Introduction:
Joseph A. Schumpeter, a renowned Austrian-American economist, developed the Innovation Theory of Trade Cycle to explain the causes of economic fluctuations in a capitalist economy. According to him, the main cause behind economic growth and business cycles is innovation introduced by entrepreneurs.
The other theories focus on external factors like monetary changes, Schumpeter’s theory emphasizes the internal dynamics of capitalism especially the role of entrepreneurial innovation as the root cause of trade cycles. He believed that innovations occur in clusters and trigger waves of economic expansion, which are later followed by recessions and depressions once the effects of the innovations are fully absorbed.
Schumpeter’s Theory of Trade Cycle also called the Innovation Theory of Trade Cycles was developed by Joseph A. Schumpeter, an Austrian-American economist. He explained business cycles (or trade cycles) through technological innovations and their effects on investment and economic activity.
The theory involves the development of his model in to two phases. The first deals with the impact of innovation and the other is reaction to the original impact of innovation. According to Schumpeter innovation means the changes in the production of goods and also consists introduction of new goods, introduction of new methods of production, opening of new markets, discovery of new source of raw material, etc. these are the main causes of trade cycle.
The theory of Schumpeter explains the role of an innovator and an entrepreneur. An entrepreneur is not a man of ordinary ability but one who introduces something entirely different and new. An entrepreneur require two things to perform his economic functions that is 1. The existence of technical knowledge and 2. The power of disposal over the factors of production in the form of bank credit.
The innovating entrepreneur is financed by the expansion of bank credit. Since investment is an innovation is risky, an entrepreneur must pay interest on it. With his newly acquired funds, the innovator starts bidding away resources from other industries. Money income increases ,prices begin to rise, thereby stimulating further investment. The new innovation start producing goods and there is an increased flow of goods in the economy . Further supply exceeds demand. Price and cost of production of goods starts declining until recession sets in. Because of the low prices of goods, producers are not willing to expand production. During this period of recession, credit, prices and interest rate decline but total output is likely to average larger than in the preceding prosperity.
Thus Schumpeter’s 1st approximation consists of two phase cycle. The economy starts at the equilibrium state, rises to a peak and then starts downward into a recession and continues till the new equilibrium is reached. This new equilibrium will be at a higher level of income than the initial equilibrium because of the innovation which started the cycle. This is shown as the primary wave in the figure.
The second approximation of Schumpeter follows through the reaction of the impact of original innovation. Once the original innovation become successful and profitable, other entrepreneurs follow it. Innovation is one field induces innovations in related fields. Generally money incomes and prices rise and help to create a cumulative expansion throughout the economy. With the increase in the purchasing power of consumers, the demand for the products of old industries increases in relation to supply. Prices rise further profit increases and old industries expand by borrowing from the banks. It induces a secondary wave of credit inflation which is superimposed on the primary wave of innovation. Over optimism and speculation add it further to boom. After a period of gestation the new products starts appearing in the market displacing the old products and enforcing a process of liquidation readjustment and absorption.
The demand for all products is decreased their prices fall. The old firms contract output and some are even forced to run into liquidation. As the innovators start sleeping bank loans out of profits, the quantity of money is decreased and prices tend to fall. Profits decline. Uncertainty I risk increases. The impulse for innovation reduce and eventually comes to an end depression sets in I’m the painful process of readjustment to the point of previous neighborhood of equilibrium begins ultimately the natural forces of recovery brings about a revival
also read: write a note on control of business cycle.