INDUCED INNOVATION, DIFFUSION OF INNOVATIONS AND BUSINESS CYCLES
This chapter first of all discusses the question of factor substitution and its relevance for sustained full-employment growth. It then attempts to relate this discussion to the diffusion of technical innovations and to major fluctuations in the economic system.
An important assumption in general equilibrium theory is that the 'principle of substitution' between labour and capital will operate in competitive markets to balance supply and demand for labour and capital. In the event of 'over-supply' of labour, the relative 'price' should fall, leading to substitution of labour for capital until a full-employment equilibrium is attained. In the event of labour shortages, the relative price of labour should rise, leading to substitution of capital for labour. The interest rate, as the 'price' for capital, is assumed to perform a similar equilibrating function in relation to the supply and demand for capital. Of course no one ever believed that these mechanisms operated instantaneously or perfectly in the real world, but the tendency in mainstream neoclassical theory was to assume that the mechanism was a relatively automatic and self-regulating one provided markets were free to operate.
This notion of a smoothly functioning compensation mechanism lies behind much of the insistence, both in contemporary debates and in earlier ones in the 1920s and 1930s, on downward flexibility in wage rates as the key policy problem involved in a return to higher levels of employment, especially in Europe.
This chapter will argue that this view rests on a mistaken conceptualisation of the process of technical change in industralised capitalist societies and that the problems of persistent structural unemployment and of cyclical fluctuations relate not so much