52 CHAPTER 2. BASIC NEOCLASSICAL THEORY
FIGURE 2.12 General Equilibrium
Equilibrium Budget Line
Production Possibilities Frontier
c* = y* A Slope = -w* = -MPL = MRS
0 l* 1.0
2.B. SCHUMPETER’S PROCESS OF CREATIVE DESTRUCTION 53
2.B Schumpeter’s Process of Creative Destruc-tion
Capitalism’s Forces of Creative Destruction Unleash Opportunities for Investors
by Frederick B. Taylor, Vice Chairman and Chief Investment Oﬃcer Updated: 4/9/02
Writing about capitalism more than 50 years ago, economist Joseph Schum-peter coined the phrase "creative destruction" to describe the process by which a free-market economy is constantly evolving, as new and better ways of doing business are introduced and the old and outmoded fall by the wayside. Creative destruction "revolutionizes the economic structure from within," said Schum-peter, "destroying the old one, (and) creating a new one." He argued that this dynamic process was central to capitalist system’s ability to maximize output and total wealth creation over time.
Creative destruction is not a steady process. While the forces of creative destruction are always present in a capitalist system, the process often occurs in intense bursts - "discrete rushes," as Schumpeter termed them, "which are separated from each other by spans of comparative quiet." Historically, we ex-perienced a period of intense creative destruction in the late 19th and early 20th centuries, and we are now living in the midst of another. At the turn of the last century, the industrial revolution had transformed agricultural economies and was radically changing most people’s lives. New industrial powers–the United States and Germany–were developing to challenge the established economies of England and France. Today, the ongoing revolution in technology and commu-nications is creating new industries and transforming or eliminating old ones. New economies are emerging that provide new markets as well as new sources of competition. Corporate restructuring and privatization of government-owned enterprises are widespread.
Usually, one can only see what is being destroyed by this process; it is much more diﬃcult to understand what is replacing it. For example, it was easy to see carriage and buggy whip manufacturers going out of business with the advent of the automobile, but much harder to visualize the mega-industry that would emerge to replace them. Similarly, as manufacturing declined in the U.S. during the latter part of the 20th century, the displacement of factory workers was evident long before the creation of jobs in the service sector that reemployed them.
Although the process of creative destruction can create tremendous oppor-tunities for investors, it is often diﬃcult to discern them early on, when the maximum beneﬁt can be gained. However, in our search for value, this is ex-actly what we strive to do for our clients.
54 CHAPTER 2. BASIC NEOCLASSICAL THEORY
On a global level, those countries where capitalism and the forces of creative destruction are permitted to ﬂourish create more attractive opportunities for in-vestors than less dynamic economies. Of course, the United States continues to be the prime example of relatively unfettered capitalism at work, and the U.S. economy has been better able not only to withstand, but to thrive amid the current forces of creative destruction–hence the sustained strong performance of the U.S. stock market in the 1990s. However, there are other countries that are also beneﬁting from the forces of creative destruction, most notably in Eu-rope. Great Britain was the ﬁrst to dismantle the government programs that had hindered its economic growth. As the rest of Europe follows suit, albeit each country at its own speed, creative destruction will be at work restructur-ing old ineﬃcient economies into more vibrant, growing ones. In particular, Ireland, Italy, Portugal, and Spain, which have less rigid economic systems than France and Germany, are learning to compete eﬀectively in the global economy. The introduction of the euro and the emergence of Pan-Europeanism are also expanding markets for companies able to compete eﬀectively in this new envi-ronment, and the "creative destruction" of national currencies has given birth to the Euro. A few Latin American countries, most notably Argentina and Chile, are becoming free-market economies. And in Asia, where we recently witnessed the destruction of the old status quo, opportunities are beginning to emerge for innovative companies.
At the root of the creative destruction process are individual companies. They are the agents of change that develop new products, new technology, new production or distribution methods, new markets and new types of organization that will revolutionize the economy. Companies that change the business model for their industry or develop a new paradigm signiﬁcantly alter the competitive landscape. As Schumpeter says, "competition which commands a decisive cost or quality advantage...strikes not at the margins of the proﬁts and the outputs of the existing ﬁrms but at their foundations and their very lives."
We want to own companies that beneﬁt from creative destruction. Good businesses that are constantly adapting to their changing environment and es-tablish a decided competitive advantage will generate strong returns for their shareholders over a long period of time. We search industries throughout the world to ﬁnd those companies that are transforming the terms of competition in their ﬁeld. The forces of creative destruction in capitalism are not only the engine of economic growth; they also generate unparalleled investment oppor-tunities for astute investors.
1. From Joseph A. Schumpeter, History of Economic Analysis, edited from a manuscript by Elizabeth Boody Schumpeter (New York: Oxford Uni-versity Press, 1963).
In this chapter, we extend the basic neoclassical model to include a government sector that demands some fraction of the economy’s output for some purpose that we view as being determined exogenously by political factors. Note that this chapter does not constitute a theory of government. Rather, the theory developed here is designed to explain how the economy reacts to any given (exogenous) change in a government’s desire to tax and spend. We continue to work with a static model, so that the government must balance its budget on a period-by-period basis (i.e., the government may not run surpluses or deﬁcits). The issue of deﬁcit-ﬁnance will be addressed in a later chapter when we have the tools to investigate dynamic decision-making.
3.2 Government Purchases
Assume that the government sector ‘demands’ g units of output, where g is exogenous. There are two ways of viewing the production of output destined for the government sector. The ﬁrst way is to suppose that all output y is produced by the private sector and that the government sector purchases the output it desires g from the private sector. The second way is to suppose that the government produces the output it needs by employing workers (public sector workers). If the government has access to the same technology as the private sector, then either approach will yield identical results.
Before proceeding further, we need to ask the question: What is g used for? In reality, government purchases are directed toward a wide variety of uses, including: bureaucratic services, in-kind transfers (e.g., school lunch programs, health-careservices), militaryexpenditures, and outrighttheft(politicians lining
56 CHAPTER 3. FISCAL POLICY
their own pockets). For some types of expenditures (e.g., those expenditures that are distributed free of charge to the general population), it would make sense to think of households viewing g as a close substitute for goods and services that they might otherwise purchase from the private sector. In this case, one could model preferences as:
In this case, output that is purchased from the private sector and output that is supplied by the government are viewed as perfect substitutes by the household (e.g., as is likely the case with school lunch programs). If the school lunches sup-plied by the government do not exactly correspond to the lunches that parents would pack for their kids on their own, then might instead specify u(c+ λg,l), with λ ≤ 1. According to this speciﬁcation, one unit of government supplied out-put is equivalent to λ units of privately purchased output as far as the household is concerned.
Alternatively, government expenditures may be allocated toward uses that do not have very close substitutes in the way of market goods; e.g., military ex-penditures or a national space program. In this case, one might more reasonably model preferences as:
where λ ≥ 0 and v is an increasing and concave function. According to this speciﬁcation, households may value a national space program not for material reasons but for ‘psychic’ reasons (e.g., national pride). On the other hand, if households do not value such expenditures at all (e.g., if g is used to build a king’s castle, or used to ﬁnance an unpopular war), then one could specify λ = 0.
In what follows, we will adopt the latter speciﬁcation of preferences (3.2) for the case in which λ = 0. As it turns out, the model’s predictions for economic behavior will continue to hold even for the case in which λ > 0 (the only thing that would change is the prediction for economic welfare). On the other hand, the model’s predictions concerning behavior will generally diﬀer if we adopt the speciﬁcation (3.1).
3.2.1 Lump-Sum Taxes
Suppose that government spending is ﬁnanced with a lump-sum tax τ. A lump-sum tax is a tax that is placed on individuals that does not vary with the level of their economic activity. For this reason, it is also sometimes called a ‘head tax.’ Lump-sum taxes are not that common in reality, but for our purposes, it serves as a useful benchmark. The key restriction on government behavior is given by the government budget constraint (GBC), which in this case takes the form:
τ = g. (3.3)
As it turns out, in our model, the government ﬁscal policy will have no eﬀect on the equilibrium wage or proﬁts; i.e., (w∗,d∗) = (z,0). In general, this result
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