The innovation theory of business cycle is associated with the name of Schumpeter. This is a type of over-investment theory but it differs from it, in that it involves no shortage of savings which is responsible for the break in the period of the cycle and causes the crisis.
His theory rests on the fluctuations in the level of investment which is the most volatile of the determinants of the national income. He takes into consideration bank credit but denies that his theory is a monetary theory of business cycle.
Innovation is the most important cause of cyclical fluctuations. Had there been no innovations, the capitalist economies would have settled down to an economy of “circular flow” (stationary state). But innovations counter the circular flow. Schumpeter’s theory is based on (1) entrepreneur and (2) innovations plus the lumpiness or discontinuity of innovations.
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Innovation means the introduction of (1) new product, (2) new process, (3) new market, (4) new sources of raw material and (5) changes in the operation of business.
In a static society with no changes in the methods of production, business cycles could not exist. But the society is dynamic.
Its dynamic quality is derived from the operations of the entrepreneurs whose main function is to innovate, that is to create new ways of doing things, new products and new markets.
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Lumpiness or discontinuity means the tendency of the innovations to assume’swarm-like’ proportions, to appear in large clusters, instead of being evenly distributed through time.
Every innovation increases the demand for capital and other resources. Bank credits expand and prices rise. The process is accelerated if the innovation is successful and a large number of new concerns are started.
This is the period of prosperity. But the forces which innovations set in motion carry with them the seeds of their own destruction.
The innovation will substantially increase the supply of consumer’s goods which will bring the period of expansion to an end. The increased output of consumers’ goods will bring about a fall in prices, while factor costs would rise due to pressure of demand for the production services.
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The elimination of profits removes the impulse to further expansion. The entrepreneurs curtail their activities, bank loans are paid off, unemployment ensues and incomes reduced.
Thus the business cycle is the outcome of innovation. There is expansion when innovations are being put into effect; there is contraction when society adapts itself to the changes which innovations demand. Economic progress is not a smooth line. It expresses itself in spurts and jerks of a cyclical process.
Innovation engenders booms but booms are the cause of depression which continues until readjustment required by innovation is carried through. Schumpeter connects long waves with major innovations and short waves with minor innovations.
Schumpeter assumes that the economy is in equilibrium (S = I), there is no unemployment and only new firms can undertake innovations. The upspring is a period when innovations are taking place, prices rising and there is an outflow of new products. The Schumpeterian model starts from an assumed equilibrium position of the economic system where every firm is in equilibrium with its costs exactly equal to receipts.
The innovation disturbs this equilibrium. The innovator with bigger prospect of his business turns towards banks for more funds and thus profit rates rise.
Innovation oriented products enter the market at an increasing rate. They compete with the old products which suffer in competition and their producers’ revenue falls.
Forces of recession set in. The economic system finds its way back to a new equilibrium through a period of adaptation by most of the old firms through rationalisation and reconstruction.
The period of recession is necessary to allow the economic system to adjust the innovations and establish a new equilibrium.
Criticism:
Schumpeter’s theory is criticised on the following grounds:
1. There are no “exceptional entrepreneurs” as such. Today innovations and inventions are carried out by large corporations and not by any person.
2. Innovations are not sudden but gradual and in modern society innovational shocks are less severe than in the past. Growth of big business is the major reason for this since diversified business units can better absorb and plan for the adjustments required by innovator.
3. There may be irregularity in the rate of innovations but there is no discontinuity in them. History is a continuous process, so also innovations.
4. Schumpeter’s model is difficult to evaluate because there are sociological factors in Schumpeter’s model which cannot always be tested empirically.