Schumpeter’s Theory of Creative Destruction

Welcome to the IRLE blog!  Here we’ll highlight some topics related to the readings before the Workshop in Aspen just a few weeks away.  Today I will be the trumpeter for Schumpeter – talking about Schumpeter’s theory of creative destruction (See: Schumpeter – Capitalism, Socialism, and Democracy" Chapters 7-8; “McCraw on Schumpeter, Innovation, and Creative Destruction,” EconTalk podcast).

Schumpeter argues in "Capitalism, Socialism, and Democracy" that capitalism is never stationary and always evolving, with new markets and new products entering the sphere. He is perhaps most known for coining the phrase “creative destruction," which describes the process that sees new innovations replacing existing ones that are rendered obsolete over time.  As an example, in the late 1800s and early 1900s incremental improvements to horse and buggy transportation continued to be valuable, and innovations in the buggy and buggy whip could fetch a considerable price in the market.  With the introduction of Ford’s Model T in 1908, however, these “technologies” were effectively driven out by a superior innovation.  Over time, newer and better innovations will continue to drive out worse ones, just as the Model T did the horse and buggy and numerous iterations of vehicles have subsequently driven out the Model T and generations of its successors.  Parallels in the electric power market are easy to see, where we have seen the first steam turbines replaced, generation by generation, with the current fleet of combined cycle natural gas plants, solar panels, wind farms, and so on. 

Schumpeter’s theory of creative destruction links closely with his view of the importance of economic dynamism.  Most economic analyses are performed in the static sense, where the economist looks at the world in its current state to estimate the effect of, say, the introduction of a new policy.  While this snapshot analysis can frequently be useful, it also risks obscuring an important issue – the effect of a policy on the initial steam turbine may have effects (positive and/or negative) that are unforeseen at the time of the policy on future generations of innovations in the world of electric power generation. 

For the regulator, the importance of dynamism raises a series of difficult questions.  How should a new technology be regulated?  As an example, consider the introduction and integration of renewable power generation and distributed energy resources.  On the one hand, regulation to preserve the profits of the incumbent utility and to recover their investment in existing technologies (i.e. fossil fuel fired and nuclear power plants or the transmission and distribution network) may impede the introduction of new and better (cleaner, cheaper at a minimum terms of social cost) technologies.  On the other hand, the theory of creative destruction suggests that over time, a newer technology will replace and render obsolete what we consider to be on the cutting-edge technologically today.  So regulation that favors the new technology may, in unforeseen ways, hinder the next innovation.  How do we identify an invention that is the innovation destined to render the existing fleet obsolete, as opposed to supporting one that in fact prevents a better innovation from replacing it?  Or perhaps, how do we design regulation to support new technologies without precluding investments in the next generation of innovations?

I look forward to hearing your thoughts and to discussing this and other topics with you in Aspen.