Notes on Schumpeter's Capitalism, Socialism and Democracy

These are my notes on Joseph Schumpeter's Capitalism, Socialism and Democracy for an economics project in college.

Equilibrium models of market structure lead to the conclusion that the smaller the number of firms in an industry, and the more influence those firms have over price, the less efficient they will be in terms of output. U.S. history from roughly 1900 to 1950 leads to the opposite conclusion. Industries grew more concentrated yet "we cannot fail to be struck by the rate of advance which, considering the spectacular improvement in qualities, seems to have been greater and not smaller than it ever was before. If we economists were given less to wishful thinking and more to observation of facts, doubts would immediately arise as to the realistic virtues of a theory that would have led us to expect a very different result. Nor is this all. As soon as we go into the details and inquire into the individual items in which progress has been most conspicuous, the trail leads not to the doors of those firms that work under conditions of comparatively free competition but precisely to the doors of the large concerns." (pp. 81-2)

Equilibrium models focus on price and quantity, and evaluate 'efficiency' in terms of output, using output as a measure of social value. This leads to incorrect interpretations of cases in which 'imperfect' competition "offers compensations which, while not entering any output index, yet contribute to what the output index is in the last resort intended to measure." (p. 82)

Market process is by its nature evolutionary not static. "And this evolutionary character of the capitalist proces is not merely due to the fact that economic life goes on in a social and natural environment which changes and by its change alters the data of economic action ... The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers' goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates." (pp. 82-3)

Entrepreneurs are the individuals who discover and implement those innovations. Entrepreneurship "incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one," a process of 'creative destruction.' (p. 83 or 84)

Equilibrium models assume firms act solely with respect to the data, but in the 'perennial gale of creative destruction' firms must constantly prepare for changes in the data, for innovations. For equilibrium models, "the problem that is usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them." (p. 84)

Equilibrium models cannot account for innovations; they assume that quality cannot vary (a main target of innovation), they assume production technology is fixed (another source of innovation).

A theory including innovation leads to different conclusions from those of equilibrium models. Conditions of imperfect competition can sometimes be necessary and more efficient than perfect competition, especially in the long run.

First, output-restricting policies of firms are less important, because innovation will render them obsolete, and they acquire a stabilizing role. Restricting output (which leads to economic profit) can be a way of providing for uninsurable risk. Insurance is normally included in costs, but allowances for uninsurable risk are not, making price appear to be above costs. Some firms will fail to avoid the uninsurable risk, and achieve losses, while others achieve profits.

Second, some industries require conditions of imperfect competition in order to exist at all, so that perfect competition leads to zero output. High startup costs (no free entry) may require profits to justify investment. Variable sales may require profit in one short-term period to cover losses in another short-term period (perfectly competitive firms would not survive the losses). Also, the possibility of profits is the incentive for innovation, which leads to the greatest output expansion in the long run. Removing all profits would be efficient from an equilibrium point of view, but would reduce innovation, and so would be less efficient in the long run. Innovation has transition costs, and restrictive policies of firms with the old product or technology may ease the transition and spread the costs (retraining, unemployment etc.) over time.

Third, price rigidity has the same new role as output restriction. Price rigidity is prices being less sensitive to changes than they would be under perfect competition. A product's price may remain constant, and thus seem rigid, altough a new product offered at a lower price has superseded it. Innovations may thus provide a form of price flexibility that is not seen when focusing on one good. Quality may vary instead of price, as often happens with the introduction of new products as they are tested and refined, so that again price appears rigid but is not (price relative to quality falls). Price rigidity may serve as a stablizing force, if the intention of the pricing policy "is to avoid seasonal, random and cyclical fluctuations in prices and to move only in response to the more fundamental changes in the conditions that underlie those fluctuations." (p. 93)

Fourth, some conventional economists claim that imperfectly competitive firms will stall technological progress in an attempt to preserve their existing capital stock. This is contradicted by empirical evidence, because the vast majority of large firms have well-funded research and development departments. Also, innovations have transition costs, and the increase in productivity they bring about may not cover these costs, especially considering that today's innovation will be obsoleted by tomorrow's. Thus firms may appear to be stalling progress when in fact they are simply minimizing costs.

Fifth, monopoly is not necessarily less efficient than other modes of organization. Monopoly literally means "single seller," so most firms are monopolies (because of product differentiation). Equilibrium models usually redefine monopoly to mean single sellers whose markets are not open to other firms, and whose products have no close substitutes. Monopoly will be less important when considering innovation, which can provide a substitute. Such cases are rare, and where innovation is possible, the few remaining cases will have to behave as if competition is present (to discourage would-be innovators). As is acknowledged by many equilibrium economists, monopoly can be more efficient than perfect competition where economies of scale exist. Further, profits (which in the equilibrium models arise solely from monopoly power) are the incentive to innovate, and so can lead to more output in the long run.

Last, static equilibrium models do not account for past or expected future values of economic quantities, and can not account for unexpected change (innovation included). Dynamic equilibrium models are an improvement, because they take into account past and expected values, but still cannot account for innovation, which is the prime mover of capitalism.