Schumpeter’s innovation theory of business cycle

By Published On: June 28th, 2020Categories: Blog Post
Schumpeter’s innovation theory of business cycle

We live in a dynamic and complex world in which innovation and business success are twin sisters that occupy a decisive role in economic development. In Schumpeter’s view, “innovation is the only function which is vital in both personal and business development.” Schumpeter’s theory of innovation is one of the most discussed theories of the business cycle. Joseph Schumpeter believed that trade cycles result from the firm’s innovation activity in a competitive economy.

In his view, trade cycles are an integral part of the process of economic growth of a capitalist society. For him, innovation is the application of scientific invention to actual production. Therefore, business professionals should “exploit” market opportunities by developing innovative thoughts and ideas. However, the terms innovation and invention have some differences. The invention in common parlance is discoveries of scientific novelties, while innovation exploits market opportunities and novel application in the production process and discovers new lands for raw materials.

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Schumpeter’s model of the trade cycle consists of two stages.

The first stage deals with the early impact of the innovation which entrepreneurs introduce in their production process. The second stage follows as a consequence of the reactions of competitors to the early effects of the innovation.

Schumpeter instigates his study by assuming the balance state of the economic system where all the factors of production are fully operated. Thus, every organization is producing efficiently with average costs equivalent to the price. As a result, product prices are the same as both average and marginal costs. Schumpeter calls this equilibrium state of the economy a “circular flow” of economic activity that just recurrences itself after a period like the rotation of blood in the animal organism.

The repeated flow of economic activity gets disturbed when an entrepreneur effectively carries out an innovation.

According to Schumpeter, the key function of an entrepreneur is innovation activity which yields him real ‘profit.’ By innovation, he means “such changes in the production of goods as cannot be affected by infinitesimal steps or variations on the margin.” Innovation does not mean invention. Rather, it denotes the commercial applications of new technology, new material, new methods, and new sources of energy.

Five methods of innovation that will bring success for your organization:

  • The introduction of a new product.
  • Implementation of a new method of production.
  • The opening up of a new market.
  • The expeditions for a new source of raw materials or semi-manufactured goods; and
  • Re-organization of production processes within a firm. Innovations are the commercial applications of inventions by an entrepreneur.

With skills and thirst for new developments, an entrepreneur can introduce something new to his existing business system. He is not a capitalist but an organizer who can mobilize the necessary cash for introducing his innovation.

An entrepreneur should have a mind for exploring novel things because the innovator-entrepreneur needs two things to execute his purpose: technical knowledge for introducing innovations, and two, finance for completing his task. In Schumpeter’s view, a reservoir of unexploited technical knowledge exists in an industrial society that he can draw to build his innovation. If an entrepreneur can put forward an innovative business proposal, he can attract bank credit effortlessly. As the innovator-entrepreneur begins bidding away possessions from other industries, money incomes increase, and prices begin to rise, thereby encouraging further investment. When innovations accelerate production, the circular flow of money will surge. Supply goes beyond demand. The initial equilibrium is disturbed.


Economic activities have been continued with their expansion cycles. There is a wave of expansion of economic activity. This is what Schumpeter calls the “primary wave”. This primary wave is accompanied by a “Secondary wave” of expansion. This is due to the influence of original innovation on the competitors.

When the original innovation proves profitable, other competitors follow it in “swarm-like clusters.” Innovation in one line encourages innovations in related lines. Every business person has tried to copy the success indicators of the other persons. As a result, money, incomes, and prices rise. There is a cumulative expansion of cost-effective activity. As the purchasing power of shoppers increases, the demands for products also go up, and their prices are surging.

As possible profits in these industries upsurge, a wave of expansion in the whole economy follows. This is the second wave of credit inflation that gets superimposed on the primary wave of expansion. But, again, over-optimism and speculation add to the zest for development under boom situations.

The period of richness ends as soon as ‘new’ products prompted by the waves of innovations substitute old ones. Since the call for old products goes down, their prices drop, and consequently, their producer firms are forced to contract their output.

Some of them may be forced into shutting down. When the innovators begin repaying their bank loan out of the newly-earned profits, the quantity of money in circulation is reduced due to which prices tend to decrease and profits weakening.

In this situation, uncertainty and jeopardies increase. Depression sets in. The impulse for further innovation is exhausted. The painful process of readjustment to the point of “previous neighbor-hood of equilibrium” begins. The economy is on its way down into recession.

But, any economic condition couldn’t remain as static it always shows revival energy, which is inherent in the economy itself. The economy cannot continue in depression for long. Innovation-minded entrepreneurs carry on their search for profitable innovations. The natural forces of recovery bring about recovery. Schumpeter stated that the deflationary pressures spawned by depression are slowly offset by certain other forces, one of which is the ‘dilution or diffusion of effects’.

This is the effect of insolvencies, shut-downs, and failures of individual markets on general economic activity.

The effect of these events goes on dropping as these happen. Another reason reducing the impact of depression is that the downfall of some firms enables remaining firms to expand their operations to eater to the market fed by the collapsing firms.

These offsetting impacts have a healing effect. Further, the decline in total consumption throughout the fall will be less than that in income, resulting in the exhaustion of inventories to the point where there is a need to refill them.

As fresh investments take place, some of the more brave entrepreneurs will start innovating. Others follow, and investment surges up again in a spurt, and another rise is on the way. This finishes the stages of a full trade cycle.