Schumpeter’s Innovation Profit Theory

Schumpeter’s Innovation Profit Theory

Professor Schumpeter considers that profits arise from dynamic changes resulting from innovation. To begin with, he takes a capitalist closed economy in static equilibrium. A ‘circular flow’ that repeats itself forever characterises this equilibrium. Such a static state is a perfectly competitive equilibrium. In it, the price of each commodity is exactly equal to the cost of its production and there are no abnormal profits. Only external factors, such as weather conditions, can alter this circular flow, but only temporarily and the economy returns to a circular flow state. In a circular flow state, goods are produced at a constant rate. This routine work is carried out by salaried managers. It is an entrepreneur who disturbs the paths of this circular flow by innovating. Thus, according to Schumpeter, the innovator is not a capitalist but an entrepreneur.

The entrepreneur is not a person of ordinary managerial ability but a person who introduces a totally new product. He does not provide funds but directs their use. For his economic function he needs two things: one, the existence of technical knowledge to produce new goods; and second, the capacity to arrange for factors of production on credit. He takes loans from banks and applies his ability to use the existing technical knowledge. This brings about innovation which disrupts the circular flow of production in the economy and results in profits. Thus the function of the entrepreneur is entirely different from that of the capitalist. The entrepreneur only brings about innovation, he does not take risks. Taking risks is the function of the capitalist or the lending banks. Even if the entrepreneur is a capitalist, he still performs two functions which are quite different. Hence the entrepreneur receives rewards not for risk but for innovation.

According to Schumpeter, innovation may include:

(i) introduction of a new product;

(ii) introduction of a new method of production;

(iii) opening of new markets;

(iv) discovery of new sources of raw materials;

(v) reorganization of industry.

When an entrepreneur introduces any one of these innovations, the cost of production of the product becomes less than its selling price. This results in profits. As long as this particular innovation remains secret, the entrepreneur continues to earn profits. But this situation cannot continue indefinitely. Other entrepreneurs pounce on that innovation like a swarm of locusts. Competition for resources and services increases the cost of production while prices fall due to increase in production. The result of this dual trend is that profits disappear.

The emergence of profits due to an innovation is not a peculiarity of only one industry. Innovation in one field encourages innovation in other fields as well.  The car industry may trigger a wave of new investments in highway construction, rubber tyres and petroleum products etc. Profits are both the effect and cause of innovation. Entrepreneurs innovate attracted by profits. When entrepreneurs innovate, profits appear.

Profits appear and disappear, sometimes in one industry and sometimes in another. They are temporary and accrue to the entrepreneur who innovates but when the innovation becomes common, the benefits disappear.

Criticisms

The following criticisms have been made of Schumpeter’s innovation theory:

1. Shareholders earn profits: Schumpeter does not consider profits to be a reward for risk-taking. According to him, risk-taking is the job of the capitalist and not the entrepreneur. But in his later book Capital- ism, Socialism and Democracy, Schumpeter indicates that the rapid economic growth of the capitalist economies of the 19th century was partly because the innovating entrepreneurs were also risk-takers. In modern companies, shareholders take risks and thus earn profits.

2. Profits are a reward for uncertainty: The element of uncertainty has no place in Schumpeter’s innovation theory.  Profit is not considered as the reward of uncertainty and this view is not correct because every innovation is related to uncertainty. If innovation takes place without the element of uncertainty, then the reward of innovation is not profit but only the wages of management.

3. Incomplete explanation: Innovation is not the only work of the entrepreneur for which he gets profit. The entrepreneur gets profits due to his organizational ability, while he can reduce the business costs. Thus, Schumpeter’s theory is an incomplete explanation of the origin of profits.