Innovation and creative destruction

Joseph Alois Schumpeter can be considered the father of modern innovation eco-nomics. He showed that development is a historical process of structural changes

driven by innovation and defined innovation as new combinations leading to new products, processes, organizations, inputs and markets (Schumpeter 1912, 1939, 1943). In his theory of economic development, either entrepreneurs (Schumpeter 1912) or R&D labs (Schumpeter 1943) introduce these new com-binations, thereby triggering profound changes in the economic structure and creating business cycles (Schumpeter 1939). In Schumpeter’s original theory of economic development (1912) the abilities and initiative of entrepreneurs, which generally draw upon the discoveries of scientists and inventors, create entirely new opportunities for investment, growth and employment. The profits made from these innovations are then the decisive impulse for new surges in growth, acting as a signal to swarms of imitators (Freeman 1982, p. 2). It is important to note that not every imitator can make big profits. When the bandwagon starts rolling, some people fall off, profits are gradually competed away until recession sets in and the whole process may be followed by a depression before growth starts again, with a new wave of technical innovation and organizational and social change (Freeman 1982, p. 2). Hence, according to Schumpeter (1912), the innovation process can be divided into four dimensions: invention, innovation, diffusion and imitation. In Schumpeter’s analysis, the invention stage or the basic innovation has less impact on the economy than the diffusion and imitation stages. The mac-roeconomic effects of any basic innovation are scarcely perceptible for at least the first few years, or even longer. What matters in terms of economic growth, investment and employment is not the moment of the basic innovation itself, but rather its diffusion, the swarming process when imitators begin to realize the prof-itable potential of the new product or process and start to invest heavily in that technology (Freeman 1982, p. 5). Examples of technologies and innovations that radically changed the economy and society are steam power, electricity, and ICT.

They caused a wave of new products and services and changed society in the first and second Industrial Revolution and during the current move towards an infor-mation society.

Within the field of Neo-Schumpeterian economics, a large number of stud-ies have been made on entrepreneurship, innovation, knowledge spillovers and networks, business cycles and structural change (e.g. Freeman 1982, 1987;

Dosi et al. 1988; Klepper 1997; Audretsch and Thurik 2000; Perez 2002, 2007;

Fagerberg et al. 2005; Hanusch and Pyka 2007a, 2007b). An important feature of Schumpeterian analysis is the consideration that structural changes might be driven by the capabilities of single individuals (Schumpeter 1912) and/or (the research labs of) big enterprises (Schumpeter 1943). The emphasis on single agents stands in contrast to the common perspective of most approaches in economics, where the (representative) agents are determined by the system. Other interesting features of Neo-Schumpeterian economics are the consideration of historic devel-opment processes and the emphasis on the interaction of heterogeneous agents (Hanusch and Pyka 2007a, 2007b). Generally speaking: ‘Neo-Schumpeterian economics deals with dynamic processes causing qualitative transformation of economies driven by the introduction of various and multifaceted forms of novel-ties and the related co-evolutionary processes’ (Hanusch and Pyka 2007a, p. 280).

Qualitative change, punctuated equilibrium (considering the idea of permanent and disruptive changes) and pattern formation are core topics of interest in the Neo-Schumpeterian analysis of economic development (see Hanusch and Pyka 2007a, 2007b). While the concept of structural change mainly refers to a change in the number and balance of sectors, the Neo-Schumpeterian concept of qualita-tive change is broader, as it also considers changes on more disaggregated levels (e.g. the organizational structure between and within the enterprises of a sector), as well as changes in domains that are not strictly economic, such as education or regulation. Qualitative change is considered to be basically driven by innovation;

making fertile relations and coordination between the industrial, the financial and the public sectors, all necessary to exploit and deploy the full power of innova-tion for economic and human development (Perez 2002, 2007; Hanusch and Pyka 2007a, 2007c, 2007d; Hartmann et al. 2010).

An influential contribution to the understanding of the cyclical long-term transformation of economies and co-evolutionary institutional changes has been made by Carlota Perez (1983, 2002). She illustrates how technological revolu-tions and strong surges of development typically follow a sequence of steps in the core countries of the technological revolution, for example going from a tech-nological breakthrough towards a hype in the financial sector to financial bubble explosions. At the turning point a decoupling of the new emerging technological paradigm and the existent socioeconomic system can often be seen, and substan-tive social and institutional changes are necessary to allow the technologies to spread more broadly across the society. The new paradigm, though, eventually becomes complacent, saturated and stagnating, which can lead again to a socio-economic crisis that requires the emergence of a new technological revolution and techno-economic paradigm. Perez (2002) makes a distinction between five technological revolutions between the 1770s and the 2000s.

1 The Industrial Revolution, starting in Britain with the historical milestone of Arkwright’s mill opening in Cromford in 1771.

2 The age of steam and railways, which literally took off with the test of the Rocket steam engine for the Liverpool-Manchester railway in 1829.

3 The age of steel, electricity and heavy engineering, which can be related to the opening of the Carnegie Bessemer steel plant in Pittsburgh, Pennsylvania in 1875 and led to the industrial forging ahead of USA and Germany.

4 The age of oil, the automobile and mass production, which began when the first Model T come out of the Ford plant in Detroit, Michigan in 1908.

5 The age of information and telecommunications, starting when the break-through of the creation of the Intel microprocessor was announced in Santa Clara, California, in 1975.

Each of these techno-economic paradigms seems to follow recurrent phases of irruption, frenzy, synergy and maturity. Figure 2.1 shows the panorama of the changing context of the twentieth century according to Carlota Perez (2011).

It becomes obvious how technological revolutions, financial bubbles and social transformations are related to each other, leading to a cyclical evolution of irrup-tion, frenzy, synergy, maturity and crises. In the maturity phase of the age of steel and heavy engineering, the socio-political split exploded during the First World War and the Russian Revolution. It was during this period that also the age of mass production, automobile and oil started. After the First World War it unfolded its full power. The Roaring Twenties, however, then led to polarization of the rich and poor and the financial crash in 1929. The rise of fascist govern-ments unfortunately went together with the use of mass production technologies to provide weapons for total war. New institutional arrangements after the Second World War, such as the Marshall Plan, Bretton Woods and modern welfare states, allowed the synergy of new technologies: the institutional setting led to coher-ent growth with increasing positive externalities, production and employmcoher-ent expansion in the post-war golden age. When entering the maturity stage, the new paradigm once again encountered crisis, symbolized by the hippie movement and social unrest in 1968, the Vietnam War and stagflation in the West. It was at this moment that technological breakthroughs allowed the emergence of the new age of information and telecommunications, which after the frenzy phases led to bubble explosions in the 2000s. These bubble bursts now require new insti-tutional arrangements to allow the information technologies to unfold their full Figure 2.1 Carlota Perez’ analysis of technological revolutions and waves of

development in the twentieth century Source: Perez, C (2011).

potential and spread across the world, lifting social welfare in both developed and developing countries.

The inspiring analysis of Perez on the dynamics and bubbles of golden ages has recently been complemented by an expansion of the research on creative destruction and economic diversification processes that lead to a change in the composition of socioeconomic systems (e.g. Saviotti 1996; Frenken et al. 1999;

Saviotti and Pyka 2004; Hausmann et al. 2011). Creative destruction processes are driven by selection, variation and adaptation processes in which new sec-tors emerge and the balance and composition of the economic system changes.

Whereas new sectors emerge some other sectors decrease in importance or even become obsolete. In total, however, the number of sectors and their complex-ity tends to increase, because innovation allows higher levels of specialization and productivity, leading to more consumption and choices of occupation, and typically not all sectors become obsolete, but many can decrease in relative impor-tance. For example, light bulbs have largely replaced candles and the Internet is now increasingly replacing printed newspapers. But we still have candles and newspapers continue to be a main source of news. As Saviotti (1996) based on Pasinetti (1981, 1983) pointed out, selection and creative destruction makes some products, capabilities and sectors obsolete, but in the long run the system needs to diversify over time to overcome the problems on the demand side.

The question that then arises is: in which ways and in which directions do countries diversify? Empirical studies show strong path dependencies in the diversification process. Countries and regions typically diversify their production structures into related activities (e.g. Frenken et al. 2007; Hidalgo et al. 2007;

Saviotti and Frenken 2008). This means, for example, that a region that special-izes in cotton farming may diversify into textile production and fashion design, but may not necessarily jump straight from cotton production into the chemical or aerospace industry. This is natural as most new capabilities build upon previous capabilities and experiences. Innovation is certainly a key driver of diversifi-cation (Schumpeter 1912; Saviotti 1996; Saviotti and Pyka 2004; Klinger and Lederman 2006). However, there are different types of innovation, such as product, process, or radical and incremental innovations, which lead to differ-ent types of economic diversification, such as related or unrelated variety growth (Frenken et al. 2007; Saviotti and Frenken 2008). Related variety refers to diver-sification into similar sectors (such as from cars to trucks). Unrelated variety growth refers to diversification into entirely new sectors (such as introducing and establishing a software industry in a former agricultural region). Most innovative activities in processes, products and services are of an incremental nature and lead to the diversification of the economy into similar, related products (e.g. new car models or the new generation of smartphones). However, for long-term eco-nomic development, radical innovations (such as steam power, electricity or the Internet) leading to profound structural changes and unrelated variety growth is even more decisive than incremental innovations (Schumpeter 1912; Perez 2002;

Saviotti and Frenken 2008). Radical innovations (such as the first steam machine,

automobile or personal computer) bring the system out of equilibrium, promote economic growth and lead to business cycles (Schumpeter 1912).