Tuesday, August 28, 2012

The Theory of Economic Development

Nowadays, most of people would agree that innovation is the key driver of economic growth. That idea, however, was not common 100 years ago, and it is remarkable that Joseph Schumpeter argued that innovation is the key factor of economic development and the driver of economic cycle in his book “The Theory of Economic Development” in 1911.

Circular Economic System
In analyzing economic development Schumpeter started with economic model. He thought economy as a circular system, and he argued that the way of economic investigation is to understand the causal relationship between the “unknown” economic phenomena and “known” external factors. According to Schumpeter, it is not the explanation if an economic phenomenon is explained by another economic phenomenon – as that is something like a tautology.

“When we succeed in finding a definite causal relation between two phenomena, our problem is solved if the one which plays the “causal” role is non-economic. … If, on the other hand, the causal factor is itself economic in nature, we must continue our explanatory efforts until we ground upon a non-economic bottom.” (page 5)

“The economic system will not change capriciously on its own initiative but will be at all times connected with the preceding state of affairs.” (page 9)

If we trace back production processes, we get to only two factors. One is human being, and another is nature (lands).

What is Economic Development?
According to Schumpeter, “development” has the following characteristic.

First, it comes from within the economic system and is not the result of changes of external inputs. Schumpeter strictly separated economic change due to external factors from that due to internal ones. He said: “By ‘Development’, we shall understand only such changes in economic life as are not forced upon it from without but arise by its own initiative, from within.” (page 63)

Thus economic development is accompanied by the changes in consumers’ wants, since they are the only those who bring about the change within the economic system. Schumpeter thought that the producer of new goods, or entrepreneur, initiate economic change, by educating consumers - “they (consumers) are taught to want new things, or things which differ in some respect or other from those which they have been in the habit of using.” (page 65)

Then how are the new goods created? Schumpeter argued that new goods are created through new combination, i.e. the way to combine materials and forces differently from what is done before. According to Schumpeter, there are five types of new combinations: (1) the introduction of a new good, (2) the introduction of a new method of production, (3) the opening of a new market, (4) the conquest of a new source of supply of raw materials or half-manufactured goods, and (5) the carrying out of the new organization of any industry. (page 66)

Second, development occurs disruptively, not smoothly. They cannot be understood by means of any analysis of the circular flow, although they are purely economic and although their explanation is obviously among the tasks of pure theory, Schumpeter argued.

Schumpeter said that entrepreneurs appear not continuously, because the appearance of one or a few entrepreneurs facilitates the appearance of others, and these others facilitates the appearance of more, in ever-increasing numbers (page 228), until entrepreneurial profits are eliminated. This proposition explains why we see boom and crisis. The advent of a number of entrepreneurs create new economic orders as well as booming periods, which inevitably brings about the crisis in the future by the force of equilibrium.

Third, it brings qualitative changes or “revolutions”, which fundamentally displace old equilibria and create radically new conditions and economic orders.

Schumpeter understood the economic development as a dynamic process, in which three corresponding opposites interact: “First, by the opposition of two real processes: the circular flow or the tendency towards equilibrium on the one hand, a change in the channels of economic routine or a spontaneous change in the economic data arising from within the system on the other. Secondly, by the opposition of two theoretical apparatuses: statistics and dynamics. Thirdly, by the opposition of two types of conduct, which, following reality, we can picture as two types of individuals: mere managers and entrepreneurs.” (page 83)

Will to innovate
Schumpeter said that to create new things is difficult because of three reasons.

First of all, it is impossible to survey exhaustively all the effects and counter-effects of the projected enterprise, as entrepreneurs by definition create things invisible at the beginning.

Thus Schumpeter pointed out the importance of intuition: “Here the success of everything depends upon intuition, the capacity of seeing things in a way which afterwards proves to be true, even though it cannot be established at the moment, and of grasping the essential fact, discarding the unessential, even though one can give no account of the principles by which this is done. Thorough preparatory work, and special knowledge, breadth of intellectual understanding, talent for logical analysis, may under certain circumstances be sources of failure.” (page 85)

Secondly, people tend to have conservative mindset, feeling reluctance to do something new even if the objective difficulties do not exist. “Thought turns again and again into the accustomed track even if it has become unsuitable and the more suitable innovation in itself presents no particular difficulties. The very nature of fixed habits of thinking, their energy-saving function, is founded upon the fact that they have become subconscious, that they yield their results automatically and are proof against criticism and even against contradiction by individual facts. “ (page 86)

Thirdly, the difficulty comes from the social environment against those who initiate something new. This is natural antagonism, as innovations often demolish the existing businesses or social apparatuses.

Thus, Schumpeter emphasized the importance of will to go through all the difficulties that entrepreneurs should endure. He argued that there are three wills that enable entrepreneurs to carry on.
(1) The dream and the will to found a private kingdom
(2) The will to conquer
(3) The joy of creating, getting things done, and exercising one’s energy and ingenuity

What I learned the most in this book is that the good study comes out of solid framework. Innovation is often treated as something mystical, but Schumpeter explained the phenomena using certain framework (in his case, economic model). Although “the framework of innovation” sounds contradictory, as innovation is something that destroys the existing framework, we still need to stick to framework in the first place, to come up with something beyond the framework.  In other words, the framework ready to undergo dynamic change may be what is needed to get to brilliant idea.

Joseph A. Schumpeter, “The Theory of Economic Development”, Transaction Pub; Reprint edition, 1983/01

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