Concept of Capital Formation | Economics

In this article we will discuss about the concept of capital formation.

Advanced countries are characterised by high levels of capital investment. This results in a high level of income flow. Contrarily, developing countries like India are capital-scarce. Consequently the level of income is low. In low-income countries saving is low. There exists gap between saving and investment. The most common explanation for low level of savings is the low per capita income.

A large number of people live in poverty and distress. Most rural people live from hand to mouth. Besides a large part of the farming community are distinguished by unemployment. Even if they are removed from farming there will be no reduction in total output. The unproductive workers are supported by productive members. Naturally, they could not save what they could have saved.

According to another view, surplus generation is little in poor economies not because of mass poverty but because of lack of industrialisation. W.A. Lewis says, “If we ask why saving is so low in poor countries the answer is not that their people are poor but that their capitalist sector is so small”.

In Lewis model it has been shown how large industries, by offering higher wages, can attract surplus rural manpower into the capitalist sector and thus generate surplus fund by paying workers less than the value of their marginal product. Reinvestment of the surplus would lead to further ex­pansion of employment and generation of more surplus. This process will continue till the surplus farm labourers are absorbed in the capitalist sector.

The problem of capital formation in developing countries is not merely one of shortage of investible resources but one of its judicious use. Much of the savings is wasted in such countries and are not used for the creation of additional capital. Social customs and religious ceremonies — both private and public — lead to unproductive investments. Furthermore, a large part of small savings in the rural sector remains idle.

They are neither mobilised nor channelized. To this may be added the asset preference pattern of the people. Rural elites invest savings in land, real estate and savers of urban sector invest in housing, jewellery, etc.

A significant portion of household savings is thus used up in buying physical assets instead of financial assets. What is more tragic is that governments of such countries do spend money lavishly for unplanned and unproductive purposes ignoring their social responsibility. Administrative and defence expenditures very often exceed outlays on education, health care and social capital.

In reality, what is scarce is not capital as such as is commonly assumed but viable projects into which capital can be invested in order to earn a reasonable rate of return. Nobody can afford to produce luxury cars in most African countries where most people cannot even afford bicycles.

The mere raising of aggregate savings and investment ratio is not enough since there is considerable wastage of capital resources in under-developing countries due to:

(i) Wrong choice of investment projects,

(ii) Inefficient implementa­tion and management, and

(iii) Inappropriate pricing policies.

Capital formation or accumulation means increasing a country’s stock of real capital. Since every country possesses only a limited supply of factors of production, an increase in the production of capital goods neces­sitates a smaller production of consumer goods. Consumers, therefore are required to save in order to set free factors of production to make capital goods.

Since production is a continuous process, some amount of capital is always wearing out in the process of use; the worn-out capital must be replaced if the existing stock of capital is to be maintained. So, capital formation necessitates production of new capital goods in excess of the amount required to replace worn-out or obsolete capital.

Economic pro­gress, then, requires formation of capital. But, developing countries like India are so poor that they are near the minimum level of subsistence Thus while in developed industrial countries 25% to 30% of income is used for capital formation through the saving-investment process, developing coun­tries like India struggle hard to save and invest even 15% of their national income. The urgency of current consumption competes for scarce resources. This leads to under-investment in productive instruments capable of in­creasing the nation’s rate of economic growth.

In the words of Ragnar Nurkse, “The meaning of capital formation is that society does not apply the whole of its productive activity to the needs and desires of immediate consumption but directs a part of it to the making of capital goods, tools and instruments, machines and transport facilities plant and equipment – all the various forms of real capital that can so greatly increase the efficiency of productive effort”.

In a broad sense the formation of capital means something more than mere accumulation of physical capital. It involves development of human capital as well. As Alfred Marshall put it, “Capital consists in a great parts knowledge and education.” As G. Mier has said, “It has become evident that the effective use of physical capital itself is dependent upon human capital”. In other words, the absorptive capacity for physical capital depends on technical and professional people. So, the term encompasses as not only investment in physical capital but in human capital as well. The two are indeed complementary to each other.

Factors Governing Capital Formation:

Since economic growth of a country depends upon how rapidly its capital resources are increased, most countries have come to emphasize capital formation. In countries like the U.S.A., Japan and Germany capital forma­tion takes place at a fairly high rate. Capital formation takes place through the construction of mills and factories, plants and machinery, roads, rail­ways, irrigation canals, electricity generating plants, etc.

The question then arises:

How much capital is to be created per annum or at what rate the stock of capital to be increased? Creation of capital —capital formation—primarily depends on the savings of the community. Savings can take place when a man foregoes present consumption for the sake of future prosperity. So, in order to raise the rate of capital formation present consumption must be restricted.

There are two important features of capital. Firstly, it entails a sacrifice, since resources are devoted to making non-consumable capital goods in­stead of goods for immediate consumption. Secondly, it enhances the productivity of the other factors, viz., land and labour.

In fact, it is this enhanced productivity which represents the reward for the sacrifice in­volved in creating capital.