Crawl Across the Ocean

Tuesday, January 12, 2010

35. Creative Destruction

Note: This post is the thirty-fifth in a series. Click here for the full listing of the series.

I've talked a few times about the notion of trade being a win-win (pareto-efficient), and how the first welfare theorem of economics talks about how under conditions of perfect competition, nobody can be made better off without anyone being made worse off.

In my readings on economic topics, I find that people often therefore regard anything that interferes with perfect competition as a bad thing. Additionally, it is common to see people discuss markets as though they were in a mostly static state, where all that could vary was the price charged by a company, and that competition consisted solely of price competition1. In this post I want to highlight how capitalism itself, at its core, depends, and is in some ways defined by beneficial breaches to conditions of perfect competition.

Weber covered this ground (as I discussed here), in contrasting the capitalist system with a traditionalist market based one, but the best known description comes from Joseph Schumpeter, who popularized the phrase 'Creative Destruction' in his book, 'Capitalism Socialism Democracy.'

Creative destruction is the process by which innovation (e.g. competition on some basis other than price) upsets the balance of a market. More accurately, it is not that innovation upsets a balanced competitive market, but rather that ongoing innovation prevents most markets from ever even approaching the notion of prefect competition in the first place.

Unlike the case of a typical trade which is a win-win for all involved, creative destruction is an inherently competitive process meaning that it creates both winners and losers.

As Wikipedia says with unusual eloquence,
Creative destruction can hurt. Layoffs of workers with obsolete working skills can be one price of new innovations valued by consumers. Though a continually innovating economy generates new opportunities for workers to participate in more creative and productive enterprises (provided they can acquire the necessary skills), creative destruction can cause severe hardship in the short term, and in the long term for those who cannot acquire the skills and work experience.'

The most famous example of people hurt by 'creative destruction', is the case of the Luddites who were (per Wikipedia),
a social movement of British textile artisans in the early nineteenth century who protested—often by destroying mechanised looms—against the changes produced by the Industrial Revolution, which they felt were leaving them without work and changing their entire way of life.

It wasn't just that they 'felt' that way, their way of life really was threatened by the innovation and price competition underway in their industry. You don't see a lot of textile artisans around nowadays.

Schumpeter is a great writer so here's a fairly lengthy excerpt to get the flavour of what his argument was:

Capitalism, then, is by nature a form or method of economic change and not only never is but never can be stationary. And this evolutionary character of the capitalist process is not merely due to the fact that economic life goes on in a social and natural environment which changes and by its change alters the data of economic action; this fact is important and these changes (wars, revolutions and so on) often condition industrial change, but they are not its prime movers. Nor is this evolutionary character due to a quasi-automatic increase in population and capital or to the vagaries of monetary systems, of which exactly the same thing holds true. The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers, goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.

As we have seen in the preceding chapter, the contents of the laborer's budget, say from 1760 to 1940, did not simply grow on unchanging lines but they underwent a process of qualitative change. Similarly, the history of the productive apparatus of a typical farm, from the beginnings of the rationalization of crop rotation, plowing and fattening to the mechanized thing of today–linking up with elevators and railroads–is a history of revolutions. So is the history of the productive apparatus of the iron and steel industry from the charcoal furnace to our own type of furnace, or the history of the apparatus of power production from the overshot water wheel to the modern power plant, or the history of transportation from the mailcoach to the airplane.

The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation–if I may use that biological term–that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in.

. . .

Every piece of business strategy acquires its true significance only against the background of that process and within the situation created by it. It must be seen in its role in the perennial gale of creative destruction; it cannot be understood irrespective of it or, in fact, on the hypothesis that there is a perennial lull.

. . .

The first thing to go is the traditional conception of the modus operandi of competition. Economists are at long last emerging from the stage in which price competition was all they saw. As soon as quality competition and sales effort are admitted into the sacred precincts of theory, the price variable is ousted from its dominant position. However, it is still competition within a rigid pattern of invariant conditions, methods of production and forms of industrial organization in particular, that practically monopolizes attention. But in capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization (the largest-scale unit of control for instance)–competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives.

This kind of competition is as much more effective than the other as a bombardment is in comparison with forcing a door, and so much more important that it becomes a matter of comparative indifference whether competition in the ordinary sense functions more or less promptly; the powerful lever that in the long run expands output and brings down prices is in any case made of other stuff.

It is hardly necessary to point out that competition of the kind we now have in mind acts not only when in being but also when it is merely an ever-present threat. It disciplines before it attacks. The businessman feels himself to be in a competitive situation even if he is alone in his field or if, though not alone, he holds a position such that investigating government experts fail to see any effective competition between him and any other firms in the same or a neighboring field and in consequence conclude that his talk, under examination, about his competitive sorrows is all make-believe. In many cases, though not in all, this will in the long run enforce behavior very similar to the perfectly competitive pattern.

I haven't really made the connection with ethics clear so far, so a few comments on that may be in order. First of all, Jane Jacobs contrasted the desire for innovation under commercial ethics with respect for tradition, so this is another confirmation of that split.

Secondly, there is the recognition that the process of the market is not a pareto-optimal, win-win one where there are no losers and nobody has any real reason to complain, but rather is a competitive one where the essence of the system is people making voluntary transactions that have significant negative repercussions (externalities) for parties not part of the transaction (e.g. your boss and an Indian worker agree that your job will now be done in India).

The fact that we don’t suffer from more Luddite style violence, reflects that society makes an effort to assist those blown over by the gale of capitalism and, related, that a critical mass of people feel they have more to lose from fighting the system than by going along.

Also, the process of innovation itself relies heavily on the ethics that Jacobs outlined. Optimism to make one believe that the untried plan will work and a willingness to be thrifty and productive in order to save the resources that will be used to make the productive investments needed.

1 In economics, but not in business books where simple models such as Porter’s Five Forces model present a more realistic assessment of the situation and discussion of pricing in the context of business strategy.

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