Innovation Theory of Trade Cycle: by J.A.

Schumpeter
The innovation theory of a trade cycle is propounded by J.A.
Schumpeter. He regards innovations as the originating cause of
trade cycles. The term “innovation” should not be confused with
inventions. Inventions, in ordinary parlance, are discoveries of
scientific novelties. Innovation is the application of such inventions
to actual production (i.e., exploiting them).
• It is innovations that are subject to cyclical fluctuations, not
inventions. Innovation, thus, in economics means the commercial
application of inventions like new techniques of production, new
methods of organization, novel products, etc.

• Schumpeter regards trade cycles as the offspring of economic

progress in a capitalist society. Cyclical fluctuations are
inherent in the economic process of industrial production.
When there are internal changes taking place on account of
innovation, the development process begins.

Schumpeter classifies innovation into five categories as follows:

(i) Introduction of a new type of goods.

(ii) Introduction of new methods of production.

(iii) Opening of new markets.

(iv) Discovering new sources of raw materials.

(v) Change in the organization of an industry, like the

creation of a monopoly, trust, or cartel or breaking up of
a monopoly, cartel, etc.

• Innovation, however, does not arise spontaneously. It must be

actively promoted by some agency in the economic system.
Such an agent, according to Schumpeter, is an “entrepreneur”,
entrepreneurs are innovators.
 • To carry out his innovative function, the entrepreneur needs
two things.
• First, he must have the technical knowledge to produce new
products or new services.
• Second, since the introduction of innovation presupposes the
diversion of the means of production from the existing to new
channels, the entrepreneur must also possess the power of
disposal over the factors of production.
• The necessary command over the productive factor is provided
by the monetary factor in the form of credit. The
entrepreneur secures funds for his project not from saving out
of his income but from the crediting bank system.
• Thus, money capital and bank credit play a significant role in
the Schumpeterian theory.
• According to Schumpeter, credit is important only in so far as
the innovation is concerned in the context of a progressing
economy, and only if the innovator requires credit to carry on
his function, i.e., innovative activity. In the absence of
innovation, in a circular flow of money economy, where Say’s
Law of Market operates in toto, no credit is required.

The strategic factors in the Schumpeterian theory are:

(i) innovations

(ii) entrepreneurs.

• Innovations brought about by entrepreneurs disturb the

circular flow of the stationary economy, so the development is
a dynamic, discontinuous, cyclical process.
• Schumpeter attributes the swarm-like appearance of
entrepreneurs to the cyclical nature of economic progress. In
his view, the cyclical upswing starts when entrepreneurs start
investing in the commercial applications of their innovative
ideas.
• This may start gradually when a few leading entrepreneurs
with drive come into the field but once these few innovators
 have demonstrated the profitability of their ventures, others
will imitate and follow suit. With a few leaders smoothening
the path, the original innovators are soon followed by a swarm-
like appearance of entrepreneurial activity.
• Schumpeter assumes that innovating activity is helped by the
banking systems’ readiness to give credit. The “swarm-like”
appearance of entrepreneurial activity naturally raises the
volume of investment which in turn raises income, employment,
and output.
• Thus, the prosperity phase gathers momentum and the
economy moves up, away from the neighbourhood of
equilibrium.
• In short, the clustering of innovations creates a discontinuous
disturbance in the economy. It will lead to an overwhelming
outflow of new products when all these innovations are
beginning to have their full effect. When the market is flooded
with new products, their prices fall and profit margins decline.
On the other hand, the credit-financed innovations bid up the
factor prices and so the costs of production rise.
• Innovations will now cease. Hence prosperity will end and
recession begins. At this stage, credit deflation also ensues
with the persistent tendency of new firms to utilize the sales
receipts of their new products to repay their bank loans. This
tends to put the old firms in a difficult position of
readjustment and adaptation.
• For, when credit deflation sets in, the flow of money stream
into the economy will slacken hence the demand for revenues
of the old firms, making their position still more awkward; so,
the recession is aggravated further.
• Schumpeter describes this process as “auto-deflation” implying
thereby that commercial banks play only a passive role in the
process.
• The recession in the economic system is caused by the
stoppage of innovations and the slackening of entrepreneurial
activity. He stresses that innovations halt not because there is
 a lack of inventions, but because the economic environment is
not favorable for further innovation.
• When there is overproduction in the prosperity period, general
prices decline, reducing the profit margins. The disappearance
of profit margins of new investment makes innovations
financially unattractive.
• Further, during an economic crisis, expectations are dampened
under conditions of uncertainty. Since the clustering of
innovations in the prosperity period had led the economy to a
very dis-equilibrated state, all values and estimates in the
system change now.
• This makes the accurate planning of new investments
extremely difficult. So, the economic situation so developed
acts as a deterrent to the planning and formation of new
enterprises.

However, Schumpeter’s theory of trade cycles is imperfect.

It suffers from many drawbacks such as:

(i) His theory is highly institutional: it requires the existence of a
typical institutional framework of society for its validity. He
considers entrepreneurs as mere innovators. Further, he
overemphasizes the role of the entrepreneur, thereby creating a
very strong personal element in the path of industrial progress.

(ii) Schumpeter attributes trade cycles to the phenomenon of

innovations only. But the trade cycle being a complex phenomenon
cannot be attributed to a single factor alone.

(iii) Schumpeter unrealistically assumes that innovations are

financed solely using bank credit. They must be financed out of
voluntary savings. Moreover, major innovations generally require
long-term credit, whereas the banking system usually grants only
short-term loans.