Schumpeter on Strategy

By Jerry Neumann

It’s Friday and I’m procrastinating, so here you go.

Let’s talk about Joseph Schumpeter. Good old John Joseph Jingleheimer Schumpeter, as he wasn’t called. Schumpeter once wrote in his diary that he aspired to be the greatest economist, horseman, and lover in the world1. I can imagine the women and horses edging away nervously. Luckily he had it going on with the economics.

The mainstream of economics, then as now, pretty much tries to describe the economy as if it shouldn’t change. If it is changing, it’s changing towards an equilibrium, where it won’t have to change any more. Schumpeter noticed that this is not how it works2. Both the economy as a whole and individual businesses change constantly. His model of the latter, in his Theory of Economic Development3, explains how some entrepreneurs make an unusually large amount of money.

I would quote the book itself, but the argument is spread out over the course of the chapter. Schumpeter wasn’t a bad writer and the chapter is worth reading, but he never really summarizes his main points. So this is my recapitulation of it.

There are three main parts.

First, almost all entrepreneurs don’t make an abnormal amount of money, even of the successful ones. They make the same amount as if they were doing the same job for someone else. This is not what our entrepreneurial mythology tells us, so some explanation.

In a market economy, at equilibrium, Schumpeter says profit gets competed away. By profit he means “surplus” profit: the money a company makes if its inputs are priced correctly. Crucially this includes the cost of money adjusted for the risk the investor is taking. That is, you can’t increase risk and say “look, now there’s a profit.” That profit is the cost of the money used in the business.

The reason this is true is that if a company produces something using the same inputs as its competitors, and has the same outputs as its competitors, then the costs of its inputs and the price of its outputs are the same. If there were profit above the cost of capital, “surplus” profit, then existing businesses would lower prices to get more customers, or new businesses would start to take some of the surplus profit, until there was none left to take.

These new businesses would be startups, and their founders entrepreneurs. But these entrepreneurs would earn no more than they would if they did the same job as employees for someone else. This is because even the founder, as manager of the company, is an input, just like the other employees. The founder makes the same amount of money for their job as they would working the same job in any other business..there is no other money to make, there is no surplus for the founder. There is no “entrepreneurial profit”, as Schumpeter called it.

Is this true in the real world? Below is a chart from Scott Shane’s The Illusions of Entrepreneurship.4 It shows employee income compared to entrepreneur income, by decile. Note that for the middle eight deciles, they are the same. 80% of entrepreneurs make the same amount of money they would if they were employed.

The vast majority of entrepreneurs are people creating their own job so they can work for themselves.

Shane notes that the median revenue of an owner-managed firm is $90,000 and that 81% of founders have no desire to grow their business. This is because most founders are “just trying to make a living, not trying to be a high-growth business.” And they “start firms in industries where there are a lot of firms already in operation” and “report they have no competitive advantage.”5 Why do these people go to the trouble then of starting their own company rather than just taking a job? “The real reason most people start businesses…has nothing to do with wanting to make money, to become famous, to better their own communities, to seek adventure, or even to improve the world. Most people start businesses simply because they don’t like working for someone else.”6

Obviously, some entrepreneurs do make a lot of money. This is the second part of Schumpeter’s argument. Those that make money, an entrepreneurial profit, do so by breaking the status quo. They innovate. They either get their inputs for less or they sell their outputs for more.Their innovation is either an efficiency innovation that allows them to create the same output with less input, or a value innovation that allows them to create a better or different output (that the can therefore sell for more) with the same input. Or they have a little bit of both. This allows them to create an entrepreneurial profit.

Third part of the argument: this entrepreneurial profit goes away over time. Competitors figure out that there is this extra money and they imitate the innovator. When this happens, the surplus or excess profit is worn away as imitators enter the market and compete with the innovator.

Fyi: this diagram is not to scale, and the decay rate is just notional.

The total excess value created by the entrepreneur here is the area under this curve. This value is somehow split between the various participants in the startup–the founder, the employees, the financiers, etc.

So this is a kind of cool, and perhaps somewhat obvious in retrospect, model. Innovation leads to excess value that is then distributed mainly to founders and VCs. Using it leads to a couple interesting lines of thought.

It explains most of mainstream business strategy

As the second diagram above shows, there are two ways to create excess profit through innovation: by using innovation to lower cost or by using innovation to create a product you can charge more for. Doing one of these or both of them is integral to breaking out of the pack of competitors. This is one reason businesses focus so heavily on innovation. The bigger the innovation, the greater the excess profit, but even small innovations that result in a slightly lower price or slightly improved performance over the competition is important.

Interestingly, these are the only strategies to create excess profit that Schumpeter’s model allows. You might notice the resemblance to Michael Porter’s “generic strategies” (from his book, Competitive Strategy, considered one of the most important books on business strategy of all time.) Porter identifies three “generic” business strategies in the book. He calls them “cost leadership”, “differentiation”, and “focus”. The first two are the strategies Schumpeter called out. The third, “focus”, counsels a company to focus on a sector so they can get to some combination of the first two strategies. An innovation that allows one of these three strategies Porter calls a “competitive advantage”.

The third diagram expands on this. Since the total value is the area under the excess profit curve, you increase total value realized from an innovation by slowing the decline of the excess profit and extending the period until it is competed away. Doing this creates a “sustainable competitive advantage” (also commonly called a “moat”.)

One way to do this is through hampering competition with regulation: intellectual property or licensing standards or whatnot7. Another is to continuously improve the innovation to keep ahead of the competition. If you constantly tinker to improve, “learning by doing” then you benefit from the “experience curve“.

Another way is to slow competition is to divvy up the market between existing competitors so that none of you are really directly competing. This is generally illegal if it involves colluding, but a legal way to do it is to segment the market into slightly different products: sports cars for one company, pickup trucks for another. This is called “positioning”. Positioning can even be done into positions that didn’t previously exist: “blue oceans”. Just enumerate the various attributes your product can meaningfully differ on and find an unexploited combination that your company can excel at. Voila, zero competition…for a little while.

At the corporate level–that is, above the product level–you want to make sure that when one source of excess profit is petering out, you have another ready to go. You do this by investing in innovation. Some of this investment is in existing products, some of it is in new ideas. Rationally, you should invest the most in products that can be developed into the largest profits. The Boston Consulting Group’s growth-share matrix (“cash cows”, “stars”, “question marks”, and “dogs”) gets at this.

Etcetera. It’s too bad Schumpeter didn’t write business how-to books. He would have made a killing.

There are two fundamentally different types of startups

We call all companies started by entrepreneurs “startups”, but the kind that is started as a job replacement and the kind that is started to create entrepreneurial profit are different animals altogether.

As an aside, before I launch into this, don’t think this is a dis. I have started the first sort of company, the job replacement type. It happens to be in the venture capital space, so sometimes I confuse myself with the kinds of entrepreneurs I back–who start the second kind of company–but I would probably take home the same amount of money as an employee at a fund, though I would then have to work for someone else, which would suck.

Anyway, back to the two kinds of startups. The first kind is incredibly important for the people who start them. Starting your own company is, in the words of the Kauffman Foundation, “a self-actualizing and a self-transcending activity that—through responsiveness to the market—integrates the self, the entrepreneur, with society.”8 Who doesn’t want to self-actualize and integrate their self with society? I mean, poetry it’s  not, but underneath the weird phrasing these are actually excellent goals: doing what you love and having an interesting time while you do.

But the second kind of startup is responsible for most new jobs, brings fundamentally new products to market, and improves the overall quality of life. These are the sorts of goals that policymakers aim for when they talk about startups.

There is no accepted nomenclature that differentiates the two kinds of startups so people conflate the two. This leads to all sorts of confusion among governments, academics, financiers, journalists, etc.9 When newspaper articles talk about the decline in entrepreneurship, do they mean the first kind of startup or the second? Or both? They don’t know because they don’t even know there’s a real, fundamental distinction. This lack of understanding leads to bad conclusions.

If we could get people to understand that the kind of entrepreneurship that lets people work for themselves is primarily valuable to the individual while the kind that creates new products, lowers costs, and creates new jobs is valuable to society as a whole, we could direct attention and resources better.

People will always want to work for themselves, we don’t need to encourage them, we just need to let them. Less regulation, universal healthcare, a better small business loan infrastructure…these would all increase the number of this type of startup.

If we want more world-leading companies we need more funding for basic research, easier and cheaper access to higher education (and not just STEM) so people aren’t as burdened with student debt, and a better understanding of what makes these companies succeed. Different kinds of startups, different policies.

None of this is new–Schumpeter wrote the first edition of The Theory of Economic Development in 1911 (though my copy is the 1934 edition). So I’m not really expecting people to suddenly understand this difference. But at least now you do. It’s worth thinking about when you’re procrastinating on a Friday.