LOYOLA COLLEGE

ASSIGNMENT
TOPIC:

Name: SAFWAN AHMED M P

Dept. No : 19-UBU-060

Subject: Entrepreneurship Development

Submitted on: 6/09/2021

Submitted to: Dr. Ceciliya Jothi Muthu. S

SCHUMPETER’S THEORY
According to Schumpeter, innovation refers to any new policy that an entrepreneur
undertakes to reduce the overall cost of production or increase the demand for his products.
Schumpeter’s Theory of Innovation is in line with the other investment theories of the
business cycle, which asserts that the change in investment accompanied by monetary
expansion are the major factors behind the business fluctuations, but however, Schumpeter’s
Theory posits that innovation in business is the major reason for increased investments and
business fluctuations.

According to Schumpeter, the cyclical process is almost exclusively the result of innovation
in the organization, both industrial and commercial. By innovation he means, the changes in
the methods of production and transportation, production of a new product, change in the
industrial organization, opening up of a new market, etc. The innovation does not mean
invention rather it refers to the commercial applications of new technology, new material,
new methods and new sources of energy.

Thus, innovation can be classified into two categories:

- The first category includes all those activities which reduce the overall cost of
production such as the introduction of a new method or technique of production, the
introduction of new machinery, innovative methods of organizing the industry, etc.

- The second category of innovation includes all such activities which increase the demand
for a product, such as the introduction of a new commodity or new quality goods, the
emergence or opening of a new market, finding new sources of raw material, a new variety or
a design of the product, etc.

Schumpeter has developed a model in two stages, i.e. first approximation, and second
approximation, in order to further explain his business cycle theory of innovation. The first
approximation lays emphasis on the primary impact of innovatory ideas while the secondary
approximation deals with the subsequent responses obtained from the application of the
innovations. Let’s study these stages in detail:

 First Approximation: This stage begins with the economic system in equilibrium in

which there is no involuntary unemployment, firm’s mc = mr (marginal cost is equal
to marginal revenue) and price = Average Cost (AC). In the situation of complete
 equilibrium in the economy, if the firm decides to undertake a new technique of
production, then the same needs to be financed through bank credit. Since the
economy is in equilibrium, there are no surplus funds to finance the new venture.
 But after a certain level, with an increase in the level of output the
price and profitability decreases. This is because the further innovation
does not come by quickly and thus, there will be no additional demand
for the funds. Instead, the firms which borrowed the funds from the
bank start paying it back. This results in the contraction in money
supply and hence the prices fall further. The process of recession
begins and remains until the equilibrium in the economy is restored.
 Second Approximation: The second approximation deals with the waves generated
by the first approximation. The speculation is the main element of second
approximation. As the primary wave of expansion begins, the investor, particularly in
capital goods industries, expects this upswing to remain permanent and hence borrows
heavily.
 Even the consumers expecting the prices to increase in future go into
debt to acquire durable consumer goods. This heavy indebtedness turns
out to be havoc when prices begin to fall. Both the investors and
consumers find it difficult to meet their obligations, and this situation
leads to a panic and then depression.

Example of Schumpeterian Theory

The internet is one of the best examples of creative destruction, the term that Schumpeter
coined to describe the dismantling of long-standing practices in order to make way for
new technologies, new kinds of products, new methods of production, and new means of
distribution. Existing companies must quickly adapt to a new environment (or fail).

The advent of the Internet rendered many products, methods of production, and means of
distribution obsolete. It also caused a drastic curtailing of many jobs, including the roles
of bank tellers, secretaries, travel agents, and retail store employees. With the rise of
mobile internet technology, publishers of printed material everything from magazines to
maps also suffered.
 The Internet, in addition to other innovations in the field of information technology the
microprocessor, the laser, fibre optics, and satellite technologies have all fundamentally
altered the way that business is conducted.

CRITICS ON SCHUMPETER’S THEORY

1. Schumpeter’s theory is not basically different from the over-

investment theory; it differs only in the respect of the cause of
variation in investment when the economy is in stable equilibrium.
2. It is not only difficult but also unavailing to perform the objective
evaluation of Schumpeter’s theory of the business cycle because its
arguments are more based on the sociological factors rather than
the economic factors.
3. Like other theories of the business cycle, this theory also leaves out
other factors that cause fluctuations in the economic activities.
Innovation is not the sole factor, rather is only one of the factors that
cause fluctuations in the economy.

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