From General Equilibrium to Schumpeter

A simple model of cost innovation in a monetary economy is presented that illustrates the essentially dynamic model of Schumpeter involving breaking the circular flow of capital is logically consistent with the General Equilibrium (GE) model of an exchange and production economy. The GE model as presented by Arrow, Debreu and McKenzie is a nonprocess model; and the original theory deals with the non-constructive proofs of existence of competitive equilibria (CEs). To associate this theory with GE it is necessary to recast the basic model as a process model. The GE model is enlarged and specified as a playable game by adding rules to describe the mechanisms that carry process. Although we believe that GE was a great intellectual achievement, it strangled dynamics and the type of low dimensional equilibrium dynamics of the rational expectations school is profoundly misleading. It turns out that, by remodeling GE as a process model even with only one or two strategic moves, Pandora's Box of mechanisms appears and the functions of markets, money and default conditions all emerge as logical necessities. It is shown that the opportunity for process innovation can be described minimally and formally modeled by considering the availability of a new process as a function of a controlled stochastic variable where success depends on chance modified by the level of investment. The Schumpeterian concept of “breaking the circular flow of capital” appears naturally as a disequilibrium phenomenon where the extra resources are captured by a strategic disequilibrating allocation of money. & 2015 Elsevier B.V. All rights reserved. 1. The circular flow and equilibrium In a modern economy much of economic activity calls for the use of money and credit, both for decentralization and control. Money, credit and financial institutions provide the links between statics and equilibrium and dynamics and disequilibrium. General equilibrium deals precisely with equilibrium states. In spite of its elegance and abstraction, as was noted by Koopmans (1977), a general equilibrium theory is pre-institutional. Because the economic world is highly complex and multivariate, radical simplification is called for in the mathematization of the models studied. When process models of general equilibrium are formulated mathematically even the convergence to equilibrium from positions out of equilibrium