Creative Destruction
Although the profit rate in all competitive industries tends toward the same level, that’s just a tendency. Change is constant—tastes change, technologies change, and, in their pursuit of profit, entrepreneurs are always trying to discover new and better products and processes—so some profitable industries are always popping up and some unprofitable industries, as well. So the great economic problem is never solved completely, but in a dynamic economy, resources are always moving toward an increase in the value of production. In a dynamic economy, entrepreneurs listen to price signals and they move capital and labor from unprofitable industries to profitable industries.
230
According to the elimination principle, above-normal profits are eliminated by entry and below-normal profits are eliminated by exit.
These dynamics illustrate a general feature of competitive markets that we call the elimination principle: Above-normal profits are eliminated by entry and below-normal profits are eliminated by exit.
The elimination principle says that above-normal profits are temporary. Great ideas are soon adopted by others; they diffuse throughout the economy and became common-place—and no one profits from the commonplace. Since no one profits from the commonplace to earn above-normal profits, an entrepreneur must innovate.
The economist Joseph Schumpeter was eloquent on this point. In textbooks, he said, competition is about pushing price down to average cost:
[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 … 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….
CHECK YOURSELF
Question 12.2
In Chapter 7, we saw how prices are signals. In competitive markets, how are profits signals?
Question 12.3
In a competitive market, how does a firm make profits if it has no control over price?
This process of Creative Destruction is the essential fact about capitalism.1
Thus, the elimination principle serves as both a warning and an opportunity to entrepreneurs. Stand still and fall behind. Leap ahead and profits may follow. In a dynamic economy, there is a constant dance between elimination and innovation. Above-normal profits are constantly being eliminated by competition, and new sources of profit are constantly being created through innovation.