Thursday, January 29, 2015

Reading :: The Theory of Economic Development

The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle
By Joseph A. Schumpeter

In my last few reviews, I've felt compelled to say that I'm not an ethnographer, nor am I an entrepreneur. At the risk of sounding like Dr. McCoy, I'm not an economist either. But I wanted to read this book because it's a classic for entrepreneurs. In this review, I'll focus mainly on the terms and concepts that have made their way into the entrepreneur lexicon. Since I'm reading the Kindle version, I won't use page numbers.

Schumpeter defines economic development as "only such changes in economic life as are not forced upon it from without but arise by its own initiative, from within," and argues that "Development in our sense is then defined by the carrying out of new combinations." He continues, "This concept covers the following five cases: (1) The introduction of a new good ... (2) The introduction of a new method of production ... (3) The opening of a new market ... (4) The conquest of a new source of supply of raw materials or half-manufactured goods ... (5) The carrying out of the new organization of any industry." These all will sound familiar to entrepreneurs today: they are potential component claims in the complex argument of the entrepreneur's pitch.

Combining "new combinations of the means of production" and credit, Schumpeter says, yields "the fundamental phenomenon of economic development. The carrying out of new combinations we call 'enterprise'; the individuals whose function it is to carry them out we call 'entrepreneurs.'" He adds that "we call entrepreneurs not only those 'independent' businessmen in an exchange economy who are usually so designated, but all who actually fulfil the function by which we define the concept, even if they are, as is becoming the rule, 'dependent' employees of the company, like managers, members of the boards of directors, and so forth, or even if their actual power to perform an entrepreneurial function has other foundations, such as the control of a majority of shares."

Yet "our concept is narrower than the traditional one in that it does not include all heads of firms or managers or industrialists who merely may operate an established business, bur only those who actually perform that function." And a few pages later: "whatever the type, everyone is an entrepreneur only when he actually 'carries out new combinations,' and loses that character as soon as he has built up his business, when he settles down to running it as other people run their businesses." The functions are different: "Carrying out a new plan and acting according to a customary one are things as different as making a road and walking along it."

Critically, entrepreneurs are not the same as inventors. "As long as they are not carried into practice, inventions are economically irrelevant. And to carry any improvement into effect is a task entirely different from the inventing of it, and a task, moreover, requiring entirely different aptitudes. Although entrepreneurs of course may be inventors just as they may be capitalists, they are inventors not by nature of their function but by coincidence and vice versa."

"Capital," Schumpeter says, "is nothing but the lever by which the entrepreneur subjects to his control the concrete goods which he needs, nothing but a means of diverting the factors of production to new uses, or dictating a new direction to production. This is the only function of capital" (His emphasis).

Once the new combinations have been carried out, Schumpeter says, "the new process of production will be repeated. And for this entrepreneurial activity is no longer necessary." Entrepreneurship in his sense is fleeting, an innovative stage that leads to stable production, and an entrepreneur who is not engaged in this stage is no longer an entrepreneur.

At the end of the book, Schumpeter responds to critics. Most interesting for me was the criticism: "why is it that economic development in our sense does not proceed evenly as a tree grows, but as it were jerkily; why does it display those characteristic ups and downs?" And he answers: "exclusively because the new combinations are not, as one would expect according to general principles of probability, evenly distributed through time—in such a way that equal intervals of time could be chosen, in each of which the carrying out of one new combination would fall—but appear, if at all, discontinuously in groups or swarms." Schumpeter argues that these swarms are due to three things: (1) "the vast majority of new combinations will not grow out of the old firms or immediately take their place, but appear side by side, and compete, with them." (2) An en masse increase in entrepreneurial demand "signifies a very substantial increase in purchasing power all over the business sphere." (3) trying new combinations results in more errors. "Why do entrepreneurs appear, not continuously... but in clusters? Exclusively because the appearance of one or a few entrepreneurs facilitates the appearance of others, and these the appearance of more, in ever-increasing numbers" (his emphasis). One or two entrepreneurs lead, and once they are successful, others rush in.

I found the book interesting, although hard to get through in spots. My real interest is in how entrepreneurs see opportunity and how they argue in ways that help others see it. And for those purposes, Schumpeter's foundational work has been helpful. I wouldn't call this book a page-turner, but if you're interested in entrepreneurship and how entrepreneurs argue, it's a must read.

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