February 4, 2023 

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ACTUAL INVESTMENT: Investment expenditures that the business sector actual undertakes during a given time period, including both planned investment and any unplanned inventory changes. This is a critical component of Keynesian economics and the analysis of macroeconomic equilibrium, which occurs when actual investment is equal to planned investment. The difference between planned and actual investment is unplanned investment, which is inventory changes caused by a difference between aggregate expenditures and aggregate output. Should actual and planned investment differ, then aggregate expenditures are not equal to aggregate output, and the macroeconomy is not in equilibrium.

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A fundamental process of capitalism, popularized by Joseph Schumpeter, in which the benefits of growth and prosperity induced by innovations also result in the costs of disrupting existing means of production. The creation of new activity involves the destruction of existing activity. This notion attributes business-cycle instability to innovations, including both the expansionary rise of prosperity, as well as a contractionary decline. Creative destruction is based on the idea that rather than tending toward equilibrium, the economy is largely in flux. A key question is one of cause and effect. Does innovation cause destruction or does destruction induce innovation?
Creative destruction is the observation noted by Joseph Schumpeter (1883-1959) that a capitalistic economy is inherently driven by innovations, which are intertwined with the destruction of old parts of the economy and the creation of new. That is, the innovation of a new product triggers capital investment, economic expansion, greater employment, and enhanced living standards, but by replacing existing production workers are unemployed, factories are shut down, and firms go bankrupt. In the same way that making an omelet requires breaking a few eggs, creating new prosperity involves destroying old production.

The introduction of the automobile, for example, greatly improved transportation, but also virtually destroyed the "horse-and-buggy" industry. The innovation of MP3 players, such as the iPod, enhanced music listening, but created havoc for compact discs and other "non-digital" means of distributing music. As the new product stimulates the economy, creates jobs, induces investment, and improves living standards, production of the old goods is disrupted. Sales of the old decline, resources are unemployed, and capital investment is nonexistent.

The pattern of destruction and creation is key to business-cycle instability. According to this view, innovations are the engine that stimulate the economy and propel it to greater prosperity and business-cycle expansion. The disruption of existing activity, in contrast, results in economic decline, unemployment, and business-cycle contraction.

The process of creative destruction has two common interpretations, one more microeconomic, the other more macroeconomic. The difference is based on cause and effect. The microeconomic view is that innovations cause the destruction of existing activity. The automobile destroys the horse and buggy industry. The macroeconomic view reverses cause and effect, that the decline in an existing industry induces the creation of new activity.

An Economy in Flux

Creative destruction relays on the view that the economy is in a state of flux, frequently changing, rather than tending toward a state of equilibrium. Disequilibrium, not equilibrium, is what best characterizes the day-in and day-out status of the economy.

In comparison, most economic analysis, especially standard microeconomic analysis of the market presumes that the equilibrium is the common state of being. If the market is not in equilibrium, then it is headed directly toward equilibrium.

Alternatively, creative destruction works from the notion that innovations periodically and perpetually trigger changes and economic instability. The economy might achieve equilibrium, but temporarily and only in passing, as one innovation after another disrupt the process.

Out with the Old, In with the New

An expression that captures the essence of creative destruction is that "you can't make an omelet without breaking a few eggs." The unbroken eggs represent current production -- the status quo. The omelet represents something new, different, and better -- an innovation. The price of progress is the destruction of the status quo. The creation of the omelet destroys the eggs.

More to the point of the economy, innovations are inherently better than existing activity. That's what makes them innovations. Being better, they eventually replace existing activity. Cars replace horses. Airplanes replace trains. Computers replace typewriters. MP3 players replace CD players. Incandescent light bulbs replace candles. As production of the new increases, production of the old necessarily declines.

Ideally the labor, capital, land, and entrepreneurship that comprised the old would be instantaneously reallocated to the new. Such seldom happens. Resources used in the old are seldom suited for production in the new. The labor, capital, and materials used to produce horses are not the same as those needed for car production. For labor, this results in what is termed structural unemployment, labor lacking the skills needed for available jobs.

The end result of this process is that old industries are demonstrably destroyed. Workers are unemployed, factories are shut down, businesses file for bankruptcy.

Innovation and Entrepreneurship

Two cornerstones of the creative destruction process are innovation and entrepreneurship. Entrepreneurship is the driving force that brings innovations to the forefront of the economy -- the creation that triggers destruction. While these terms are related, important differences exist.
  • Entrepreneurship: This is the factor of production that assumes the risk of organizing production.

  • Innovation: This is introduction and dissemination of new products, technologies, and ideas that improve the economy or society.
In many cases entrepreneurs are also innovators. Creative destruction is most likely to result when entrepreneurs are also innovators. Not only do entrepreneurs organize production, but they do so in the pursuit of an innovation. And innovators often need to take on the risk of organizing production. However, not all innovation involves entrepreneurship. And entrepreneurship does not always require an innovation.

For example, an entrepreneur might organize the production needed for a restaurant that sells hamburgers, french fries, and milk shakes using tried and true production techniques. Nothing new, nothing innovative. Or an innovator might initiate the dissemination of a new term for slurping a carbonated soft drink, "psaibenz." Doing so does not really involve the entrepreneurial risk of organizing production.

Cart or Horse?

A key question for creative destruction is one of cause and effect. Does innovation cause destruction or does destruction lead to innovation? An answer to this question involves the difference between microeconomics (the study of parts of the economy) and macroeconomics (the study of the whole economy).

From a microeconomic perspective, a given firm or industry is very likely destroyed by the innovation of a better alternative. When a hypothetical blacksmith like Bernard was forced to shut down his shop in Shady Valley, USA in 1923, the automobile was surely identifiable as the culprit. With fewer horses needed to haul buggies around the streets of Shady Valley, Bernard and other blacksmiths in the area had less horse-shoeing business. Blacksmithing was destroyed by the creation of the automobile.

A broader macroeconomic view might tell a different cause-and-effect story. This view relies on the notion of induced innovation, which contends that innovations are induced or caused by economic and social conditions. In particular, during an business-cycle downturn, the costs and risks of undertaking innovations are lower. An unemployed worker has less to lose by undertaking a risky pursuit than an employed worker. Why not give it try? What do you have to lose?

This suggests that the "destroyed" firms, by freeing up resources and reducing the costs of innovation, are what actually induce the innovation, rather than vice versa.


Recommended Citation:

CREATIVE DESTRUCTION, AmosWEB Encyclonomic WEB*pedia,, AmosWEB LLC, 2000-2023. [Accessed: February 4, 2023].

Check Out These Related Terms...

     | innovation | induced innovation | technology | risk | institution | process innovation | product innovation |

Or For A Little Background...

     | business cycles | macroeconomics | microeconomics | cause and effect | capitalism | economic growth | entrepreneurship | equilibrium |

And For Further Study...

     | alternative business cycles | behavioral alternatives | innovation profit | innovation and entrepreneurship | structural unemployment |

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