Schumpeterian Growth Via the Industry Life Cycle Hypothesis; An Industrybased Examination of the Current Long Wave As Displayed

in American Manufacturing, 1980-2009; Or, How I Learned To Stop Worrying and Love the Business Cycle1

Anthony Lucci ECO100 Honors Thesis Dr. Conrad Herold Spring 2011

To restate in English, this paper tries to test if long-run business cycle trends are a result of long-run growth trends among the most innovative industries. (ie. Does sustained, diminished growth in the technology sector mean sustained, diminished growth for the greater economy?)

1 Introduction and Literature Review

Kondratiev Waves Kondratiev waves (also known as long waves, long cycles, K-waves, or supercycles) are long-run economy-wide business cycles with a length of some 40 to 60 years that proponents observe at the both national and international level. These long-run fluctuations are named after Russian economist Nikolai Kondratiev (1892-1938, also spelled Kondratieff), who concluded that these cycles were the result of major, paradigmatic, technological change. Since Kondratievs initial discussion of them in the 1920s, long waves have fallen in and out of popularity in the economics profession. While Kondratiev was not the first to describe these long-run fluctuations, he was, as Schumpeter notes, the "one who brought the phenomenon fully before the scientific community and who systematically analyzed all the material available to him on the assumption of the presence of a Long Wave, characteristic of the capitalist process" (Schumpeter 1939, 164). Goldstein identifies two major periods of research and interest in long wave cycles. The first runs from Kondratiev in the 1920s, through Joseph Schumpeter and others in the 1940s, to Gaston Imbert in the 1950s, after which interest trails off and practically disappears in the late 50s and 60s. Long wave cycle theory revives again in the mid-1970s, and grows into a formidable body of theory, with several schools of thought pursuing a wide variety of distinct research programs using a variety of methodologies (Goldstein, chp. 1 and 2). Austrian economist Murray Rothbard once sardonically claimed that the long wave comes back into fashion every time a systemic crisis appears imminent (Rothbard, par. 3).

While working for the Soviet government throughout the 1920s, Kondratiev in fact formulated a few different theories on long waves. These theories can be broken down to two time periods; the Kondratiev of 1925, and that of 1928. In 1925, Kondratiev published works detailing endogenous2 long cycles that also integrated exogenous3 changes such as wars, revolutions and gold production into the model. The idea of the long wave as a war cycle would be later expounded upon by international relations scholars such as Immanuel Wallerstein (Goldstein, chp. 5 and 6). By 1928, Kondratiev had abandoned using the aspects not endogenous to his model to explain long waves. Some economists, most notably Andrew Tylecote, see this abandonment as a retreat in the face of political pressures from within the Soviet government. However, as Vincent Barnett reasons, it is much more likely that Kondratiev sought to focus on an endogenous theory of long cycles driven by innovation because the second approach is much more effective (Barnett, 475). According to Barnett, the notion that Kondratiev abandoned the more political, exogenous factors of his theory out of political pressures is at best unlikely. Joseph Stalin did not closely follow highly technical debates in the economic journals of his time. Besides, Kondratiev was pro-market and opposed farm collectivization in both 1925 and 1928. The likelihood of Kondratiev tweaking his most important contribution to economics out of political pressure, and still outwardly opposing farm collectivization, is highly unlikely (Barnett, 476). Despite the supposed fad nature of the long wave, there has been consistent and substantial scholarship on the issue. A wide variety of distinguished names such as Joseph
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Determined within the system itself; the price of oil in the US as a result of supply and demand. Determined outside of the system; the emergence of OPEC in the 1970s that drove up the price of US oil.

Schumpeter, Walt Rostow, and Ernest Mandel have published on the topic, though they take a variety of significantly different approaches. Rosenberg and Frischtak, for example, in a widely cited article critical of the long wave literature, find that the approach of Schumpeter is starkly different from that of Rostow, Mandel, Forrester and others in their explanation of the flow of causality in long waves (Rosenberg and Frischtak, 146). Nathan Rosenberg and Claudio Frischtak, when examining the "specification of causality among factors associated with long wave phenomena," find that there are essentially two schools of thought on long waves. Walt Rostow, Ernest Mandel, and Jay Forrester all follow Kondratiev and treat innovation as the dependent variable in the long cycle: "technological activities stand in the position of dependent variables whose volume and timing are determined by deeper-rooted forces that shape the rhythm of capitalist development" (146). Schumpeter, however, most famously championed the opposite view that innovations both cause and make the long cycle possible. Thus, with Schumpeter: "innovation is at the center of both cyclical instability and economic growth, with the direction of the causality moving clearly from fluctuations in innovation to fluctuations in investment and from that to cycles in economic growth" (Rosenberg and Frischtak, 146). Schumpeter essentially sees the process as evolutionary. While the cycle generally lasts 40-60 years, there is no deterministic way to tell how long each cycle will last or how big the swings will be. At most, one could use Mmtaz Keklik's model4 to maybe project the last 10 years or so, but even that speculation is tenuous. Innovation is at the root of the birth and decline of long waves. The timing of innovation is only deterministic in the sense of Aghion and

Discussed at length in Section 2- Discussion of Modelling.

Howitt's framework5 of research this time period being a function of research in the next. The process Schumpeter envisioned is much more organic and adaptable than the one described by Rostow, Mandel and Forrester. According to Schumpeter, innovation drives both cyclical instability and economic growth. The growth process is derived from bursts of innovation causing bursts in investment. These bursts in investment are thus the engine of a capitalist economy. This is a view of long waves as endogenous products of creative destruction via innovation. I will mostly focus on the Schumpeterian view of long waves for the rest of this paper. Schumpeterian Innovation Several authors, including Mmtaz Keklik, find a theoretical progression between an earlier Schumpeter, that of the Theory of Economic Development, published in 1911, and a later Schumpeter, that of Capitalism, Socialism and Democracy, published in 1942. The earlier Schumpeter, sometimes dubbed Schumpeter Mark I, perhaps reflecting "the late nineteenth century European industrial structure" (Keklik, 12), envisions innovation as a result of the efforts of the visionary entrepreneur operating in a competitive free market. Innovation in Schumpeter Mark I tends to be realized during the infant stage of an industry when the small firm of the entrepreneur is sufficient for the research necessary for innovation. Schumpeter Mark II, however, tends to dominate as leading industries mature, grow, and begin to operate behind barriers to entry in imperfectly competitive markets. Mark II is characterized not by the visionary efforts of the entrepreneur, but rather the economies of scale of a large firm. These large firms use a research and development (R&D) division to create the ideas necessary to further innovate (Keklik, 1). In this respect, John Bellamy Foster finds Schumpeter to be "the first mainstream
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Discussed in page 9.

(non-radical) economist to address theoretically the rise of a new stage of concentrated capital," what Schumpeter at first called "trustified capitalism." Foster points to Schumpeter's 1928 essay, "The Instability of Capitalism," as the turning point in the development of Schumpeter's thought (Foster 2011 and Schumpeter 1928). With respect to the long wave, Schumpeter Mark I is seen in the initial phase of the long wave cycle. During this phase, industry growth and change are occurring at a breakneck pace and industry concentration is diluted among many small firms. As the top firms in an infant industry mature and expand, Mark II becomes the dominant process. This maturation allows the deepening possible to maximize operational efficiency and push the long wave towards its peak. It is important to note that Mark I and Mark II are processes for individual industries. It is entirely possible, and in fact reality, for different industries in an economy to be experiencing different phases of Mark I and Mark II simultaneously. It is this heterogeneous dynamic that helps to diversify growth across the economy so that it not be dictated by a singular industry. It should also be understood that an entrepreneur does not go to bed one night during Mark I and awake to find his firm in Mark II. The transitional process is gradual, and its classification can sometimes be arbitrary (Keklik, 3). Industry-based Theories of Schumpeterian Innovation According to Keklik, there are three prominent industry-based strands of theory on how this Schumpeterian innovation dynamic is realized. These three approaches are: 1) firm sizebased theories, 2) industry life cycle theories, and 3) new evolutionary theories (Keklik, 13). The first approach, firm size-based theories, is certainly the most traditional form of industrial analysis. Metrics like firm size and industry concentration ratios help to put a yardstick to the composition of an industry over the innovation process. Proponents of this approach, such as

Morton Kamien and Nancy Lou Schwartz, have shown empirically that large firms can have an advantage when efficiently using R&D output. However, their research concludes that technical change is carried out more efficiently by small and medium sized firms. In fact, the literature shows a convergence around the conclusion that firm size and research intensity do not have a linear relationship. Kamien and Schwartz, among others, have shown that innovational effort (through measures like R&D employment) has increasing returns to scale until a maximum effort is reached in the intermediate firm size range. After this maximum is achieved, innovative activity largely remains constant or declines. Similar studies have shown that R&D per patent as a measurement of innovative activity moves inversely after the aforementioned maximum is reached (Kamien and Schwartz, 34). Further, Zoltan Acs and David Audretsch have shown empirically that less concentrated industries produce more innovations (measured in one way by patents) than highly concentrated, oligopolistic industries (Acs and Audretsch, 678) The second industry-level approach to Schumpeterian innovation are industry life cycle theories. William Abernathy and James Utterback are among the lead authorities in this field, and their research output has shaped the literature. All of the literature reflects a consensus that industries follow a structured path from inception to maturity. The nascent phase of an industry can be thought of as Mark I. Because of the radical uncertainty in a nascent industry, small firms provide the brunt of innovative activity in a risk-loving fashion. This turbulence remains feverishly high until the industry standardizes its production methods. With decreased turbulence, the firms that were winning in Mark I start to obtain a growing market share caused by losers leaving the market. As the industry approaches Mark II, innovative activity moves from product innovation to process innovation. The product at this stage has largely been determined,

and the competition existing in the market is mainly focused around cost efficiency (Abernathy and Utterback, 639). According to Abernathy and Utterback, product and process innovation follow a three stage development process. The first stage is marked by product innovations (creation of new goods or services) that arise from market needs. Production experience is not crucial in this stage because productive knowledge comes from outside the industry. These demand innovations are heterogeneous in their composition as the industry has yet to converge around a product; leaving market uncertainty high. Firms are small in this stage and growth shows increasing returns to scale (Abernathy and Utterback, 640). The second stage of the industry life cycle is an intermediary phase. Many of the trends observed in the first stage start to decelerate or reverse. Firms become larger as growth rates slow. Uncertainty about production decreases which attracts many firms using a fast second strategy. Product differentiation becomes crucial for firms looking to secure a toehold in the maturing industry. This maturation is fulfilled in the third stage (Abernathy and Utterback, 641). The third stage of the life cycle is marked by the complete maturation of an industry. In this ultimate stage, the industrial product has been standardized, and firms become focused in cost minimization through increased production runs among other tactics. All innovations at this point are process innovations (improvements to existing goods and services). Growth becomes constant at this point, and the industrial product becomes more inflexible. Industrial concentration rises as the winners of the first two stages force out smaller firms that are not cost competitive (Abernathy and Utterback, 641). The third major Schumpeterian approach in at the industry level are new evolutionary theories. These New Institutionalists, who claim Schumpeter as one of their own, focus on the

importance of industry specific factors in understanding industrial innovation. Institutionalists' view widening (enlarging the innovative base with new innovators) and deepening (contraction of firm concentration towards longer production runs) as being shaped by the technological regime that defines each industry. Franco Malerba and Luigi Orsenigo define technological regimes with respect to opportunity, appropriability, cumulativeness and properties of the knowledge base. The two posit that opportunity (ease of opportunity for entrepreneurs to innovate) and appropriability (the ability of entrepreneurs to protect their innovation to reap profits) conditions in each industry affect the process of innovation with respect to firm size and concentration. Cumulativeness conditions refer to the fact that existing innovators may remain innovative in the future relative to non-innovators, and knowledge base conditions refer to the degree of scientific and technical difficulty of innovating in a certain industry (Malerba and Orsenigo, 48). This analysis views the long wave, and economic growth in the broadest sense, as a continual oscillation between widening and deepening patterns of innovation. During widening phases opportunity is high, and appropriability is low. Widening can be seen as in synchronization with Mark I in which entrepreneurial entry is easy due to easily imitated technology. Cumulativeness conditions are low due to the intense market competition that leads to short-lived rents. Deepening, on the other hand, is an inversion of the previous phenomenon. Low opportunity and high appropriability and cumulativeness create barriers to entry for small firms. Because of these relationships, industry specific technological regimes help dictate innovative activity in terms of firm size and industry concentration (Malerba and Orsenigo, 50). While it is true that the intensity of innovation varies across industries due to regime conditions, it has shown to be true that industries with greater deepening are more innovative

overall. It should be noted here that firm size-based, industry life cycle, and new evolutionary approaches rather parochially focus on a single industry. These approaches do not factor interindustry effects into their analysis. These analyses also use short time-series data which do not allow them to view a long run phenomenon like long waves. They provide a strong example of the innovative quality of leading industries posed by Schumpeter, but ignore the effect that these leading industries have on the broader economy. In fact, the effect that these innovations have on the macroeconomy is what cause long waves in the first place. However, these approaches can be useful in explaining the internal dynamics of a long wave (Keklik, 19). Knowing that widening during Mark I of an infant industry can lead many small firms to huge innovation, and deepening during Mark II will culminate in large, rigid production runs that raise industry concentration, we can develop an explanation for long wave stagnation. Ultimately, this stagnation will open the door for the next innovation to cause the next long wave. What makes these theories applicable to the long wave is their ability to describe the stagnation that endogenously brings about innovation in a cyclical and unavoidable manner. Macro, Endogenous Analysis of the Schumpeterian Long Wave The burgeoning literature on endogenous growth has been dubbed Neo-Schumpeterian by Paul Romer himself (Romer 1994, 17). According to Philippe Aghion and Peter Howitt, Romer and Robert Lucas do a good job of explaining how the accumulation of knowledge in a society is the determinant of long-run economic growth. However, according to Aghion and Howitt, what the main contributors to new growth theory do not pay attention to is the ability of innovations to improve the quality of products. This continual improvement of consumers goods makes the old products obsolete. This reality of obsolescence is what, in Aghion and Howitts opinion, drives the cycle of creative destruction (Aghion and Howitt 1992, 323). This author purposely makes

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reference to the improvement of consumers goods given what is probably Joseph Schumpeters most oft cited quote (bold type added by this author):
The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers goods, the new methods of production or transportation, the new markets [This process] incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. (Schumpeter 1975, 83)

According to Aghion and Howitt, a period between successive innovations is random. However, the relationship between the amounts of research done in the two temporal periods can be modeled as deterministic in two ways. First, the payoff for research in this time period is the rent that can be accrued from the yield of such research. These rents, however, will only last until the next innovation makes the current research yields obsolete. Therefore, the present value of research is a function of the arrival rate of new innovations, and is based in the reality of creative destruction (Aghion and Howitt 1992, 324). The second effect that can determine the level of research in a given time period (which largely determines the long-run rate of growth) is a general equilibrium effect via skilled labor. Defined as being able to work in research or manufacturing, demand for skilled labor is a function of expectations for research next period (thus raising the real wage of skilled labor in the next period). Higher wages for skilled labor next period will diminish rents of the entrepreneurial innovator. Thus, the expectation of more research next period discourages present research by reducing the entrepreneurial innovators expectations of rents in the future (Aghion and Howitt 1992, 324).

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In a 1998 article, Aghion and Howitt further integrated the endogenous growth literature with long wave theory by proposing the existence of General Purpose Technologies (GPTs). These GPTs, while not explicitly called long wave innovations, are described as:
...technologies whose introduction affects the entire economic system. More precisely, whilst each new GPT raises output and productivity in the long-run, it can also cause cyclical fluctuations while the economy adjusts to it. Examples of GPTs include the steam engine, the electric dynamo, the laser and the computer (Aghion and Howitt 1998, 54).

For all intents and purposes, it can be assumed that the authors are referring to long wave innovations without expressly using the word Kondratiev (Aghion and Howitt 1998, 55). In the rest of the 1998 article, Aghion and Howitt develop a model for explaining the tail end of a long wave; the daunted long slump. The authors present, in simplified form, models that help to capture the reasoning behind the timing and duration of these stagnation periods without providing empirical justification (Aghion and Howitt 1998, 56). Perhaps the strongest corroboration for the existence of the long wave in a macroeconomic sense is Diego Comin and Mark Gertlers 2006 article titled MediumTerm Business Cycles. This piece builds a model that seeks to measure high and medium-frequencies in data on national output of the American economy. Differing from the approaches of Robert Solow (Solow, 151) and Olivier Blanchard (Blanchard, 89), Comin and Gertler analyze both high frequency (0 to 8 years) and medium-frequency (850 years) as fluctuations that mutually affect each other. It was the intuition of the authors that conventional business cycle analysis swept many of the variations in the data under the rug. Previous models of the likes of Solow and Blanchard sought to separate the high

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and medium-term, and study the conventional, high-frequency business cycle apart from medium-frequency variations in data. According to Comin and Gertler, analyzing these two fluctuations in the data as mutually affecting each other composes a medium run that runs beyond 8 and up to 50 years (Comin and Gertler, 524). It can be safely inferred that this notion of the medium run in Comin and Gertler is an allusion to the long wave. Comin and Gertlers research output strongly supports their claim of a medium run analogous to the notion of a long wave. By modifying a conventional business cycle model to accommodate for changes in R&D, technology adoption and price variations, the two were able to produce comprehensive proof of a cyclical trend beyond that of the conventional cycle (Comin and Gertler, 549).