Innovation Theory of Business Cycle

Innovation Theory of Business Cycle:

The innovation theory is mainly the work of Joseph Schumpeter, a brilliant economist of the U.S.A. He has explained the business cycle in terms of innovations that take place in the economic system of a capitalist country from time to time. By innovation, he means the introduction of something new that changes the existing methods of production. It may mean any of the following things.

• the introduction of a mechanical invention.
• the introduction of a new product.
• the introduction of a new technique of production.
• the development of new markets for the existing products.
• the development of new sources of raw materials for existing enterprises.
• the development of new types of raw materials in place of old ones.
• the introduction of changes in the forms of business organization.
• the introduction of new methods of management in business.

An innovation differs from an invention in one essential respect; an invention is a discovery of something new, whereas an innovation is the actual introduction or application of something new. The hope of increasing profits or of maintaining them in the face of severe competition is an important incentive for business innovations. Innovations are, thus, inevitable in the highly competitive capitalist economy.

Some of the major innovations of the mid-twentieth century have been jet airlines, nuclear-powered electricity generating stations, automatic automobile plants, etc.

Innovation may be of two types-

• greater waves of innovations.
• smaller waves of innovations.

The former causes long business cycles (long waves) while the latter lead to short business cycles (short waves).

According to Schumpeter, the smaller waves of innovations do not take place in isolation from each other. On the contrary, they tend to cluster or bunch together. In other words, they come in groups. Why? The reason is that business leaders do not put into effect a new idea as soon as it occurs to them. The promising new ideas keep accumulating till the business leaders find the time propitious for putting them into effect. Once a particular new idea (or, innovation) is introduced by the leading firms, the other firms follow suit in herdlike imitation.

Let us now see how Schumpeter proceeds to explain the upswing and the downswing of the business cycle in terms of innovations. According to him, whenever an innovation takes place, it causes disequilibrium in the existing economic system. This disequilibrium in the economic system continues till there is readjustment at some new equilibrium position.

To illustrate the upswing, Schumpeter finds it convenient to assume that the economy is in a state of full employment. All the productive factors are already fully employed, and there is none that is unemployed. Now, let us suppose that some innovation takes place in such a society, say, some new product is introduced by the business leaders. This means the establishment of an altogether new industry in the economy. Since all the factors of production are already fully employed, the new industry will have its quota of factors by withdrawing them from the existing industries through promises of higher rewards to them. The rewards of the factors as a whole will increase. This will increase the production costs in the existing industries. In addition to the increase in production costs, the output of the existing industries will also decline for the simple reason that less of the productive factors are now available to them than before for the purpose of production. Meanwhile, the establishment of the new industry will be financed through the expansion of bank credit. The factors employed in the new industry will have to be paid rewards higher than what they were receiving in the existing industries. The workers employed in the new industry will have now larger purchasing power which they would spend on buying the goods produced by the existing industries. Consequently, the demand for the products of the existing industries will go up, and the output of these products will have diminished on account of the reduced supply of productive factors to them. The result will be a sharp rise in prices and profits of the Existing industries. Attracted by high profits, the entrepreneurs in the existing industry will expand output and capacity. This expansion of the existing industries will be financed through the expansion of bank credit. This process will be repeated till inflationary conditions develop in the economy.

The new industry will, of course, take some time to establish itself. During the interim period, the new industry will act as an inflationary force for the simple reason that, while it has put additional purchasing power in the hands of workers, it has not yielded an equivalent output in the market to absorb the increased purchasing power. Even after the new industry makes available its output to the market, it shall not cease to be an inflationary force for the economy. Attracted by the high profits made by the pioneering firms, certain other firms will join the new industry. The activities of these firms will be financed by additional expansion of bank credit. This will add more fuel to the inflationary fire. This process will repeat itself till the economy finds itself in the upswing of the business cycle.

Let us now see how the economy passes from a period of prosperity (upswing) to a period of depression (downswing). As the product of the new industry comes into the market, it competes with the products of the old industries. The consumers will buy the new product by postponing their demand for the old products. To that extent, the demand for the product of the old industries will decline. The prices of the products of these industries will register a fall. Meanwhile, the firms in the new industry will begin to repay (out of their profits) the loans which they had borrowed from the banks. This reduces the supply of bank credit which has a deflationary effect on the economy. In view of the decline in demand, the firms in the old industries begin to reduce their output by laying off workers and other factors of production. The unemployed workers, having no purchasing power, reduce their purchases of the goods of not only the old industries but of the new industry as well. The demand for goods diminishes still further. Ultimately, the economy finds itself in the downswing of the business cycle.

The innovation theory has been criticized on the ground that the basic assumptions of the theory are unrealistic. The theory obviously rests on two major assumptions. Firstly, it assumes that there is already a full employment situation in the economy- all the factors of production including labor are already fully employed. Now, this assumption, as we know, is totally wrong. Normally, there is less than full employment in a capitalist economy. Some factors are in a state of unemployment or semi-employment. If this is so, then an innovation (say, the establishment of some new industry) may not result in the withdrawal of productive factors from the existing industries. Nor may the costs of the existing industries increase on account of competitive bidding by the new industry. An important basis of the innovation theory is, therefore, gone. Secondly, the theory assumes that every innovation in business is financed through the expansion of bank credit which ultimately results in an inflationary situation. Now this assumption is also not wholly true. The innovations in business enterprises are mostly financed by drawing upon development reserves specially kept for the purpose rather than through the expansion of bank credit. If this is so, business innovations may not cause inflationary pressures in the economy.

This, however, does not imply that the innovation theory is devoid of any use. Major innovations, by leading to large capital investments in new plants and equipment, often provide an important stimulant to business activity. But as an explanation of the business cycle, the theory is clearly inadequate.