Schumpeterian “Creative Destruction” and the Perfection of Market Imperfections

So for reasons not worth going into (OK, Twitter spat), I became interested in whether my understanding of Schumpeter and his Marx-inspired theory of “creative destruction” was wrong. I have a bit of an allergic reaction to the term, which I associate with CEOs shrugging off layoffs as “churn” and taking the Jack Welch position that such actions are just a sign of a company moving forward. I had read Schumpeter before and had fuzzily associated the term with the breakdown of monopoly advantage and extraction of excess profits through rent-seeking. When an article used it as seeming shorthand for Time Inc. “shrinking” I thought, “Aha! Not right! Time still has a ton of monopolistic power – it’s why they can make so much money from decidedly crappy magazines.”

I was mostly wrong in my remembrance. The section of Schumpeter’s book the term “creative destruction” comes from (“Can Capitalism Survive” from Capitalism, Socialism, and Democracy) does indeed deal primarily with monopoly advantage, but the application of creative destruction is not limited to that section. In fact, creative destruction isn’t really limited at all. Schumpeter calls it the “perennial gale” that blows through every element of capitalism. To Schumpeter, it makes as little sense to say “the media industry is undergoing creative destruction” as it does to say “Bruce Willis is undergoing gravity” – creative destruction never stops, and effects all industries equally all the time. Sometimes the effects are more evident, but the toaster industry is living with creative destruction as much as Time Warner.

But in short, I was wrong. The traditional media can be seen as being affected by “Schumpeterian Creative Destruction” (although they can’t be seen as going through it – there is no ‘through’).

Still, I’m glad the Twitter exchange happened, because it gave me a chance to re-read the monopoly power section of the work, and to see why that was the most salient aspect of the work for me. The reason is simple – it’s a great read, and well worth your time. The basic idea is that the so-called “market imperfections” of capitalism are not actually imperfections, but instead crucial to how the market produces progress. In fact, Schumpeter, in a weird move for a Marxist, argues that attempts to remove these market imperfections would lead to a less effective capitalism. Here’s some notes on the argument he makes:

Market distortion is essential to investment. In a market with perfect competition, who would want to invest? In a perfect market, the price you can charge for a product comes so close to its cost that investment is not worth the return. For this reason, capitalism needs monopolistic practice. Monopolies rarely exist in absolute terms, but rent-seeking and associated behaviors are the norm. My ability to wage an advertising campaign against an upstart competitor is a small form of monopolistic power. The fact that it is hard for people to get their data out of my online service is a small form of monopolistic power.

The reason investors invest is in hope of monopoly-like advantages. The price of GOOG or APPL is based on the idea that they will be able to charge marginally more for their products than they cost to make because of advantages that make competition imperfect – that’s where profit comes from. Those advantages include patents, copyright, “mindshare”, ability to take on debt, exclusive contracts with suppliers and distributors, user lock-in:

Similarly, if a patent cannot be secured or would not, if secured, effectively protect, other means may have to be used in order to justify the investment. Among them are a price policy that will make it possible to write off more quickly than would otherwise be rational, or additional investment in order to provide excess capacity to be used only for aggression or defense. Again, if long-period contracts cannot be entered into in advance, other means may have to be devised in order to tie prospective customers to the investing firm.

So the point of investment (according to Schumpeter) is to accrue monopoly-like advantages. It’s not necessary to see this as greedy behavior – it is only through securing excess value in good times that a corporation can survive periods of difficulty. In other words, the ability to distort the market slightly is crucial to long-term survival of firms:

On the other hand, enterprise would in most cases be impossible if it were not known from the outset that exceptionally favorable situations are likely to arise which if exploited by price, quality and quantity manipulation will produce profits adequate to tide over exceptionally unfavorable situations provided these are similarly managed. Again this requires strategy that in the short run is often restrictive. In the majority of successful cases this strategy just manages to serve its purpose. In some cases, however, it is so successful as to yield profits far above what is necessary in order to induce the corresponding investment. These cases then provide the baits that lure capital on to untried trails.

Again, the main point here is that these minor distortions of perfect competition are not a malfunction of capitalism, but the lynchpin that hold the whole thing together.

If all capital seeks out situations where monopolistic practice is possible, how is such steady productivity of capitalist economies possible? This is really the primary question for Schumpeter, I think. He spends a long portion of the book outlining the steady increase in productivity of capitalist economies, and notes that productivity increases primarily benefit the masses:

It is the cheap cloth, the cheap cotton and rayon fabric, boots, motorcars and so on that are the typical achievements of capitalist production, and not as a rule improvements that would mean much to the rich man. Queen Elizabeth owned silk stockings. The capitalist achievement does not typically consist in providing more silk stockings for queens but in bringing them within the reach of factory girls in return for steadily decreasing amounts of effort.

To a Marxist like Schumpeter, this is a serious problem. If Capitalism improves life for the poor in predictable ways, then perhaps socialism is unnecessary. But it is also a great puzzle – if Capitalism is primarily a monopoly-seeking then how can it lead to productivity gains at all? The answer, as we are seeing, is that capitalism succeeds because of its so-called imperfections.

Monopolies aren’t necessarily bad. Whirlwind ride, but again, these are just notes. Schumpeter first says the term monopoly is overapplied, but also misapplied as a derisive term. Long-run monopolies, says Schumpeter, can only survive by not acting like monopolies. As soon as they use too much of their monopoly power, they open up opportunities for those wishing for a piece of the market (or for governments wishing to destroy them). Additionally, monopolies have some social benefits. A monopoly can attract the best intellects and maximize their influence. Their better financial standing provides stability to those using their services.

(Interestingly, I see some of the logic Robert Bork would advance in his dismantling of anti-trust law).

Perfectly free entry into a new field paradoxically prevents entry into that field. Again, we know this stuff from things like patent debates, but I think its formulation here is interesting:

But perfectly free entry into a new field may make it impossible to enter it at all. The introduction of new methods of production and new commodities is hardly conceivable with perfect—and perfectly prompt—competition from the start. And this means that the bulk of what we call economic progress is incompatible with it. As a matter of fact, perfect competition is and always has been temporarily suspended whenever anything new is being introduced—automatically or by measures devised for the purpose—even in otherwise perfectly competitive conditions.

Innovation takes investment. If there’s no potential for market distortion – if the market immediately sucks profit out of the enterprise or doesn’t allow for future extraction of excess profit, then why enter the market? Paradoxically, investors looking to enter new fields do not want to enter fields which have low barriers to entry.

The pivot to socialism is that the “striking” success of Capitalism is not because of free competition, but because competition is made imperfect:

So I’m wondering how a socialist like Schumpeter is going to get from “Hey, all these problems with capitalism are not actually problems” to “Socialism is the way to go.” It comes towards the end:

In this respect, perfect competition is not only impossible but inferior, and has no title to being set up as a model of ideal efficiency. It is hence a mistake to base the theory of government regulation of industry on the principle that big business should be made to work as the respective industry would work in perfect competition. And socialists should rely for their criticisms on the virtues of a socialist economy rather than on those of the competitive model.

In other words, if you are a government interventionist of any sort, then it’s important to understand the social benefits of monopolistic behavior.

Anyway, that’s the section. Again, worth a read if you (like me) have a day off and a warm spot to read in.



3 thoughts on “Schumpeterian “Creative Destruction” and the Perfection of Market Imperfections

  1. Pingback: Schumpeterian “Creative Destruction” and the Perfection of Market Imperfections « Mike Caulfield

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