Creative destruction
Michael D. Pfarrer and Ken G. Smith
Coined by Austrian economist Joseph Schum peter in Capitalism, Socialism, and Democracy (CSD) (1942), creative destruction is an evolu tionary process within capitalism that ‘‘revolu tionizes the economic structure from within, incessantly destroying the old one, incessantly creating the new one.’’ It is this ‘‘perennial gale’’ that every firm operates in, and in that ‘‘every piece of business strategy acquires its true sig nificance’’ (1942: 83; original emphasis).
From his definition, one can conclude that Schumpeter viewed the market and competition as dynamic and in flux. Educated in Vienna at the turn of the century, Schumpeter was a stu dent of the Austrian school of economics, a loose knit group of researchers and acolytes that studied in the tradition of Carl Menger. Unlike traditional economists, who focus on equilibrium and a static form of competition, the Austrians view the market as a dynamic process (Smith, Ferrier, and Ndorfer, 2002). Whereas classic economic theory believes the key to competitive advantage and sustainable profits lies in the dampening of competition through barriers to entry and strategic position ing (Porter, 1980), the Austrians believe that abnormal profits and competitive advantage are fleeting, due to the perennial gale of firm actions and rival reactions. Innovation and firm success lead to imitation, which leads to erosion of profits.
Whereas classic economic theory largely ignores change, uncertainty, and disequilibrium, the Austrians emphasize innovation, flexibility, 50 creative destruction and heterogeneity (Jacobson, 1992: 784). Central to this debate is the role of the entrepreneur. The ideas of perfect competition and efficient markets, bulwarks to classic economic theory, downplay the role of the entrepreneur in market development and the accrual of profits (Jacob son, 1992). Schumpeter and the Austrians, how ever, see the entrepreneur as the central player in the market process. For Schumpeter, the entre preneur is any manager or decision maker who innovates (Allen, 1991, I: 104). These innova tions, or ‘‘new combinations,’’ include new goods, new methods, new markets, new sources of supply, and new industry organizations (Schumpeter, 1934: 66). Other Austrians, notably Kirzner (1973), have focused on the entrepreneur’s use of idiosyncratic information to take advantage of opportunities not noticed by others. Different entrepreneurs will thus discover different opportunities because they possess different knowledge (Shane, 2000). Therefore, developments of new combinations will not be evenly distributed among industries and over time; instead, they will appear in ‘‘dis crete rushes’’ or ‘‘swarms’’ (Schumpeter, 1934, 1942).
Schumpeter and other Austrian economics adherents view the market as never reaching equilibrium, due to the role of entrepreneurial innovation (Smith, Ferrier, and Ndorfer, 2002). These innovations, or ‘‘new combinations,’’ direct the flow of resources toward fulfillment of consumer needs as opportunities arise, and when an innovating firm takes action that gener ates profits, competitors will respond (Schum peter, 1942). The response leads to an inability of the innovators (first movers) to sustain profits (competitive advantage) due to imitation (Lee et al., 2000; Ferrier, Smith, and Grimm, 1999; Grimm and Smith, 1997). As the value of the new creation is destroyed, market leaders lose their advantage, and profit margins slow. Imita tion increases, and overall market expansion slows, moving the business cycle toward equilib rium – until another innovation shatters the status quo (Schumpeter, 1934; Jacobson, 1992). The successful firm, then, must constantly be innovating to sustain profitability, and to avoid the perennial gale of creative destruction.
Schumpeter’s idea of creative destruction is borne from the ideas he put forth in his two best known works, the Theory of Economic Develop ment (TED) and CSD. Schumpeter’s concept of creative destruction is explored in chapter 7 of CSD, ‘‘Can capitalism survive?’’ Ironically, many of today’s modern Austrians, as well as other strategy researchers, use creative destruc tion as support for capitalism’s unique ability to reincarnate itself, but fail to focus on the nega tive impact that such a process might have. In order to fully understand the definition of cre ative destruction and its impact on current re search, it is important to understand the context within which its author placed it.
Robert Loring Allen’s biography of Schum peter, Opening Doors (1991), expertly explains Schumpeter’s affection for capitalism, but also his belief in its demise. Schumpeter argued capitalism’s success would ‘‘inevitably lead to the throttling of innovation and a transition to socialism’’ (1991: xi). His thesis states that capitalism, ‘‘while economically stable . . . cre ates . . . a mentality and a style of life incompatible with its own fundamental conditions. [It] will be changed . . . although not by economic necessity and probably even at some sacrifice of economic welfare, into an order of things which it will be merely a matter of taste and terminology to call Socialism or not’’ (Schumpeter, 1928: 385–6). Loring goes on to elaborate on Schumpeter’s expectations, saying that capitalism’s success re moves the entrepreneurial stimulus to gain profit (1991, II: 27). Whereas success may breed success, profit gainers also tend to become sated after a while. Schumpeter did not deny capitalism’s role in the economic progress of the last two centuries, but he also felt that its overemphasis on profits would eventually fail to make people better or happier (Loring, 1991, II: 123–4). Indeed, as innovation becomes routine, growth will slow, and the entrepreneur will not feel the urge to challenge the status quo. The capitalists will thus become the bureaucrats and the ruling class, and the disenfranchised will eventually lash out against the ‘‘system’’ (Schumpeter, 1942). In the end, capitalism will fail because it has done its job too well – ‘‘it has created the institutions and condi tions . . . that can easily be transformed into socialism’’ (Loring, 1991, II: 126). Interestingly enough, Schumpeter did not foresee the role of creative destruction in continually renewing creative destruction 51 the innovative and capitalist process, thus permitting capitalism to be reborn again and again.
While Schumpeter initially insisted that in novations typically originated in new, small firms (1934), he later argues in CSD that it is large, established enterprises frequently enjoying monopoly power that play the role of innovative leaders (1942). Schumpeter claims that because technical innovation is inherently risky, risk bearing appears to be more likely when firms are able to deploy an array of restrict ive practices to protect their investments. He also argues that perfect competition is not only impossible but also inferior, and should not be set up as a model of ideal efficiency. Challenging the microeconomic theory assertion that mono polies’ pricing behavior distorts socially benefi cial resource allocation, Schumpeter claims that monopolies have to exercise their power cau tiously, both in pricing and product policy, out of fear that they could stimulate another wave of monopoly eroding changes. Therefore, mono polies are not nefarious, but rather have greater incentive to develop innovations, and thus bene fit consumers (Conner, 1991). As one would expect, there continues to be challenges to this notion and other Schumpeterian ideas among economic, organizational, and strategic research ers (see Scherer, 1992, for a review).
Perhaps the greatest challenges, however, to Schumpeter’s ideas of innovation, disequilib rium, and the role of the entrepreneur have come from fellow Austrian adherents. Israel Kirzner (1973, 1997) has long argued that in novation induces an ‘‘equilibrating’’ change to the status quo, in contrast to Schumpeter’s more ‘‘disequilibrating,’’ radical upheaval. Frank Knight, in his theory of entrepreneurship, argues that the innovator and capitalist are inter twined, whereas Schumpeter believes that their functions are separate (Evans and Jovanovic, 1989). Because of that, Knight argues entrepre neurs have to be responsible for their own capital funding. Schumpeter, thinking the entrepreneur is not a risk taker (1934: 77), feels that there are no liquidity constraints to being an entrepre neur, and that eventually the capital markets will bear the financial risk of discovery.
Schumpeter’s ideas have flourished among his disciples and today’s researchers. Many argue that Austrian economics is still radical and beyond the mainstream (Jacobson, 1992), but its vestiges can be seen in several fields, includ ing competitive dynamics (cf. Smith, Ferrier, and Ndorfer, 2002; D’Aveni, 1994), dynamic capabilities (cf. Eisenhardt and Martin, 2000; Teece, Pisano, and Shuen, 1997), evolutionary theory (cf. Nelson and Winter, 1982), and the entrepreneurship based (cf. Shane and Venka taraman, 2000) and resource based view litera tures (cf. Barney, 1986). Definitions of creative destruction and the ‘‘perennial gale’’ also abound: ‘‘Inevitable and eventual market decline of leading firms through the process of competi tive action and reaction’’ (Smith, Ferrier, and Ndorfer, 2002); ‘‘Advantage is created and des troyed. Eventually every advantage will be eroded as realization of profits invite imitation. Firms that attempt to maintain the status quo are doomed’’ (Grimm and Smith, 1997); ‘‘Techno logical change occurring in upheavals’’ (Wald man and Jensen, 2001); ‘‘Invention of a new technology creates market disequilibrium’’ (Shane, 2000); and so on.
If ‘‘no general laws of business exist,’’ as Jacobson writes, and ‘‘business success is a ‘sci ence of the specific’ ’’ (1992: 803, 804), then Austrian economics in general, and Joseph Schumpeter’s idea of creative destruction in par ticular, should serve well the modern researcher who believes that markets are always changing, and that the pursuit of innovation is paramount to firm survival.
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