Pfarrer, M.D., & Smith, K.G. 2005. Creative destruction. In M. Hitt & D. Ireland (Eds.), The Blackwell Encyclopedia of Management. Entrepreneurship: 50-52. London: Blackwell.

Creative Destruction, coined by Austrian economist Joseph Schumpeter in his 1942 work, Capitalism, Socialism, and Democracy (CSD), is an evolutionary process within capitalism that "revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating the new one" (p. 83, [italics in original]). It is this "perennial gale" that every firm operates in, and in that "every piece of business strategy acquires its true significance" (p. 83).

From his definition, one can conclude that Schumpeter viewed the market and competition as dynamic and in flux. Educated in Vienna at the turn of the century, Schumpeter was a student of the Austrian School of economics, a loosely-fit group of researchers and acolytes that studied in the tradition of Carl Menger. Unlike traditional economists, who focus on equilibrium and a static form of competition, the Austrians view the market as a dynamic process (Smith et al. 2001). Whereas classic economic theory believes the key to competitive advantage and sustainable profits lies in the dampening of competition through barriers to entry and strategic positioning (Porter 1980), the Austrians believe that abnormal profits and competitive advantage are fleeting, due to the perennial gale of firm actions and rival reactions. Innovation and firm success lead to imitation, which leads to erosion of profits. Whereas classic economic theory largely ignores change, uncertainty, and disequilibrium, the Austrians emphasize innovation, flexibility, and heterogeneity (Jacobson 1992, p. 784). Central to this debate is the role of the entrepreneur. The ideas of perfect competition and efficient markets, bulwarks to classic economic theory, downplay the role of the entrepreneur in market development and the accrual of profits (Jacobson 1992). Schumpeter and the Austrians, however, see the entrepreneur as the central player in the market process. For Schumpeter, the 2 entrepreneur is any manager or decision maker who innovates (Allen 1991(1), p. 104).

These innovations, or "new combinations", include new goods, new methods, new markets, new sources of supply, and new industry organizations (1934, p. 66).

Other Austrians, notably Kirzner (1973), have focused on the entrepreneur's use of idiosyncratic information to take advantage of opportunities not noticed by others. Different entrepreneurs will thus discover different opportunities because they possess different knowledge (Shane 2000). Therefore, developments of new combinations will not be evenly distributed among industries and over time; instead, they will appear in "discrete rushes" or "swarms" (Schumpeter 1934, 1942). Schumpeter and other Austrian economics adherents view the market as never reaching equilibrium due to the role of entrepreneurial innovation (Smith et al. 2001). These innovations, or "new combinations", direct the flow of resources toward fulfillment of consumer needs as opportunities arise, and when an innovating firm takes action that generates profits, competitors will respond (Schumpeter 1942). The response leads to an inability of the innovators (first movers) to sustain profits (competitive advantage) due to imitation (Lee et al. 2000; Ferrier et al. 1999; Grimm and Smith 1997). As the value of the new creation is destroyed, market leaders lose their advantage, and profit margins slow. Imitation increases, and overall market expansion slows, moving the business cycle toward equilibriumuntil another innovation shatters the status quo (Schumpeter 1934; Jacobson 1992). The successful firm, then, must constantly be innovating to sustain profitability, and to avoid the perennial gale of Creative Destruction. Schumpeter's idea of Creative Destruction is borne from the ideas he put forth in his two best-known works, the Theory of Economic Development (TED) and Capitalism, Socialism, and Democracy (CSD). Schumpeter's concept of Creative Destruction is explored in Chapter VII of CSD, "Can Capitalism Survive?" Ironically, many of today's modern Austrians, as well as other 3 strategy researchers, use Creative Destruction as support for capitalism's unique ability to reincarnate itself, but fail to focus on the negative impact that such a process might have. In order to fully understand the definition of Creative Destruction and its impact on current research, it is important to understand the context within which its author placed it. Robert Loring Allen's 1991 two-volume biography on Schumpeter, Opening Doors, expertly explains Schumpeter's affection for capitalism, but also his belief in its demise. Schumpeter argued capitalism's success would "inevitably lead to the throttling of innovation and a transition to socialism" (1991 p. xi). His thesis states that capitalism, "while economically stable...creates...a mentality and a style of life incompatible with its own fundamental conditions. [It] will be changed...although not by economic necessity and probably even at some sacrifice of economic welfare, into an order of things which it will be merely a matter of taste and terminology to call Socialism or not" (Schumpeter 1928, p. 385-6).

Loring goes on to elaborate on Schumpeter's expectations, saying that capitalism's success removes the entrepreneurial stimulus to gain profit (1991(2), p. 27). Whereas success may breed success, profit gainers also tend to become sated after awhile. Schumpeter did not deny capitalism's role in the economic progress of the last two centuries, but he also felt that its overemphasis on profits would eventually fail to make people better or happier (Loring 1991(2), pp. 123-4).

Indeed, as innovation becomes routine, growth will slow, and the entrepreneur will not feel the urge to challenge the status quo. The capitalists will thus become the bureaucrats and the ruling class, and the disenfranchised will eventually lash out against the "system" (Schumpeter, 1942). In the end, capitalism will fail because it has done its job too well"it has created the institutions and conditions...that can easily be transformed into socialism (Loring, 1991(2), p. 126).

Interestingly enough, Schumpeter did not foresee the role of Creative Destruction in 4 continually renewing the innovative and capitalist process, thus permitting capitalism to be reborn again and again. While Schumpeter initially insisted that innovations typically originated in new, small firms (1934), he later argues in CSD that it is large, established enterprises frequently enjoying monopoly power that play the role of innovative leaders (1942). Schumpeter claims that because technical innovation is inherently risky, risk bearing appears to be more likely when firms are able to deploy an array of restrictive practices to protect their investments. He also argues that perfect competition is not only impossible but also inferior, and should not be set up as a model of ideal efficiency. Challenging the microeconomic theory assertion that monopolies' pricing behavior distorts socially beneficial resource allocation, Schumpeter claims that monopolies have to exercise their power cautiously both in pricing and product policy out of fear that they could stimulate another wave of monopoly-eroding changes. Therefore, monopolies are not nefarious, but rather have greater incentive to develop innovations, and thus benefit consumers (Conner 1991). As one would expect, there continues to be challenges to this notion and other Schumpeterian ideas among economic, organizational, and strategic researchers (see Scherer [1992] for a review). Perhaps the greatest challenges, however, to Schumpeter's ideas of innovation, disequilibrium, and the role of the entrepreneur have come from fellow Austrian adherents. Israel Kirzner (1973, 1997) has long argued that innovation induces an "equilibrating" change to the status quo, in contrast to Schumpeter's more "disequilibrating", radical upheaval. Frank Knight in his theory on entrepreneurship, argues that the innovator and capitalist are intertwined, whereas Schumpeter believes that their functions are separate (Evans and Jovanovich, 1989). Because of that, Knight argues that entrepreneurs have to be responsible for their own capital 5 funding. Schumpeter, thinking the entrepreneur is not a risk taker (1934, p. 77), feels that there are no liquidity constraints to being an entrepreneur, and that eventually, the capital markets will bear the financial risk of discovery (1934). Schumpeter's ideas have flourished among his disciples and today's researchers. Many argue that Austrian economics is still radical and beyond the mainstream (Jacobson 1992), but its vestiges can be seen in several fields, including competitive dynamics (cf. Smith et al. 2001; D'Aveni 1994), dynamic capabilities (cf. Eisenhardt and Martin 2000; Teece et al. 1997), evolutionary theory (cf. Nelson and Winter 1982), and the entrepreneurship (cf. Shane and Venkataraman 2000) and resource-based view literatures (cf. Barney 1986). Definitions of Creative Destruction and the "perennial gale" also abound: "Inevitable and eventual market decline of leading firms through the process of competitive action and reaction" (Smith et al. 2001); "Advantage is created and destroyed. Eventually every advantage will be eroded as realization of profits invite imitation. Firms that attempt to maintain the status quo are doomed" (Grimm and Smith 1997); "Technological change occurring in upheavals" (Waldman and Jensen 2001); "Invention of a new technology creates market disequilibrium" (Shane, 2001); and so on. If then, that "no general laws of business exist", as Jacobson writes (1992, p. 803), and "business success is a 'science of the specific'..." (p. 804), then Austrian economics in general, and Joseph Schumpeter's idea of Creative Destruction in particular, should serve well the modern researcher who believes that markets are always changing, and that the pursuit of innovation is paramount to firm survival.

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