Factors Affecting Capital Formation: Demand Side & Supply Side

The following points highlight the two main factors that affect capital formation of an economy. They are: 1. Demand Side, and 2. Supply Side.

Factor # 1. Demand Side:

The demand for capital mostly depends upon the incentives for investment in an economy.

It will be high if the incentive to invest is strong, while it will be low if it is weak.

The incentive to invest almost depends on the rate of profitability of investment. In under-developed countries, lack of demand for capital is marked by an acute shortage of capital. Lack of demand only refers to the demand for capital of the private investors and not considered from the point of view of the economy as a whole.

Therefore, lack of incentives for private investment arises primarily from the small size of the domestic market. If the people are poor and size of the market is small, private investment will not be very profitable and incentives for investment will automatically be poor.

In under developed countries, lack of demand for capital arises from low production and small purchasing power of the common man. But in developed countries, the problem is of different nature. In such countries, the shortage of demand for capital comes from the deficiency of aggregate effective demand which is due to over saving.

This type of shortage can be remedied through money expansion. Here, it must be kept in mind that monetary expansion in under-developed countries will lead to inflation because there is always shortage of demand arising from the shortage of supply of goods and services in the market.

In fact, small size of the market is responsible for lack of incentives for investment and entrepreneurs do not find it profitable to set up modern industries. Therefore, the size of the market can also be enhanced by the method of public expenditure, salesmanship, adjustment and formation of custom duties or free trade agreements etc.

Thus, rise in productivity is a crucial determinant of the size of the market. Prof. Ragnar Nurkse also proposes simultaneous investment in a number of industries to expand the size of the market in under developed economies. In addition to the small size of the market, there are other factors which limit the demand for capital in under developed countries.

They are listed as under:

(i) Lack of Entrepreneurship:

Generally, in under developed countries, there is acute shortage of efficient, dynamic and daring entrepreneur who are capable of taking risks in business. In the absence of such qualities of entrepreneurs, the saving of the people cannot be properly utilised in speculative activities, thus, fails to create further capital accumulation.

(ii) Lack of Availability of Skilled Labour:

Under developed countries always suffer from the availability of skilled and trained labour. Due to their backwardness in technology, it inhabits the demand for capital.

(iii) Shortage of Basic Facilities:

Investment is hindered by the shortage of basic facilities like power, transportation, communication and research institutions etc. The limit the scope for higher investment.

(iv) Availability of Cheap Labour:

There is abundant labour supply in under developed countries due to the higher population and mass unemployment. This leads to the adoption of labour intensive techniques rather than capital intensive techniques which, in turn, decreases the demand for capital.

(v) Primitive and Out-dated Agriculture:

In under developed countries, the main occupation of the people is agriculture. About 70 per cent people directly or indirectly are dependent on agriculture for their livelihood. They use primitive and out-dated methods of cultivation.

The holdings are uneconomical, subdivided and fragmented. The land tenure system is defective which discourages investment in this sector. They do not apply scientific methods of cultivation.

(vi) High Interest Rates:

Another reason which limits the demand for capital is that there is comparatively high interest rates in poor and under-developed countries. High interest rates adversely affect the marginal efficiency of capital which, in turn, discourages investment in a country.

(vii) Taxation Policy:

In most of under developed countries, higher taxation policy has been adopted as a planned strategy for mobilisation of additional resources to meet the needs of the development and to decrease the gulf between the poor and the rich. Extremely higher taxes on income and profit hamper the incentive to make investment in an economy.

(viii) Unstable Political Environment:

In under developed countries, unstable political environment is witnessed which is greatly responsible for low demand for capital. These countries have backward and traditional systems which fail to develop suitable environment for making favourable investment in the country.

(ix) Lack of National Feelings:

In the present days, under-developed countries also lack national feelings which discourages new investment. In fact, security of life and property are the basic needs for capital formation.

Factor # 2. Supply Side:

In an economy, supply of capital is always determined by the availability of investible funds which represent a surplus over the consumption requirements of the people.

There are two sources of supply of money:

(i) Domestic supply of money; and

(ii) imported capital (foreign capital).

Therefore, the total supply of money is made up of domestic savings and net capital imports. Without saving, there is no accumulation of capital. There are three sources, from where savings emerge.

They are:

(a) Saving by individuals and house-holds

(b) Saving by business enterprise and joint stock companies

(c) Saving by governments

The inadequate supply of capital in under-developed countries is largely due to the under-mentioned reasons:

(i) Low level of per capita income because majority of people live on subsistence level.

(ii) Common people lack saving habits.

(iii) Lack of banking and investment opportunities.

(iv) Lavish spending on conspicuous and ceremonial consumptions.

(v) People are more Interested in Purchase of Gold, Jewellery and Land Etc.

(vi) Unfavourable cultural and institutional set up.

(vii) Rapid increase in population.

(viii) Other reasons—wasteful practices, lack of desire of progress, demonstration effects and lack of foresightedness, in congenial environment etc.