The leading economic theoretician to work on business cycles in the first half of the twentieth century was undoubtedly Joseph Schumpeter. The innovations theory of business cycle is associated with the name of J.A.Schumpeter. Schumpeter makes innovation the central cause of the recurrence of business cycles in the modern industrial economies. According to Schumpeter, the key to the explanation of business cycle lies in the recurring bursts of innovational investment activity that dominates the capitalist economies. Schumpeter viewed the business cycle as a natural outgrowth of economic progress.
Schumpeter states,” The booms consist in the carrying out of innovations in the industrial and commercial organism. By innovations, I understand such changes of the combinations of the factors of production as cannot be affected by infinitesimal step of variations on the margin. They consist primarily in changes in methods of production and ways of transportation, or changes in industrial structure, or in the production of a new article, or in the opening of new markets or finding new sources of material. The recurring periods of expansion of the cyclical movements are the form progress takes in capitalistic society.”
Innovations are lumpy and bunched in time leading to the corresponding surge of investment outlay necessary for their commercial exploitation. The lumpy and surging investment activity is sufficient to create conditions of boom in economic activity. An innovation is different from an invention. An innovation is the initial application of an invention to commercial production while an invention is the discovery or development of a new process, product or service by scientists or engineers. Despite the fact that inventions might appear more or less continuously through time, innovations-initial commercial exploitation or inventions-show marked discontinuities because a majority of the businessmen being risk avoiders are reluctant to innovate at all under ordinary circumstances. An innovator is one who is the first to make the commercial application of invention and consequently bears the risk involved in introducing a new good or service or process in the market. Actually producing and marketing the new product can only prove the success or failure of an innovation. This virtually amounts to groping in the dark, inviting avoidable risks which most firms would choose to avoid preferring to produce and market only the old and tried goods and services produced through the traditional processes and methods. The majority of firms are simply the imitators.
Schumpeter’s conclusion is stated very clearly: “booms and consequently depressions are not the work of banks: their cause is a non-monetary one and entrepreneurs demand is the initialing cause even of so much of the cycle as can be said to be added by the act of banks.”
The entrepreneurs translate inventions into innovations, relying largely on their business acumen and believing that success will be theirs. When the innovation proves successful extraordinary profits accrue to the innovators. But very soon other imitates the innovation by adopting new processes of production and producing and marketing the goods and services similar to those produced and marketed by the innovators. The innovation especially when it comes about at a time when the economy is operating at near-full or full employment level, causes a rise in prices because entrepreneurs compete in bidding for the available supply of resources. Profit opportunities appear brighter and investment is stimulated. A surge of investment activity grips the economy and leads to cut- throat competition that results in bringing down the profits of the innovator. The expansion comes to an end as the process of introducing innovations in the economy comes to an end for the time being. The innovation opportunities are not, however, limitless. As a result, after some time the opportunities for investment in the new spheres decline. Thus the innovational net advantage disappears. The upswing turns into a downswing. According to Schumpeter, innovational activity is ‘lopsided, discontinuous, disharmonious by nature… the disharmony is inherent in the very modus operandi of the factors of progress. Being unbalanced, the prosperity cannot be sustained and ‘depression is nothing more than the economic system’s reactions to the boom or the adaptation to the situation into which the boom brings the system.’
The lower turning point of business cycles i.e. recovery occurs when following a period of readjustment to the changed economic circumstances created by the previous boom, prices have fallen to a point where the pioneering business entertaining the hope that any further fall is most unlikely to happen, once again start innovating. The introduction of innovation heralds the beginning of the recovery, which soon leads to rapid expansion of the economy.
Innovations are lumpy and bunched in time leading to the corresponding surge of investment outlay necessary for their commercial exploitation. The lumpy and surging investment activity is sufficient to create conditions of boom in economic activity. An innovation is different from an invention. An innovation is the initial application of an invention to commercial production while an invention is the discovery or development of a new process, product or service by scientists or engineers. Despite the fact that inventions might appear more or less continuously through time, innovations-initial commercial exploitation or inventions-show marked discontinuities because a majority of the businessmen being risk avoiders are reluctant to innovate at all under ordinary circumstances. An innovator is one who is the first to make the commercial application of invention and consequently bears the risk involved in introducing a new good or service or process in the market. Actually producing and marketing the new product can only prove the success or failure of an innovation. This virtually amounts to groping in the dark, inviting avoidable risks which most firms would choose to avoid preferring to produce and market only the old and tried goods and services produced through the traditional processes and methods. The majority of firms are simply the imitators.
Schumpeter’s conclusion is stated very clearly: “booms and consequently depressions are not the work of banks: their cause is a non-monetary one and entrepreneurs demand is the initialing cause even of so much of the cycle as can be said to be added by the act of banks.”
The entrepreneurs translate inventions into innovations, relying largely on their business acumen and believing that success will be theirs. When the innovation proves successful extraordinary profits accrue to the innovators. But very soon other imitates the innovation by adopting new processes of production and producing and marketing the goods and services similar to those produced and marketed by the innovators. The innovation especially when it comes about at a time when the economy is operating at near-full or full employment level, causes a rise in prices because entrepreneurs compete in bidding for the available supply of resources. Profit opportunities appear brighter and investment is stimulated. A surge of investment activity grips the economy and leads to cut- throat competition that results in bringing down the profits of the innovator. The expansion comes to an end as the process of introducing innovations in the economy comes to an end for the time being. The innovation opportunities are not, however, limitless. As a result, after some time the opportunities for investment in the new spheres decline. Thus the innovational net advantage disappears. The upswing turns into a downswing. According to Schumpeter, innovational activity is ‘lopsided, discontinuous, disharmonious by nature… the disharmony is inherent in the very modus operandi of the factors of progress. Being unbalanced, the prosperity cannot be sustained and ‘depression is nothing more than the economic system’s reactions to the boom or the adaptation to the situation into which the boom brings the system.’
The lower turning point of business cycles i.e. recovery occurs when following a period of readjustment to the changed economic circumstances created by the previous boom, prices have fallen to a point where the pioneering business entertaining the hope that any further fall is most unlikely to happen, once again start innovating. The introduction of innovation heralds the beginning of the recovery, which soon leads to rapid expansion of the economy.
Schumpeter’s theory of business cycle suffers from several weaknesses:
1. The extent to that innovations are introduced before the previous business cycle has run out its course and before readjustments to the previous cycle have been made, significantly affect the depth and behavior of trade cycle.
2. The theory has not taken into consideration the amount of bank credit created during prosperity. The greater the amount of bank credit absorbed in the system of financing innovations by the old industry, the greater will be the rise in prices.
1. The extent to that innovations are introduced before the previous business cycle has run out its course and before readjustments to the previous cycle have been made, significantly affect the depth and behavior of trade cycle.
2. The theory has not taken into consideration the amount of bank credit created during prosperity. The greater the amount of bank credit absorbed in the system of financing innovations by the old industry, the greater will be the rise in prices.
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