Joseph Schumpeter

Joseph Schumpeter (1883-1950) is one of the most prominent sociologists and economists of the last century. He invented the original theory of economic development and made a profound impact on modern sociology and economics. A significant contribution of his work is a dynamic development model, into which institutional and social factors are successfully “built”. According to Schumpeter, the development occurs in a capitalist economy due to the tricyclic scheme. Being a talented economist, scholar, and sociologist, Joseph Schumpeter with his teachings, new development ideas, and methods made a considerable contribution to the modern-day political economy.

Joseph Schumpeter was born in Austria, where he gained fame as a theorist after the release of one of his most famous works, The Theory of Economic Development (1911, 1912). Since 1932, Schumpeter lives and works in the United States as a professor at Harvard University, where he published not less famous works Business Cycles (1939) and Capitalism, Socialism, and Democracy (1942).

In The Theory of Economic Development, Schumpeter develops the theory of economic development, placing at the center of the analysis those internal factors that cause economic development of the system. The word “development” was a novelty for the neoclassical theory, while it gravitated to the considerations of the static problems. Two fundamental ideas were placed in the center of its attention, namely the best use of available resources and balance. At first, Schumpeter begins his analysis with the static model, which corresponded to the principles of the neoclassical theory. All the parameters of the model, including production, exchange, distribution, and consumption, remain unchanged. Moreover, everything in it seems to be moving in a circle. Accordingly, Schumpeter calls such a state the economic cycle.

Schumpeter considers the isolated economy to be dominated by private property, a division of labor, and free competition. The main objective of the work was to present a logically complete model of economic changes over time. Schumpeter believes that it is impossible without thorough monitoring of the entrepreneurship.

Theory of Utility

Schumpeter is a supporter of the Austrian version of the marginal utility theory. The starting point for him was the notion of extra utility. Consequently, the extra utility commodity of the goods A is measured by the difference between the value of A and the value of goods B, which were not produced due to the fact that the resources were spent on the creation of A.

As a result, the unmet need to put pressure on the economy. Moreover, the more the benefit-determined type of goods is produced, the greater becomes the pressure of not manufactured goods, and, therefore, the lower becomes the gains achieved by continuing production. In equilibrium, the additional utility of produced goods is equal to zero. In this case, the last part of the total amount of any product is produced in conditions when there the excess of the produced beneficial effect on costs does not exist anymore. Therefore, the increase in the cost either postpones or does not occur at all.

Accordingly, there is no profit in the state of equilibrium. The paradox is that the economy remaining in perfect condition would have to function without making any profit. However, it does not mean that capital in equilibrium brings no income over the usual cost. It only means that Schumpeter considers such profit as wage for the management of capital, which, like any wage, must be attributed to the costs. Moreover, in terms of equilibrium, the true or entrepreneurial profits associated with the successful introduction of the new goods, new methods of production, and new forms of organization equals zero.

Schumpeter’s contribution to the economic theory in the opinion of many scientists consists precisely in the fact that he explores the factors that “blow up” the balance of the market system from the inside. New production combinations, which determine the dynamic changes in the economy, become the internal factors of the change . Schumpeter identifies several types of radically new combinations of production factors:

• the creation of a new product;
• the use of new production technologies;
• the use of the new organization of production;
• the opening of new markets and sources of raw materials.

New combinations of production factors were called “innovations.” It should be emphasized that in Schumpeter’s terminology, “innovation” is not synonymous with the word “invention.” Entrepreneurial activity is associated with the use of existing resources rather than creating new ones. The opportunities of the new means of application in excess are revealed on their own. However, as Schumpeter suggests, such opportunities are mainly “dead”. The employer realizes them in practice, overcoming technological and financial difficulties. Moreover, the entrepreneur opens new ways of receiving profit, which should be seen as an excess of the income that was established in the circuit. It is the industrialist, who is given in Schumpeter’s economic development concept a particularly important role. It is a person whose function is the accomplishment of a new combination of production factors.

Typically, the employer meets the opposition of the environment. He/she principally establishes the innovations, but innovations in the economy, as a rule, are implemented not after the spontaneous rise of new demands on behalf of the customer but when the production itself instills new needs to consumers. As a result, the production process is the implementation of new combinations, covering five major cases:

1. the creation of a new good;
2. the introduction of a new method of production;
3. development of a new market;
4. obtaining new raw materials supplier;
5. implementation of reorganization.

Manufacturers, in their turn, are the economic entities with the function of new combinations implementation that act as their active component. Such a new combination must take the necessary means of production from a particular old combination (a form of competitive displacement of old manufactures).

Considering the motives of economic activity in a static state, Schumpeter identifies the motive of the fulfillment of the needs on the basis of rational behavior (utility or profit maximization). Considering the dynamic model, Schumpeter believes that the motives of entrepreneurial activity are irrational because the main motives are self-development of personality, success, and creativity joy. The entrepreneurs are driven by a desire for activity and will to win. It is interesting to note that the businessman, according to Schumpeter, is not burdened with an excess of intelligence, which, in the given case, is a positive quality. It is the relative limitations of outlook that do not give him the opportunity to compare a variety of different options of the achievement of the objectives and undergo long hesitations. The isolation of irrational motives in the behavior of entrepreneurs led to the recognition that the theory of entrepreneurship is an area where economic science and psychology have found a common language that facilitated the emergence of such science as the “economic psychology”.

Schumpeter claims that in usual conditions of the circuit, each economic entity has solid ground and can behave the same way as all the participants, who expect such behavior from him/her. Nevertheless, the other situation can be considered when the manufacturer faces an unusual challenge. As a part of the usual circuit, he/she usually moves with the flow. Nevertheless, if he/she wants to change something, the manufacturer has to act in opposition to the set rules. Accordingly, what first was one of the well-known key elements, becomes an obstacle. Additionally, the quantity of goods becomes unknown, as well. Where once set regime ends, many manufacturers stop operating, while others continue working in a different way. It explains the division of the entrepreneurs into a separate group, distinguishing them from “just the bosses” or the owners of capital.

However, in order to be able to perform new combinations, the entrepreneur needs to possess not only a certain number of abilities and energy. He/she also needs to possess the “purchasing power”. If the employer does not have the ready purchasing power necessary for the realization of the project, he/she has to borrow it from someone. If he/she does not manage to fulfill it, he/she cannot be called a businessman. Therefore, the first need of the entrepreneur is the need for credit.

The impetus of innovation is the entrepreneurial profit when its source is the revenue growth or decrease in costs as the result of transformation. One of the main features of business profits (income of those who implemented a new combination) is its not-averaging. The law of price equity and the law of marginal productivity have absolutely no influence on it. Another of its most important features is the fragility. It disappears as soon as the innovative form of manufacture becomes traditional. Such transformation, if it is successful enough, utilizes other changes and becomes widespread very quickly.

The macroeconomic results of extensive use of innovation conclude that the economy is emerging from the equilibrium state as the conditions of its functioning become different. Gradually, new prices correspond to new costs, business profits disappear, and the economy receives an opportunity to enter a new equilibrium state. The transition of the economy from one equilibrium to another, as a result of the actions of innovators, is, in fact, what Schumpeter calls economic development.

Schumpeter specifically emphasizes that the meaning of economic development is not a new state of balance but the transition to it, as any new equilibrium will still be destroyed. Therefore, the market economy in which businesses operate cannot be fixed and does not grow at a steady pace. It is incessantly revolutionized from the inside due to the new business, and due to the introduction of new products’ industrial structure, new production methods, and new business opportunities. Any existing structure, as well as all conditions of business operation, are in a continuous process of change. Any current situation is undermined. In such a state of complete disorder, competition acts in a completely different way than in stationary progress. The opportunities for income can be obtained due to the production of new items or the same items but in a cheaper way, continuously materializing and requiring new investments. The new products and methods compete with old products and methods not on equal terms, while the former has a crucial advantage, meaning a possible elimination of the latter. Respectively, it is the process of making a “progress”.

Since the produced goods by the innovator are unique, every innovator can be simultaneously considered a monopolist (although one can be a monopolist, not being an innovator). Schumpeter calls the monopoly that provides temporary excess profit at the expense of innovation an effective one. The super profit of the effective monopoly, unlike the usual monopoly super-profits, disappears as soon as used innovations spread throughout the economy. Every effective monopoly pursues its private interests, but the result, as in the case of perfect competition, is the gainings of the whole society.

Money and Capital

For the creation of new capital, one needs the credits and commercial banks and not just cash. There is a significant difference between credit and cash. Cash can be considered as :

1. the certificate of production completion and the consequent increase of the total product;
2. an order to receive a part of the product.

In contrast, credit payments lack the first property. They do not represent the certification of production completion. It occurs only after the successful implementation of the relevant new combinations. Therefore, the banker is also a co-producer of a new product. Accordingly, it is not true that money represents only a means of circulation of goods and services and can not independently generate new important phenomena. On the contrary, it affects the whole economic process.

Taking into account such functions of money and credit, it turns out that without the loan the phenomenon of economic development can not be understood. Schumpeter viewed credit as an essential condition of the utilization of existing factors for the creation of new productional combinations. For innovators-entrepreneurs to have at their disposal the means of production, they have to use a bank loan. Banks “create” money for innovators, and it becomes a reason for the redistribution of resources (social capital). Thus, the bank, according to Schumpeter, is a special phenomenon that, on behalf of the national economy, gives authority an opportunity to implement new industrial combinations. They act as essential intermediaries between the desire to engage in the innovation process and the ability to do it. The fee for the provision of such opportunities is called the percentage, which is the price paid for the new productive forces acquisition. According to Schumpeter, it is the development in the true sense of the word (not a circuit), that needs a loan.

Schumpeter is aware that an increase of money in circulation due to the credit provided by the bank causes a general rise in prices, especially on industrial resources, including labor. Nevertheless, according to Schumpeter, it is not just inflation that is considered in the quantitative theory. As a result of such initial inflation of economic, the circuit may be broken: the companies that operate traditionally experience bankruptcy (because the new conditions revenues do not cover costs), while entrepreneurs and innovators, on the contrary, make a profit. Consequently, not only the price increase, but also a parallel change in the economic structure, and the transition to a new stage of the development spiral take place. Therefore, a bank loan is closely related to the phenomena of economic development, and the money functions not only as a medium of exchange and the measurer but also as a catalyst for economic growth.

Schumpeter admits only the money-form of capital. Capital is a means of payment, which, being disposed of under the control of the entrepreneur, changes the structure of production. Advanced capital that turns into a means of production, stops functioning as a capital and becomes a property. Capital is the lever that allows the entrepreneur to receive the needed goods in his complete disposal. Moreover, it is a means that provides the entrepreneur with the opportunity to use the benefits in order to achieve new goals, as well as to orient the production in a new direction. It is the only function of capital. In general, the economist admits that the capital market is a money market.

Joseph Schumpeter as an outstanding economist and sociologist has made an indelible contribution to the respective field at his time. According to his teachings, the driving force of the development is an entrepreneur and innovator. Therefore, scientists considered the private entrepreneur classical type system based on a small and medium property the foundation of capitalism. Highlighting the central psychological motive to explain the economic phenomenon, Schumpeter considered the panic associated with the termination of the economic boom to be the cause of the economic crisis. Moreover, from all forms of capital, Schumpeter recognizes only the monetary form. Many of his ideas were innovative and distinctive with their novelty and farsightedness.