In the 1950s, in “Capitalism, Socialism, and Democracy,” Prof. Schumpeter observed that capitalism was not static. The evolution of new markets and new products entering the sphere was the centerpiece. He also detected that emergence of innovations offering better alternatives, often at a lower cost, was destroying incumbent products, jobs, firms, and industries. Hence, he coined the phrase “creative destruction” to articulate this phenomenon. In fact, Schumpeter’s creative destruction is the core strength of capitalism for offering increasingly better products at less cost. However, what is the role of the Market Economy in driving Schumpeter’s creative destruction? In explaining it, he placed the entrepreneur as the cornerstone of capitalism.
But is entrepreneurship enough to keep improving products and processes? Is there a limit to advancement? Moreover, does the race of offering better products at a lower cost runs the risk of monopolization? On top of it, what is the role of technology?
Offering better products at lower cost—conflicting objectives
To live our life, we have to serve numerous purposes. They are like meeting hunger or going from one place to another. The list is already long, and it is expanding. In fact, our living standards depend on the quality and cost of getting our jobs done. To execute our jobs, we deploy products. Therefore, for the continued growth of living standards, we need the flow of increasingly better products at a lower cost, while giving us more comfort. Moreover, we need new products to get our emerging jobs done. Indeed, the perennial gale of Schumpeter’s creative destruction is the power of capitalism to meet this agenda.
But how do we meet this conflicting agenda, while meeting increasing consumption with depleting resources? Moreover, we need also to pay increasingly more for labor to produce those products. Ideas for mixing inputs like materials, energy, and labor play a crucial role in meeting the conflicting goal.
Praxis is the genesis of Schumpeter’s creative destruction
In ancient philosophical writings, praxis is a reoccurring topic. It refers to the humans’ act of engaging, applying, exercising, realizing, or practicing ideas for Getting jobs done better. Subsequently, this topic intrigued legendary Carl Marx. He referred to it for explaining human beings’ creative urge to generate ideas through which man creates and changes his historical world and himself. In fact, these ideas fuel our capability of offering better means, whether light bulbs, automobiles, or smartphones. In explaining the waves of innovations, often causing destructions to jobs, firms, and industries, Prof. Schumpeter extended Marx’s praxis into creative destruction. Subsequently, modern economic thinking finds this theory as the cornerstone in explaining how economies evolve and the role of the market economy. Moreover, it has also been a critical topic in theorizing sustained growth paths, free from growth traps.
As opposed to increasing the supply of raw materials and labor, there has been a growing focus on ideas in producing economic outputs. Moreover, it’s pivotal for meeting sustainable envelopment goals. Therefore, the challenge is to produce more economic value by consuming less raw materials, labor, and energy.
The flow of Knowledge for Ideas to Drive Schumpeter’s creative destruction
Knowledge is the input to the creative process of producing ideas. Through observations, experimentation, and imagination, human beings gather knowledge. In fact, knowledge immerges in three different forms: 1. Art, 2. Tacit, and 3. Scientific. Scientific knowledge could be termed as a codified one. Through experience, human beings gather tacit knowledge. Imagination and intuition produce knowledge in qualitative form, coined as art. Consequentially, all these three forms of knowledge fuel the creative process of idea formation. But to scale up the implementation of ideas, we need effective and efficient means, which demands scientific knowledge.
Institutional capacity for increasing the knowledge stock is pivotal
There appears to be a close feedback loop among the three important forms of knowledge. However, systematic research is needed to increase the knowledge stock for creating the Flow of Ideas. In fact, this flow of ideas is vital in improving existing products and also innovating new ones. Hence, there is a strong role of institutional R&D, both within profit-making firms and governments’ R&D centers, for empowering the market economy and offering us an increasingly higher quality of living. In retrospect, such a necessity started the formation of the USA’s science and technology policy.
Prof. Vannevar Bush made this argument in his report to the US president Roosevelt. In this report of Science, The Endless Frontier, Mr. Bush called for an expansion of government support for science, which culminated in the National Science Foundation. In the absence of federal support for increasing R&D investment, consequentially increasing the knowledge stock, the success market economy out of creative destruction could have been significantly different.
Subsequently, the US government’s policy-making steps progressed in establishing National Science Foundation and Defence research agencies like DARPA and ARPA.
Competition to profit from ideas drives creative destruction
Human beings are driven by economic incentives. How can we offer increasingly better products at a lower cost, while we keep paying more inputs like labor, energy, and raw materials? We understand the role of ideas. These ideas should be produced, refined, and integrated into products and processes. That is the place, we find the role of firms competing to profit from ideas. In the absence of profit-making incentives, productive activities do not compete for ideas for offering better products at a lower cost. This is the nucleus of the strength of the free market.
However, in the absence of profit-making competition, even the rich stock of knowledge does not fuel Innovation. For this reason, the former Soviet Union could not turn their high scientific success into innovation for fueling economic growth. In fact, it’s partly attributed to the downfall of a command-driven economic structure, as the growth was extremely low due to the slow pace of innovation. On the other hand, economies embracing free-market economic principles have been experiencing far higher growth.
Paul Romer’s Ideas and Objects shed further light
In articulating the role of ideas, Prof. Paul Romer has articulated the production function as a function of ideas and objects. He argued that economic value depends on objects and, most importantly, on ideas of mixing them. Ideas offer the opportunity for profit-making firms to compete by offering increasingly higher-quality products at decreasing costs. However, to profit from ideas in a competitive market, profit-making firms need excludable ideas. Patents, speed of idea generation and exploitation, scale advantage through global reach, complementary assets, and human capital are often sources of making ideas excludable. In the absence of excludability, often access to ideas alone does not create profit-making incentives for competing firms.
Entrepreneurship without the flow of knowledge does not cause Schumpeter’s creative destruction
As Prof. Schumpeter observed, entrepreneurs are the cornerstone of capitalism. But what are they going to offer? By mixing objects like labor, raw materials, and energy with commodity ideas, entrepreneurs cannot succeed in offering better quality at a lower cost to make a profit. Just by imitating or replicating, entrepreneurs cannot find a scalable growth path. For this reason, most of the small and medium-sized enterprises remain stuck for decades. They need to have access to ideas, to begin with. In advanced countries, like the USA, federal funding in R&D has been a source of ideas. Particularly, defense-related R&D agencies have been playing an important role in increasing the supply of idea-producible knowledge stock. They are also demonstrating ideas out of newly generated knowledge.
In the absence of this flow of knowledge and ideas, entrepreneurs or Startups cannot succeed just relying on their hard work, intense desire, and risk capital. For example, in the absence of the knowledge stock and ideas of a graphical user interface developed by Xerox’s R&D lab, Jobs could not have succeeded in transferring garage startups into a mega success story. Even today, Apple mostly relies on sourcing ideas, often developed by defense programs, and fine-tuning them to succeed in releasing successive better versions of its iconic iPhone. The necessity of the flow of knowledge and ideas is often overlooked to power entrepreneurship to fuel economic growth, particularly in developing countries.
Uprising of Monopoly
In the race of profiting from ideas, dominant firm/s emerge. They acquire the excludable capability to keep making successive better versions at decreasing cost. They also succeed in leveraging core assets further by innovating a family of products. The inherent scale effect of ideas produces a Natural tendency of monopoly. With the growth of excludable ideas in product value, the Monopolistic market power keeps rising. Therefore, it appears that rising monopoly in idea-intensive industries is a natural characteristic. But often, monopoly is detrimental for maximizing social welfare. Due to profit-maximizing pricing, society suffers from deadweight loss.
Unlike conventional monopiles, many of the emerging monopolies are not in the game of price-fixing through collusion. Rather such a monopoly arises out of the mission of offering better quality products at a lower cost. As a result, the existing antitrust regulatory framework does not appear to be applicable. Rather focus should be on increasing the supply of ideas for fueling startups pursuing the next wave of creative destruction.
By the way, in the absence of such flow, the freedom of pursuing entrepreneurship in the market economy is not sufficient to drive successive waves of Schumpeter’s creative destruction. That is a reason we need to keep making geographies rich with knowledge and ideas, like California, to empower young kids to plot instabilities to cause creative destruction to monopolies like Google, Facebook, Amazon, or Microsoft. Powering instabilities through the flow of knowledge and ideas for fueling the next wave could make monopolies transient.
Boom, Burst and Creative destruction
Often, it’s perceived that speculative investments create a boom, which is followed by a burst. Invariably, the profit-making opportunity around emerging technology core attracts floury of investments or startups. They often start the journey at a loss. As the race only opens profit-making opportunities for only a few, most of the entrants are compelled to exit, creating busts. But there is another effect. That is caused by Schumpeter’s creative destruction. Upon succeeding in the race of ideas, dominant firms experience a boom in their market share, revenue, and profit. This boom is followed by the burst due to the uprising of the next wave in offering better alternatives at a lower cost. The rise of startups in offering such alternatives by leveraging the next technology core causes destruction to incumbent monopolies, jobs, and products. It causes the effect of the burst.
Creative destruction is institutionalized as a routine sustaining innovation
With the progression of the race of pursuing new disruptive technology core, dominant firms start emerging with clear product designs. To sustain the journey, the focus shifts to the regular release of successive better versions for countering the force of replication, imitation, and innovations. The journey takes the shape of Incremental innovation for sustaining innovation in the market. Such incremental innovation of adding new features and/or improving existing features also keeps expanding the market. As a result, the journey of entrepreneurship for pursuing creative destruction matures into institutionalized, routine-sustaining innovation.
Innovator’s decision Dilemma cause disruption—Clayton’s Disruptive innovation
Upon succeeding in causing creative destruction, winning firms invariably become bureaucratic in pursuing incremental or sustaining innovation. Return on investments being made for incremental innovation produces more or less risk-free profitable revenue. For them, reallocating resources for pursuing risky ventures does not appear to be a good management practice. Due to adherence to sound management practices for maximizing return on allocated resources, they often shy away from taking the risk to switch to the next wave of innovation, which will likely pose the threat of disruption. Prof. Clayton termed it as Innovator’s decision dilemma. This observation is at the core of explaining why successful incumbent firms fail to make the transition to the next megatrend, as opposed to overlooking and getting disrupted.
As a matter of fact, the boom gained by dominant firms from causing destruction contains seeds of their own destruction. However, there is a fine line between Schumpeter’s creative destruction and Clayton’s disruptive innovation.
In the global race of ideas, developing countries are marginalized
Well, does the market economy offers equal opportunities for profiting from ideas to developing or less developed countries. In reference to the articulation of economic outputs as Objects and ideas, so far, developing countries are busy supplying objects. Whether in export-oriented production, import substitution, or even in the production of indigenous products, they focus on adding value through objects. But increasing roles of ideas in both products and projects, the role of objects in most of the industrial products has been falling. The content of objects like labor has been continuously shrinking due to the increasing roles of ideas in labor-saving redesigns of products and processes to produce them.
As a result, value addition by developing countries has been shrinking. On the other hand, growing scale advantage of ideas eroding the comparative advantage of local value addition for the domestic market. Due to the weak supply capacity of excludable ideas, the recent surge of startups does not appear to be a solution either for leveraging as well as coping up with perennial gale of creative destruction.