How It All Works
The Theory of Economic Development

How It All Works

Economist Joseph A. Schumpeter’s classic text describes economic processes in illuminating detail.

Groundbreaking economist Joseph A. Schumpeter (1883–1950) gained fame for his theory of “creative destruction,” which posits the economic obliteration of the old to make way for the entrepreneurial new. While this 1934 masterwork only alludes to that famous idea, it does introduce the concept of profit as “surplus value” and regards entrepreneurs as heroes in the capitalist saga. This classic treatise, despite its dense prose, remains required reading for students of economics and finance in academia, business and public policy.

The “Circular Flow”

Schumpeter notes that human beings interact socially and economically as they obtain goods and services. Workers and business owners produce goods via their labor, equipment and know-how. Experience teaches them how much to produce and when.

Economic activity may have any motive, even a spiritual one, but its meaning is always the satisfaction of wants.Joseph A. Schumpeter

Producers – whether owners, workers or farmers – operate in a closed loop with customers, because producers also consume goods. This closed loop embodies the circular flow of economic activity: All sellers are also buyers.

Demand Ensures Supply

The demand for goods ensures their supply, and that supply continues to satisfy demand. A shift in demand or supply destabilizes prices and production, and then both adapt, thus continuing the circular flow of economic activity. Members of a society each contribute something – usually labor and capabilities – and they withdraw something as well, depending on their purchasing power.

All the innumerable exchanges which we can observe in an exchange economy in each period constitute in their totality the external form of the circular flow of economic life.Joseph A. Schumpeter

The creation of goods relies on technological capability and economic justification: Innovation may improve a product immensely but may not make financial sense if it requires a great investment or would make the product too expensive.

Labor and land are the basis of all goods. Everything produced relies on someone’s work and on where that work takes place. Wages and rents represent the costs of labor, land, work and the workplace.

Economic Equilibrium

In an “exchange economy,” participants freely trade goods. The circular flow of supply and demand dictates that all production costs must equal the prices at which the products sell. This ensures economic equilibrium. Any “surplus value,” beyond the value of the work and property entailed in an item’s production, represents profit after deducting all expenses, including wages.

This relentless circular flow continues indefinitely. Producers make only enough goods to satisfy demand. A nation’s economic activity consists of entities transforming the resources of land and labor into materials for immediate consumption.

Money has, in the circular flow, no other role than that of facilitating the circulation of commodities.Joseph A. Schumpeter

In this scenario, money’s value – its ability to purchase goods – becomes strictly that of the prices of the products you can buy with it. Thus, Schumpeter posits, money exists solely as an exchange mechanism in the circular flow.

Economic Development and the Entrepreneur

Economic development propels business activity through “discontinuous changes” that emerge spontaneously from within a community’s economic life. Growth in population and demand isn’t development; rather, true economic development comes from different, innovative combinations, like new products or markets, that businesspeople introduce.

Entrepreneurs – a special breed of self-motivated leaders – work on building something new and getting a business up and running. Then they might either step in to manage the business within the circular flow, or they might remain entrepreneurs to continue to innovate.

Capitalists on the supply side confront entrepreneurs on the demand side.Joseph A. Schumpeter

But entrepreneurs need capital. Bankers are not just intermediaries but actual producers of a commodity – capital – that enables dynamic economic development. Entrepreneurs use capital to purchase goods from the circular flow to start their enterprises, so capital is an independent factor of production, like labor and land.


Schumpeter writes that, when entrepreneurs build new businesses, they make profits beyond their costs. But this profit doesn’t endure: New competitors arise and the prices of labor and land increase, squelching excess income. The once-innovative production process enters the circular flow of commerce and attains a new equilibrium point.

Entrepreneurs earn profits, while the risks fall on those who provide the capital – banks. Failure causes losses for banks, while the entrepreneur may suffer only a diminished reputation.

Innovation and Disequilibrium

A new product, market or technology causes an upswing in activity, or a boom. When the novelty wears off, activity lessens, leading to a depression. External circumstances, such as war, can influence economic swings as much as business innovations can.

In any cycle, a boom materializes on the heels of a destabilizing but promising innovation. Entrepreneurs invest in the physical plant and transportation; capital spreads to support more raw materials, labor and equipment. Wages rise, giving workers greater purchasing capacity and extending the boom into its secondary wave.

The only cause of the depression is prosperity.Economist Clément Juglar

One entrepreneur’s success breeds another innovator’s desire to take a chance, which prompts another would-be businessperson to enter the market, thereby inspiring another, and so on. The products of their creativity reach the market, shoving aside existing goods. Prices fall, ushering in the end of the boom and the beginning of the depression. Businesses disappear; new firms and products emerge. During a depression, people readjust their perceptions and expectations, seeking a new point of equilibrium. An upswing cannot take place until this new equilibrium occurs.


Schumpeter – the “bourgeois Marx” –  wrote with genius on capital and capitalism, but his texts are not an easy read. Schumpeter conveys complex economic constructs that, at times, he reduces to a gemlike clarity. At other times, you must wade through the Schumpeter swamp to gain even a glimpse of what he’s talking about. And yet those seeking to understand capitalism in its organic form and processes must read Schumpeter, whatever effort he requires. Though he wrote at a time when land itself was a driving economic force, Schumpeter’s thoughts on entrepreneurs and economic cycles could have been written just yesterday.

Joseph A. Schumpeter also wrote Capitalism, Socialism and DemocracyThe Nature and Essence of Economic Theory; and History of Economic Analysis.

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