself to the new economic conditions.
Bank credit is an essential element of Schumpeters model, according to Schumpeter, the
creation of bank credit is assumed to accelerate money incomes and prices in the economy.
It creates a cumulative expansion through out the economy, with the increase in the
purchasing power of the consumers, the demand for the products increases in relation to
supply. The rising prices and high rates of profits stimulate producers to raise investments
by borrowing from the banks. The secondary wave of credit inflation starts with the
entrance of new entrepreneurs in the field of production which superimposes on the primary
wave of innovations. This may be called boom or prosperity. Extreme optimism and
speculation in business also further enhance prosperity.
During prosperity new products start appearing in the market with the entrance of new
entrepreneurs. These products displace the old ones and thus decrease their demand and in
the market. Consequently, the prices of old products fall, with a view to liquidating their
stocks, the old firms start selling their goods at a low price and hence most of the firms incur
losses. Investment declines and unemployment starts, leading to a fall in the aggregate
demand. As the entrepreneurs start repaying bank loans, the quantity of money in
circulation is reduced and prices start falling. Profits too decline and come to zero,
uncertainty and risk increases. A wave of pessimism sweeps the entire economy, boom ends,
and phase of depression starts.
Schumpeter believes in the existence of the long wave of upswings (boom) and downswings
(depression). Once the upswing begins, ultimately, the economic force of recovery comes
into operation and brings about a revival, once again the economies come across new
equilibrium, and the new boom period starts.
End of capitalism:
Like Karl Marx, Schumpeter also believes that capitalism is self-destructive. He stated,
there is inherent in the capitalist system a tendency towards self destruction, those factors
make not only for the destruction of the capitalist system but for the emergence of socialist
civilization.
Schumpeter agrees with the Marxian thesis that capitalism has itself the seeds of its own
destruction and ultimately it will come to an end. The very success of capitalism will bring
about its decay. According to Schumpeter, capitalism cannot survive; it will die on its own
accord. It will ultimately give place to socialism.
A Critical appraisal:
Schumpeter theory of economic development has a ring of greatness. And within the
assumptions of the model, it may be regarded as a major analytical achievement. His
analysis of the process of capitalist development is appreciable and outstanding. He has
very cleverly enlightened the role of entrepreneurs in the progress and development of the
capitalist order. Schumpeters steers clear of such inhibiting factors of classical and neo-

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classical theories like dimishing returns, over population and mal-distribution of incomes.
Moreover, in place of pessimistic forebodings of classical that the economy is doomed to a
stationary state or stagnation, the theory visualizes ever-rising levels of real income with
Ofcourse temporary interruptions. Though Schumpeters theory is replete with brilliant
reasoning and the insights of a great theorist, yet it suffers from the following weaknesses
and criticisms.
1. Role of entrepreneur over-emphasized: Schumpeters theory of economic
development has unduly highlighted the role of an entrepreneur. An entrepreneur is the
prime mover of economic development. It was true almost in the 18 th and 19th centuries
when entrepreneur used to perform the functions of an innovator. However, in the modern
economic world, the act of entrepreneurship and innovation is not the work of an individual.
It is carried out by companies and that too through a group of individuals, with its
membership changing, as a result no single or particular individual or entrepreneur is
identified as responsible for introducing innovations. Even the inventions now-a-days is the
product of team work and not of an individual.
2. Analysis of capitalist process not convincing: According to Meir and Baldwin,
Schumpeters broad socio-economic analysis of capitalist process is generally admired. Yet
few seem prepared to accept his conclusions. His arguments are stimulating but not
completely convincing.
3. Emergence of socialism got based on sound reasoning: Schumpeter has not
convincingly explained as to how capitalism will eventually be replaced by socialism. His
unawareness about this factor is evident 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. As a matter of fact, Schumpeters analysis of the end of capitalism is emotional
and not real.
4. Analysis of cyclical process is wrong: Schumpeters idea that the economic
development is the result of the cyclical process is wrong. According to Nurkse, economic
development is related to continuous changes.
5. Undue importance to bank credit: Schumpeter has given undue importance to
bank credit. Bank credit may be important in the short run when the industrial concerns get
credit facilities from the banks. However, in the long run when the need of capital funds is
greater or long term capital is required bank credit is insufficient. For this, business houses,
have to float new shares, debentures etc in the market.
6. Innovation is not the main cause of economic development: Schumpeter
regards innovations as the main cause of economic development. However, this view is far
from real, because economic development of a country does not depend on innovations only
but also on many economic and social factors.
7. Little Relevance for underdeveloped countries: When viewed from the point of
view of an underdeveloped country, Schumpeters theory is found to be grossly inadequate.
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