Schumpeter’s business cycle theory and the diversification argument

Schumpeter’s business cycle theory can be divided into three component parts: entrepreneurs produce innovations, innovations generate local plan failures, and local plan failures at times grow sufficiently large to generate global recessions. The third component of Schumpeter’s theory is susceptible to the diversification argument, i.e. small micro-changes tend to average out in a large economy thereby generating little macro-fluctuation. While Schumpeter was cognizant of this problem, he did not develop an explicit mechanism to nullify the averaging out of micro-changes. We argue that the network dynamics generated by Schumpeterian innovations is the missing link in his theory. More specifically, innovations change the production network by prodding firms to seek new suppliers of inputs and new buyers of output. These production network dynamics ensure that micro-changes are not independent of each other, rather micro-changes occur in response to each other, thereby nullifying the diversification argument. Production network dynamics are capable of transforming micro-flux into macro-turbulence.