SCHUMPETER THEORY OF

DEVELOPMENT
PRESENTATION BY
HAASEENA ANWAR. M
21/PECA/002
MA ECONOMICS I YEAR
 OBJECTIVES OF THIS SEMINAR

1. Learn and understand the Schumpeterian theory of economic

development.
2. Innovation, role of innovator, role of profit and bank credit.
3. Base theory, Spread of Innovation, Cyclical process.
4. The end of capitalism for economic development.
 INTRODUCTION
• Joseph Alois Schumpeter was an Austrian
Political Economist. He was one of the most
influential economist of the early 20th
century.

• In the early 1980’s Schumpeterian economics

were considered extremely broad after a
period when traditional economic approaches
were increasingly criticized.

• He was known for his theories of Capitalist

Development and Business Cycle. The
concepts of innovation and entrepreneurship
are Schumpeter’s most distinctive
contribution to economics.

• He also argued that Capitalism is never

stationery and always evolving, with new
products and new markets entering the
sphere.

• He presented his first theory of economic

growth in Theory of Economic Development
published in German in the year 1911, in
 SCHUMPETER ASSUMPTION OF
ECONOMY FOR DEVELOPMENT

• Schumpeter assumes the economy to be a perfect competitive economy with

stationary equilibrium.
• In this equilibrium state, there is no excess profit, no excess savings, no nominal
interest, no excess investment or no involuntary unemployment.
• The equilibrium is characterized by ‘Circular Flow’ termed by Schumpeter.
 WHAT IS CIRCULAR FLOW?
• Circular flow is the a cycle where the there is repetition of same action year by year.
• It is similar to the circulation of blood in the human body.
• In an economy, for every supply, there is a corresponding demand in some corner of the economy.
• For every supply there is a demand and for every demand there is a supply in the economy.
• It is repetitive in a timeless economy.
• According to Schumpeter, circular flow is the stream of flow which is fled from continual efforts of labor and
land and flows to every economic period into a reservoir which is called as income.

CIRCULAR FLOW

EFFORTS
OF
LABOUR INCOME
AND LAND
 DEVELOPMENT ACCORDING TO
SCHUMPETER
• According to Schumpeter, development arises due to the some
spontaneous and discontinuous changes in this circular flow.
• It disrupts the equilibrium and forever alters the new equilibrium in
the place of existing equilibrium in the economy.
• This discontinuous changes is not forced to fit in the economy, rather
it is accepted due to timely changes and situations arose thereof.
• These changes are arise by the own initiative within the economy and
impacts in the sphere of commercial and industrial life.
• Development consists of carrying out new combinations which has
possibilities in this stationery state. These new combinations come in
the name of innovations.
 WHAT IS AN INNOVATION?
• Innovation is the practical implementation of ideas that result in the introduction
of new goods or services or improvement in offering goods or services.
• Innovation includes:
1) Introduction of new products
2) Introduction of new method of production.
3) Opening up of new markets
4) Conquest of new source of supply of raw material or semi-manufactured goods.
5) Creating any new industry and become like a monopoly.
• According to Schumpeter, the introduction of new product and the continual
improvements in the existing ones will lead to development.
 ROLE OF AN INNOVATOR
• Schumpeter assigns an innovator as an entrepreneur and not as a capitalist.
• An entrepreneur is one who doesn’t have just a normal managerial skill but also has an extraordinary skill
to introduce something new.
• He doesn’t provide the funds but he directs the usage.
• An entrepreneur is motivated by:
(a) desire to find a private commercial kingdom
(b) the will to conquer and prove his superiority.
(c) the joy of creating , of getting things done, or simply of exercising one’s energy and ingenuity.
• The nature and activities of an entrepreneur depends on his social-cultural environment.
• To perform his economic functions, an entrepreneur requires:
• Existence of technical knowledge
• Power of disposal in the form of credit.
• According to Schumpeter, there is a reservoir of untapped technical knowledge which he can make use of.
Thus, credit is essential for development to start.
 ROLE OF PROFIT
• The main motive of an entrepreneur to innovate is to earn profit.
• The profits are nothing but surplus over cost. It is the difference between the total
receipts and outlays.
• It is considered as the function of innovation.
• According to Schumpeter, in an competitive equilibrium, the price of each
product is just equal to the cost of production. So there are no profits.
• Profit arises due to the dynamic change resulting from an innovation.
• They continue to exist until an innovation becomes general.
 SCHUMPETER THEORY OF PROFIT
• Although profits arise due to frictions (i.e., time lags in market adjustments) and
monopoly positions, the innovation theory, advanced by Schumpeter, goes one step
ahead to suggest that profit is the reward for innovation.
• Profit is a necessary reward for inducing individuals to under­take the risks associated
with developing new products, new production techniques, or new marketing
strategies. These individuals earn higher than normal profits. But, such profits are of a
transitory nature. Such profits will gradually disappear unless strong barriers’ can be
created.
• Thus, the key ingredient to the innovation theory of profit is the dynamic and ever-
changing nature of demand that supports and rewards successful innovators.
Innovation — trying something new — is vitally necessary for economic growth.
Successful innovation provides a great stimulus to new investment, and may well lead
to the growth of large scale industries.
• Various types of risks are associated with the running of a business. Some risks such
as the risk of loss due to flood, fire or burglary, or injuries to employees, are
insurable. It is so because the laws of probability can be applied to such events and
insurance companies can calculate the degree of risk involved and fix premium on
the basis of such calculation.
• But, no one can calculate the numerical probability that a firm, or a group of firms,
will make profits or losses in future. In a dynamic world characterized by constant
changes in tastes and preference of buyers and technological progress or frequent
changes in government policy the success or failure of a particular enterprise in the
past is no good guides as to the likely success or failure of a similar enterprise in the
future. Thus, profits are to be treated as the reward for taking non-insurable risks.
• J. A. Schumpeter has, of course, emphasized the role of profit as a necessary
incentive for innovation. Innovation refers to the introduction of a new product or a
new method of producing an old product, or opening up a new market. No doubt, all
enterprises in a capitalist economy involve a high degree of risk, but innovations of
the type mentioned above carry a much higher degree of risk. Innovators are
encouraged by the prospects of large profits. Such profits often accrue to the pioneer
—one who is the first in the field.
 BREAKING THE CIRCULAR FLOW
• The Schumpeter Model starts with breaking of the circular flow using innovation in
the form of new products by an entrepreneur for the purpose of earning profits.
• For this purpose the entrepreneur is provided with bank-credit for the purpose of
capital investment.
• Since the investment in innovation is risky, the entrepreneurs are required to pay
interest on it.
• Once the innovation is successful, the entrepreneurs swarm like clusters and make
this innovation a general one.
• An innovation in one field will lead to innovations in the other related fields as well.
• For Example: The emergence of motor car industry may, in turn, stimulate a wave of
new investments in constructions of highways, rubber tyres and petroleum products,
etc.
• But the spread of Innovation is never 100 percent.
The figure represents the Spread of Innovation.
• The vertical axis shows the percentage of firms adopting the new
innovations. The time taken to adopt is shown in the horizontal axis.
• The curve OI represents the movement of percentage of firms adopting an
innovation at a particular time period.
• This curve OI shows that the firms adopt an innovation slowly at the first
and then they gain a momentum. But it never reaches 100%.

WHY SPREAD OF INNOVATION NEVER REACHES 100%?

The reason for this state is found in the year 1962 by E.M. Rogers. He calls this
curve as the ‘S’ Curve. He states that after the innovator, the early adopters
adopt the innovations. At this stage the curve OI is said to be in a lower level.
After seeing early adopters, a certain majority of people will adopt to the
innovations. They are called as the early majority. At this stage, the OI curve
gets an increase and starts to move upwards. Later, other majority people will
adopt seeing the others and its success in the market. They are called as the
late majority. Still there will be few people who will be resistant in their
adoption of innovation and remain with the same technology or product they
use. They are called as Laggards. Even if one or two of them plan to adopt the
innovation, it either becomes a general one or a new technology should have
emerged and people would have moved forward. At this point the curve OI
starts to fall down. It is because of the Laggards, that the Spread of Innovation
never reaches 100%.
 CYCLICAL PROCESS
• Since the investments are assumed to be financed by bank credits, it increases the money
income and prices and results in the cumulative expansion throughout the economy.
• With the increase in purchasing power of the consumers, the demand for the product with old
industries increases in relation to supply.
• Price raises, profit increases and old industries expands by borrowing from the banks.
• It induces a secondary wave of credit inflation which is superimposed on the primary wave of
innovation. Over-optimization and speculation will lead to boom.
• After a period of gestation, the new product starts appearing displacing the existing one. This
enforces the process of liquidation, re-adjustment and absorption.
• The demand of the product starts to decrease. Their prices starts to fall. The old firms contract
output and some firms are even forced to run into liquidation.
• As the innovators starts repaying bank loans out of profits, quantity of money is decreased and
price tends to fall. Profit declines. Uncertainty and risk increases.
• The impulse for innovation is reduced and eventually comes to an end. Depression ensues.
• Schumpeter believes in the existence of Kondratieff long wave of upswing and
downswing in economic activity.
• Each long-wave upswing is brought about by any category of innovation.
• Thus there are abundance of goods available to the masses.
• According to Schumpeter, “Mass production means production for the masses. “
• Once the long-wave upswing ends, long-wave downswing starts and the painful
process of readjustment to the “point of previous neighborhood of equilibrium” takes
place.
• Ultimately the natural forces of recovery brings in a revival.
• Once again the equilibrium is restored.
• Then the enterprising entrepreneurs begin with new innovations, others follow and a
new boom begins.
• Schumpeter describes this “Capitalist Development” as one of the “Creative
Destruction” wherein the old economic structures of society are continually destroyed
and new structures are continually created in their place.
The figure represents the curve showcasing
the cyclical process.
• The horizontal axis showcases the time taken and
the vertical axis shows the national output.
• The curve YPT showcases the long-run cyclical
upswings and downswings.
• When there is a new innovation, the economy
moves upward from Y and production increases
upto P.
• When this innovation ends and new innovation
starts, it replaces the old one.
• At this point, the output level falls from P to T.
• In this way the ‘Creative Destruction’ process leads
to a new equilibrium T which is higher than Y.
• This shows the development in the economy.
 CYCLICAL PROCESS IN ECONOMIC
DEVELOPMENT
• In this figure, the secondary wave is
superimposed over the primary wave of
innovation.
• Through over-optimization and
speculation, development proceeds more
rapidly in the prosperity phase.
• When recession starts, the cycle continues
downwards below the equilibrium level to
the depression phase.
• Ultimately, another innovation brings about
revival of the economy.
In fine, entrepreneurs are the key figures in the Schumpeterian analysis. They bring in
development in a spontaneous and discontinuous manner. Cyclical swings are the cost
of economic development under capitalism.
Secularly, continued technological progress will result in an unbound increase in total
and per capita output, since there are no diminishing returns in technological process.
As long as technological process takes place, the rate of profit will be positive.
There is therefore no a priori ceiling to the level of per capita income in a capitalist
society. Nonetheless, the economic success of capitalism will eventually lead to its
decay. For very process of capitalist development weakens the institutions and value
basic to its own survival.
Schumpeter wrote that capitalism cannot survive in future.
The very success of capitalism undermines the social institutions which protect it and
inevitably creates conditions in which it will not be able to live and which strongly point
to socialism as their heir apparent.
 PROCESS OF END OF CAPITALISM
According to Schumpeter, Capitalism can maintain itself only when entrepreneurs behaves like knights
and pioneers. But these daring innovators are destroyed by the capitalist system itself which rests on a
rational attitude.
This enquiring, skeptical and rational attitude permeates the entire capitalist society.
As a result three forces are discernible that are the beginning of the creeping death of capitalism. They
are:
• The decadence of the entrepreneurial function
• The disintegration of the bourgeois family
• The destruction of institutional framework of capitalist society.
In early stages of capitalism, the driving forces came from entrepreneurs who dared to innovate,
experiment and expand. But now innovation is reduced to routine. Technological progress has become
the business of a team of trained specialist. This reduces the industrial bourgeoisie to a class of wage
earners and thus undermines the function and the position of the entrepreneurs as the Warrior knights.
There is also destruction of the Bourgeoisie family. Parents adopt a rationalistic attitude in their
behaviour towards children. The traditional family is weakened. The desire to find a Private Kingdom, a
Dynasty is no longer there. The will to accumulate wealth gradually disappears and along with it another
important aspect of the capitalist society.
Finally Schumpeter contends that the entrepreneurs also tends to destroy the
institutional framework of the capitalist society. The tendency towards concentration
into big concerns weakens and destroys twin institutions of private property and
freedom of contract. The proprietor role is played by the salaried managers and the
former is totally divorced from the active management. According to Schumpeter it
was the rationality which destroyed the royal power in the past. Now again, it is the
rationalistic attitude of the ruling group towards domestic and international
problems that will be the bane of capitalism. But all these forces are not enough for
perish of capitalism. It is however the active hostility of the intellectuals which is
bringing the day nearer. The intellects sow the seeds of doubt and discontentment in
the minds of the masses against the social and political frameworks of the capitalist
order. By inciting the white-collar groups and the labouring classes they are able to
secure anti-capitalist political reforms. As a result, the institutional framework upon
which capitalism rests starts crumbling and there is a gradual movement towards
socialism. Eventually capitalism would fade away without any bang or whimper.
 CRITISISM OF THE THEORY
1. The entire theory is based on the innovator whom he regards as an ideal person: Such persons were
present in the 18th and 19th century. At that time, innovation was made by entrepreneurs or innovators. Now this
has moved to the hands of Joint Stock Company. So, it is been a routine of industries to innovate and there is no
need for an innovator.
2. Economic development is not the result of the cyclical process: The downswings and upswings are not
important for economic development. As, Nurkse pointed out, economic development is because of continuous
change.
3. Schumpeter’s contention that cyclical changes are due to innovations is also not correct: Cyclical
fluctuations can be due to psychological, natural and financial causes.
4. Schumpeter regards innovations as the main cause of economic development: This is far from reality
because economic development not only depends on innovation alone, but also on many other economic and social
changes.
5. Schumpeter gives too much of importance to bank-credit in this theory: Bank credit maybe important
in short run. But in long run, when capital need is larger, bank credit will be insufficient. For this floating of shares
and debentures are needed.
6. Schumpeter’s analysis of process of transition from capitalism to socialism is not correct: He does
not analyse how capitalist society transferred into socialism. He just tells the institutional framework oof capitalist
society with changes in the functions of an entrepreneur. His analysis of end of capitalism is emotional rather than
real.
His arguments are stimulating but not completely convincing… Although Schumpeter’s analysis is provocative, it
seems one-sided and over-emphasised.
 SCHUMPETER ANALYSIS AND THE UNDER
DEVELOPED COUNTRIES
The applicability of Schumpeter theory is limited in underdeveloped countries due to the following
conditions:
1. Different socio-economic order: Schumpeter theory corresponds to a particular socio-economic order
that existed in Western Europe and America of the 18th and 19th century. In underdeveloped countries,
the socio-economic conditions were altogether different and prerequisites for development in the form
of economic and social overheads are not-existent.
2. Lack of entrepreneurship: The Schumpeterian analysis depends upon the existence of an
entrepreneurial class. In such economies, there are low profit expectations and low state of technologies
which do not encourage innovational investments in new plant and equipment. Moreover, the lack of
adequate power, transport, skilled personnel, etc. act as disincentives to entrepreneurial activity.
3. Not Applicable to Socialist Countries: Schumpeter’s analysis is not applicable to the majority of
underdeveloped countries which have socialist leanings. For example, the introduction of social security
measures and high progressive income taxes are inimical to the development of an entrepreneurial class
because they tend to reduce profits.
4. Not Applicable to Mixed Economies: Moreover, Schumpeter’s innovator is a private entrepreneur who
does not fit in the present day mixed economies. In an underdeveloped country, government is the
biggest entrepreneur. The main impetus for development comes from the public and the semi-public
5. Institutional Changes and not Innovations Needed: To start the development process
and to make it self-sustaining, it is not innovations alone but a combination of several factors
like organizational structures, business practices, skilled labour and appropriate values,
attitudes and motivations which are required.
6. Assimilation of Innovations: According to Henry Wallich, the development process in
underdeveloped countries is based, not on innovation, but on the assimilation of existing
innovations. For entrepreneurs in underdeveloped countries are not in a position to innovate.
Rather, they adopt innovations taking place in advanced countries.
7. Neglects Consumption: The Schumpeterian process is ‘production oriented’ while the
development process is ‘consumption-oriented’. This appraisal is applied in the current trend
towards the welfare state in which demand and consumption play a leading role.
8. Neglects Savings: Schumpeter’s exclusive emphasis on bank credit obscures the role of
real savings in investment. It also undermines the importance of deficit financing, budgetary
savings, public credit and other fiscal measures in economic development.
9. Neglects External Effects: According to Schumpeter, development is the result of
changes that arise from within the economy. But in underdeveloped countries, changes do not
take place from within the economy rather they are the outcome of imported ideas, technology
and capital. Backward technology, low saving potential and outmoded social, economic and
political institutions are incapable of leading to development from “within” in underdeveloped
economies.
10. Neglects Population Growth: Further, Schumpeter failed to take into
account the impact of the growth of population on the economic development of a
country. High growth rate of population tends to lower the growth rate of a
developing economy.
11. Unsatisfactory Explanation of Inflationary Forces: In Schumpeter’s
system, inflationary impulses form an integral part of the process of development,
but it involves no secular inflation. The long-term price level remains stable.
However, in an underdeveloped economy the inflationary forces are very powerful.
 CONCLUSION
All the same, Schumpeter’s theory underlines the importance of inflationary financing
and innovations as the main factors in economic development. Inflationary financing
is one of the potent methods which every underdeveloped country tries to use at one
time or another. His analysis is relevant to underdeveloped countries from the
standpoint of long range increase in productivity and absorption of surplus labour in
gainful employment as a result of innovations.
 BIBLIOGRAPHY
• Jhingan, M.L. The Economics of Development and Planning. 2014.
• Diffusion of Innovation Theory: The Adoption Curve (YouTube) Channel Name:
Rare (https://youtu.be/9QnfWhtujPA) (https://youtu.be/NiNoNYLBabA)
• www.investopedia.com
• www.wikipedia.com
• https://www.economicsdiscussion.net/firm/innovation-theory-of-profit-firm-econ
omics/25884