Creative destruction

Overview

How new products and methods displace established ones, and why the process is treated as a source of dynamic efficiency.

What you need to know

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Questions from this subtopic

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1. 1

   What is meant by creative destruction?

   Model answer

   Creative destruction is the process by which innovation continually replaces existing products, firms and ways of producing with new ones. New technologies create new industries and destroy old ones at the same time, so the same force that generates growth also makes established capital, skills and firms obsolete. The idea, associated with Joseph Schumpeter, treats competition as a contest between successive innovations rather than a contest over price between firms selling the same thing.

2. 2

   Why does creative destruction suggest that a monopolist's position is less secure than a static diagram implies?

   Model answer

   The standard diagram holds technology fixed, so barriers to entry look permanent and the supernormal profit looks safe indefinitely. Creative destruction points out that the most serious threat to a dominant firm rarely comes from a rival selling the same product; it comes from a new product or process that makes the existing one unnecessary, and against which the existing barriers offer no protection. A patent, an established brand or control of a distribution channel is worthless if the whole category is displaced. Monopoly is therefore better understood as a temporary lead than as a permanent position.

3. 3

   Explain why creative destruction implies that competition should be judged over time rather than at a moment.

   Model answer

   At any single moment a market may look uncompetitive, with one firm holding most of the sales and charging well above marginal cost. Looked at over a longer period, the same market may show a succession of different dominant firms, each displaced by the next innovation, which is intense competition of a different kind. Judging by a snapshot therefore risks condemning a market where rivalry is fierce but takes the form of a race to invent rather than a race to cut prices. The relevant question becomes how quickly leaders are displaced, not how large today's leader is.

4. 4

   How does the prospect of temporary monopoly profit drive creative destruction?

   Model answer

   Innovation is expensive and risky, and it will only be undertaken if the innovator expects a reward. That reward is the supernormal profit earned while the innovation is still exclusive, before imitators arrive. The prize therefore has to be a period of market power, which is why patents are granted and why a successful innovator temporarily dominates. Other firms, seeing the profit, race to innovate around it, and their success both destroys the first innovator's position and creates their own temporary one. Monopoly profit is thus the engine of the process rather than an obstacle to it.

5. 5

   Why does creative destruction impose real costs, and on whom do they fall?

   Model answer

   The destruction is not metaphorical. Capital equipment tied to the old technology loses its value, firms that cannot adapt close, and the specific skills of their workers become worth much less, so those workers face structural unemployment and often need retraining to find comparable work. The costs are concentrated on particular occupations and, because industries cluster geographically, on particular regions, while the benefits are spread thinly across all consumers in the form of better and cheaper products. That asymmetry between concentrated losses and dispersed gains is why the process is politically contested even when the net effect is positive.

6. 6

   Analyse the implications of creative destruction for how a dominant firm should be judged.

   Model answer

   It argues for looking at the durability of the position rather than its current size. A firm with a large share held behind a legal barrier or control of an essential facility is unlikely to be displaced by innovation, so the static concerns about price and output apply with full force. A firm with an equally large share in a fast-moving technology, where the last three leaders were each displaced within a decade, faces a discipline that no measure of concentration captures. The right questions are how fast the technology is changing, whether the incumbent's advantage would survive a technological shift, and whether it is using its position to suppress the innovations that might displace it.

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