Schumpeter’s Innovation Theory of Trade Cycle

The innovation theory of trade cycles is associated with the name of Joseph Schumpeter. Schumpeter accepts Juglar’s statement that “the cause of depression is prosperity,” and gives his own view about the originating cause of the cycle.

“Innovations in the industrial and commercial organization are virtually mainly the outcome of business cycles,” states Joseph A. Schumpeter. He characterizes innovations as “such changes in the arrangement of the manufacturing components that cannot be generated by minute tweaks or by microscopic stages.” Innovations mostly include modifications to manufacturing and transportation processes, adjustments to industrial structures, creation of new products, opening of new markets, and discovery of new material sources. Inventions and innovations are not the same thing. All that constitutes an innovation is the commercial use of novel methods, materials, vehicles, and energy sources. The Schumpeterian idea states that cyclical variations originate from innovations.

Schumpeter created a model in two phases for his business cycle theory formulation, referring to them as the first and second approximations. The first estimate addresses the influence of the innovative ideas at the outset, whereas the second approximation addresses the waves that are produced when innovation is applied.

The economic system is in equilibrium when the first approximation of Schumpeter’s model begins, meaning that there is no involuntary unemployment, each business has its own mc = mr and price = ac, and there are no incentives to increase or decrease investment. If an innovation is presented as a new product or an enhanced manufacturing process, it will need bank credit financing even in an economy with perfect equilibrium. The inventive companies continue to bid higher prices for other inputs with the intention of withdrawing them from other applications because they have access to more money via the banking system. As a result of rising economic expenditure, prices start to rise. When other businesses copy the idea and take out loans from banks to expand, this process becomes even faster. As the invention is widely used, production starts to enter the market. The growth phase begins. However, more production eventually results in lower prices and profitability. There wouldn’t be a need for further funding since new technologies take time to emerge. Instead, the businesses that had previously taken out bank loans begin to repay. The money supply contracts as a result. Thus, prices continue to drop. The recession process starts and lasts until equilibrium is restored once again. The first approximation includes two stages: the expansion brought about by invention and the recession that lasts until the equilibrium position is attained.

The secondary waves produced by the waves in the first approximation are examined in the second approximation of Schumpeter’s model. Speculation is the primary component of the secondary wave. Investors anticipate the recovery to be durable when the major wave of development starts, especially in the capital goods industry. Existing businesses borrow a lot with this assumption.

Even buyers who plan for future price increases incur debt in order to purchase durable items.

This results in high debt, which becomes problematic when prices start to decline. It is difficult for debtors—investors and consumers alike—to fulfill their commitments. Panic and eventually despair are the results of this circumstance. The completion of the required liquidation, the restructuring of the debt, and the dissolution of unprofitable businesses mark the lowest turning point.


An impartial assessment of Schumpeter’s theory of the cycle is challenging, to say the least, and unlikely since a large portion of his reasoning is predicated on “sociological rather than economic considerations,” according to M.W. Lee. Therefore, it is difficult to test this notion. Furthermore, the main distinction between Schumpeter’s theory and investment theory is the reason for fluctuation in investments during an equilibrium condition of the economy. Furthermore, Schumpeter’s theory, like a lot of other theories, ignores a lot of other significant variables that affect company volatility. Innovation is not the main cause of fluctuations in the economy.

  1. Innovator not Necessary for Innovations: Schumperter’s analysis is based on the innovator. such persons were to be found in the 18th and 19th centuries who made innovations. But now all innovations form part of the functions of joint stock companies. innovations are regarded as the routine of industrial concerns and do not require an innovator as such.
  2. Innovations are not the only cause of these Cycles: Schumpeter’s contention that cyclical fluctuations are due to innovations is not correct. As a matter of fact, trade cycles may be due to psychological, natural, or financial causes.
  3. Bank credit is not the only source of funds: Schumpeter gave so much importance to bank credit in his theory. Bank credit may be important in the short run when industrial concerns get credit facilities from banks. But in the long run, when the need for capital funds is much greater, bank credit is insufficient. For this, business houses have to float fresh shares and debentures in the capital market. Schumpeter’s theory is weak in that it does not take these factors into consideration.
  4. Innovation financed through Voluntary savings does not produce a Cycle: Critics point out that if innovation is financed through voluntary savings or internal funds, there will not be an inflationary rise in prices. Consecutively, in an underemployed economy, an innovation financed through voluntary savings might not generate a cycle.
  5. Unrealistic assumption of Full Employment: Schumpeter’s analysis is based on the unrealistic assumption of full employment of resources to begin with. But the fact is that at the time of revival, the resources are unemployed. Thus the introduction of an innovation may not lead to the withdrawal of labour and other resources from old industries. Thus the competitive impact of an innovation would not increase costs and prices. Since full employment is an exception rather than the rule. Thus Schumpeter’s theory is not a correct explanation of trade cycles.
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