Joseph Schumpeter is not one of the Chicago Boyz, but we can be magnanimous and overlook that. He was an Austrian, but not part of the Austrian School (Ludwig von Mises and F.A. Hayek of sainted memory). His best-known work for the general public is Capitalism, Socialism and Democracy (1942). It is well worth the effort of reading, if only to enjoy his courteous nineteenth-century prose style, with its direct addresses to the reader. His work is instructive as well as pleasurable, in that he contributed two very useful concepts to economic thought: creative destruction and the struggle between intellectuals and capitalists. In the latter case, I think he backed the wrong horse, but we’ll come to that later. This entry will address the former.
The process of creative destruction, as he describes it, arises from the efforts of capitalists to gain at least a temporary and partial monopoly. Pure competition, as Schumpeter sees it, exists only in open markets for fungible commodity products. Outside that special case, capitalists seek to differentiate their products from the competition. The differences may be in features, price, functionality, or anything else human ingenuity can devise. The goal in economic terms is to make a set of similar goods less substitutable for each other. The effect, in the event this is successful, is a temporary and partial monopoly. For example, a computer manufacturer may find a battery design that allows longer longer operation of a laptop. He can charge more than his competitors now, regardless of his costs, because a business traveller might find the battery life to be the determining factor in his choice. He would not drive his competitors out of business because less demanding consumers would accept the shorter battery life and keep the difference in their pockets. Competitors, either anticipating this advance or seeking their own little monopolies, might find other ways of increasing battery life, or making their computers more cheaply and selling lower. They might also pursue other means of differentiation, such as increased display clarity, bundled software, or weight. Soon, others try combinations of these advantages, and lay on new ones. Eventually, the continuous improvement from product differentiation renders the original models obsolete – unsaleable at any price. Our IT people call them “mooring anchors.”
This concept neatly ties together perfect competition, real-world competition, oligopoly, and monopoly by suggesting a common method by which each might arise. In perfect competition, producers are unable to distinguish their products. Each is a perfect substitute for the other. The producers are price-takers. With product differentiation, the products are imperfect substitutes for each other and producers have some control over prices, at least to the extent that people are willing to pay for the differences (marginal utility theory and Hayek’s idea of price as information transmission would have been helpful here, but Schumpeter does not bring them into the discussion). Monopoly is the extreme case where there are no substitutes for the product, and no competitors to offer one. The other appealing feature of this idea is that it appears to resemble real-world behavior. Every product advertised in the newspaper is touted as either representing new, desirable, perhaps unique features; or else, as essentially the same as another product but at a significant discount. Businessmen constantly seek to find and exploit an advantage, or to negate one their competitors have found. The system constantly seeks but never achieves equilibrium. The result is that capitalism evolves over time.
Nobody bothers to refute Marx any more – Karl Popper left little or nothing undone – but Schumpeter’s high regard for Marx appears to have made him reluctant to use creative destruction as a refutation of the declining return on invested capital. This is one of the mechanisms that Marx thought would lead to the crisis and collapse of capital. But if entrepreneurs can discover new opportunities for higher profits, the decline does not happen, at least on the macro level. Outdated enterprises do in fact experience this decline, but they do not attract new investment and eventually are culled from the economic gene pool.
To see the effect when the operation of creative destruction is thwarted, look at a socialist economy. Capital invested according to political or social considerations rarely has a high rate of return. Worse, failing industries are kept alive artificially, continuing to draw in and destroy capital while the returns on that capital dwindle to nothing. In a bit of delicious irony, the best places to observe the declining return on capital are precisely those places that followed Marx.
Or, as an advertising guy might put it, “Have you driven a Trabant lately?”