NS4053

Winter Term 2014Schumpeterian Theories

of Growth and Development

Schumpeter IBasic Schumpeterian Model•1. Same basic production function as the Classicals and Marx – output function of labor, capital, land and technological progress

• Introduced the entrepreneur as critical element combining inputs

•2. Savings depends on wages, profits and the interest rate – savings increase with the interest rate, with workers now saving.

• Introduced idea of financial markets as critical in growth – transfer resources from surplus to deficit individuals

•3. Total investment divided into induced investment and autonomous investment

• Induced investment depends on the level of profits and the interest rate

• His innovation was to show that induced investment stimulated by recent increases in output income, sales or profits

• Autonomous investment brought forth by such long run considerations as technological change

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Schumpeter II

• Schumpeter felt the process of innovation was the critical element in autonomous investment

• He though of innovation in general as any change in the production function which would bring about an increase in output – five major forms

• Introduction of a new good – that is one which consumers not yet familiar or a new quality of good;

• The introduction of a new method of production– not previously tested by experience

• The opening of a new market

• The development of a new source of supply of raw material/production inputs

• The carrying out of the new organization of an industry

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Schumpeter III• 4. Technological progress and the rate of resource

discovery (innovations) depend on the supply of entrepreneurs

• Entrepreneur is a visionary – sees opportunity for profits in new discoveries.

• Often the entrepreneur simply uses other people’s money and ideas -- an intermediary between the financial and scientific communities

• He raises the money to launch new enterprise, assembles the factors of production, chooses top managers and sets the organization going

• He may not provide any funds of his own

• He may not be a day-to-day manager

• Nor is he usually an inventor or explorer

• Schumpeter argues inventions or discoveries by themselves have little economic effect– patent registry filled with files of inventions that never see light of day.

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Schumpeter – Entrepreneurship II

His model one of the first to explain the business cycle:•Innovation sets up only a temporary monopoly gain which is soon wiped out by imitation•For profits to continue, it is necessary to keep ahead of one’s rivals•New bank credit finances the innovation, which once successfully set up is more easily imitated by competitors•Innovations are not isolated events evenly distributed in time, place and sector•They arise in clusters as a result of lowered risk•Eventually the waves of entrepreneurial activity not only force out old firms but also exhaust the limited possibilities of gain from innovation•As borrowing diminishes and loans are repaid, the entrepreneurial activity slackens and finally ceases•Innovation, saving, credit creation, and imitation explain economic growth whereas their ebb and flow determines the business cycle. 5

Schumpeter IV• 5. The supply of entrepreneurs depends on the rate of

profits and the social climate• Like Mark Schumpeter put considerable stress on

sociological factors• “Social Climate” a complex phenomenon reflecting the

whole social political and socio-psychological atmosphere in which entrepreneurs operate

• Includes the social values of a particular country, the class structure, the educational system

• While entrepreneurs usually non-conformists, and often outcasts, social climate includes the attitudes of society toward business success and the nature and extent of the prestige and other social rewards apart from profits

• Particularly important factor in “climate” is the entrepreneur’s understanding of the “rules of the game” – the conditions under which he must operate

• Sudden changes in the rule of the game are particularly harmful to investment and enterprise

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Schumpeter V• 6. The social climate is reflected by the distribution of

income• Imperfect measure, hard to come up with good operational

definition of entrepreneurship• Schumpeter felt any development tending to squeeze

profits such as growing strength of trade unions, progressive income taxes, social welfare programs or any other government intervention designed to limit profits or redistribute income caused a deterioration of the climate.

• Explained depth and duration of depression in 1930s in terms of labor legislation, social security, public works spending progress tax structure – changed rules of the game

• In model the entrepreneurial success drives economies to high levels of prosperity – creative destruction needed for advancement

• Problem: prosperity supports a whole class of people – academics, politicians and the like who are not part of capitalism and thus do not understand its workings

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Schumpeter VI

• Over time, these groups undermine public support for entrepreneurs – increase restrictions on entrepreneurial activities.

• One of motives of entrepreneurs is to leave a large estate to their children/relatives

• Progressive taxation, wealth taxation undermines the motive for entrepreneurial activity

• With time the supply of entrepreneurs slows and the capitalist countries converge with communism:

• a hybrid system of large firms built around managers, teams and organizations where the individual plays a small role

• As in Marx, the capitalist system destroys itself.

• In Marx it is to productive causing output to run ahead of demand --unemployment,

• In Schumpeter it is too successful in creating a large surplus, thus facilitating the growth of groups that undermine the its foundations.

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Schumpeter – Extensions

Schumpeter’s model assumes that perfect competition is the norm. In today’s world:•Many economists now see pressures for innovation under oligopolistic competition with a few giant firms dominating the market providing incentives for unprecedented growth in the last century or so•Among large, high-tech business firms, innovation has replaced price as the important competitive weapon in the market•Capitalism is more likely to encourage productive entrepreneurship rather than rent seeking (non- productive) pursuit of profit.•Problem – Schumpeter’s concept of the entrepreneur is somewhat limited in developing countries.•The majority of LDC Schumpeterian entrepreneurs are trades whose innovations are opening new markets•Also, entrepreneurship in developing countries is often gap filling – seeing opportunities and responding.•In light of technical transfers from advanced economies the development of entirely new combinations should not unduly limit what is and is not considered entrepreneurial activity.

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Modern Innovation I

• Oxford Analytica, United States: Innovation Hubs Create Wealth, Division, June 24, 2013

• Innovation now is very different from what Schumpeter had envisioned.

• While rugged entrepreneur still a factor, but probably much less than he anticipated

• While the social climate is not necessarily one of encouraging entrepreneurship it does not appear as stifling as he forecast.

• Innovation has taken on a geographical dimension not envisioned by Schumpeter

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Modern Innovation II

• The new theory of innovation stresses the creation and growth of hubs and clusters.

• The ultimate success or failure of investments or businesses in the U.S. depends more than ever on geography

• The U.S. edge in key high-tech sectors will likely continue to promote job creation – even if global growth weakens

• The end of the housing collapse, which restricted labor mobility will promote faster growth

• Immigration reform if it occurs would almost cetrtinly help maintain the U.S. edge in innovative sectors

• Labor productivity is much higher in innovation hub cities than elsewhere – makes them relatively resilient during cyclical downturns

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Modern Innovation III

• Jobs associated with this new innovation economy are highly concentrated in a relatively small number of cities:

• San Francisco/San Jose

• Boston

• Seattle,

• Austin

• Raleigh/Durham

• These are “brain hub” cities

• Highly educated workforces and business-university research links have made these areas

• Rich in human capital and

• Encouraged employers and firms to locate there

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Modern Innovation IV

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Modern Innovation V

• Turns out that the new technologies all depend on highly educated employees

• Usually means those with at least a relevant four-year university degree

• Most have post-graduate training

• Result is a dynamic clustering effect where cities that already have highly educate work forces experience dynamic growth

• Attracting yet more highly educated workers

• Key cities, San Francisco Bay Area, Austin and Seattle

• Those cities outside the innovation economy experience brain drain and further decline.

• Cities outside the high tech areas include, Detroit, Cleveland and Flint

• Most US Cities are somewhere in between

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Modern Innovation VI

• Clustering around innovation industries is self-reinforcing• Once a hum such as Silicon Valley becomes and established

center of new industries• Attracts more creative and innovative individuals and

entrepreneurs• Opposite occurs in other cities such as Detroit where the

innovation economy is small• Problems: • Great divergence between different US geographical areas• Hubs focused on innovation in high value added sectors wile

traditional cities cling to manufacturing industries much more exposed to competition and globalization

• Splitting apart of income and geographical income distributions.

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Modern Innovation VII

• Hubs drive job creation not just at the top end of the market but among lower-end service employers

• However such regions still produce relatively few positions that pay wages near the median, outside the public sector.

• Dynamic helps explain both the relative resilience of the us Economic recovery

• Why the trend towards increasing wealth polarization is likely to persist

• Will there be a backlash similar to that Schumpeter predicted against the entrepreneur? This time:

• Sharply progressive income taxes?

• Protectionism?

• Expanded welfare state? 16

Expeditionary Economics I• The Schumpeterian model has recently formed the

starting point for a new branch of applied economics, expeditionary economics (ExpECON)

• ExpECON was introduced in a path-breaking article in the May/June 2010 issue of Foreign Affairs by then Kauffman Institute President and CEO Carl Schramm

• ExpECON offered as an alternative to the top-down aid-driven approaches taken in Iraq and Afghanistan

• Schramm’s basic points:

• Economic growth is vital for stabilizing post-conflict/disaster settings

• The U.S. military as often the dominant player in these environments must sharpen its ability to encourage indigenous entrepreneurship

• The conventional US approach in recent post-conflict recoveries has failed largely because it has abandoned approach so successful in building the U.S. Economy – the encouragement and support of indigenous entrepreneurial initiative and activity.17

Expeditionary Economics II• Scharamm’s work draws on many of the frustrations

with the lack of success in Iran and Afghanistan as well as conventional economic approaches to development also critiqued by:

• Dambisi Moyo – ineffectiveness of aid

• Hernando DeSoto’s – lack of property rights as an element restricting entrepreneurship

• To apply ExpECON Shramm feels the military needs to

• Expand its areas of competence,

• Rid itself of its central planning mentality, and

• Become a more flexible force that can facilitate economic growth while stabilizing the regions in which it is engaged

• ExpECON has generated considerable interest because provides deeper understanding than aid-based strategies of the dynamics at work in most conflict and post conflict disaster settings 18

Expeditionary Economics III• It lays out an optimistic plan to quickly jump-start economies

in what were previously considered impossible situations.• ExpEcon has the potential to provide a considerably less

expensive alternative than direct foreign assistance• There is also growing feeling in the U.S. military that

economic conditions are increasingly important relative to military action in creating long-standing peace and stability in many trouble spots

• At a minimum ExpEcon has shifted the focus of much work on post-conflict recovery to the role of entrepreneurship

• ExpEcon main propositions:

• The strategic use of economic development to fix failed economies in crisis states

• Fundamentally about business development

• Based on the assumption that economies growth when businesses grow; and

• Focused on local communities and local businesses

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Expeditionary Economics IV

• ExpECON is not:

• A blueprint for Western foreign direct investment;

• A call for promoting multinational corporations to set up businesses in conflict zones; and

• Focused on empowering Western aid agencies or NGOs.

• The recent experiences of Afghanistan and Iraq are cited as a reason for shifting to ExpECON leading to these propositions

• Afghanistan

• Despite billions of dollars spent over past decade in Afghanistan, the capacity of the Afghan government to deliver basic services has remained severely limited

• In the more remote areas, the government’s presence is sporadic at best

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Expeditionary Economics V• With little in the way of local governance or finance,

illegal activity continues to thrive, further undermining the authority and influence of the central government

• Still the aid effort has been so massive that an estimated 97 percent of Afghanistan’s licit gross domestic product (GDP) is derived from NATO’s military activities and donor community present

• Little evidence aid has been effective in stabilizing the country

• Some argue that aid facilitated corruption of government officials has made the situation even worse.

• Similarly little indication the aid effort has stimulated private sector activity and associated job creation.

• Rather than benefit the population and prepare them for the future, billions of aid dollars have gone to foreign contractors and Afghan elites

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Expeditionary Economics VI

• Given the fact that by 2015 the US and its allies plan to hand over security and other responsibilities to the Afghan government

• There will be significant cuts in spending and assistance with little or no indigenous production (outside of drugs) to pick up the slack

• A recession is likely to occur, derailing the transition process and condemning the country to a long period of further violence and conflict

• From the perspective of ExpECON – despite government and donor community neglect of the private sector, this segment of the economy had tremendous potential for growth and employment generation

• Further many of the broad based stereo-types often painted of entrepreneurs in conflict settings were completely wrong.

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Expeditionary Economics VII

• Extensive surveys have found:

• Afghan businesses are responding rationally to economic incentives in a highly distorted economic environment

• Uncertainty and unpredictability, not physical insecurity are the fundamental obstacles to business

• Business are adapting strategies such as vertical integration, pursuing short term trading over long-term enterprise and “buying” security in multiple ways

• Many business people believe that the Afghan government not only fails to provide basic services but also engages in corruption that directly threatens their businesses; and

• International actors distort the business environment in ways harmful to Afghan businesses

• From these findings, easy to conclude the Afghan private sector had the poential for growth and positive change – if only given a chance in the form of some degree of stability and institutional reliability

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Expeditionary Economics VIIISome questions concerning the application of expeditionary

economics in Afghanistan:• What other kind of activities should complement this

model or even be a prerequisite for it at the local level?• How should the U.S. military reinvent themselves in the

eyes of many Afghans from military actors to agents for economic opportunities and peace?

• How can the U.S. military ensure that what they does to create economic opportunities does not create new sources of conflict by destabilizing existing forces in the communities?

• How can the U.S. military ensure that expeditionary economics does not delegitimize the government at the national and local level?

• How should the transition from military-led to civilian-led reconstruction take place? and

• How can the U.S. military ensure that what they do in terms of reactivating the economy is sustainable after they leave? 24