Role of Different Factors in Capital Formation: According to Lewis

The role of different factors in capital formation is explained as below:

(a) Relation between Capital, Technical progress and Productivity:

Prof. Lewis described the relationship between capital, technical progress and productivity which are regarded as important determinants of development.

It is neither possible nor necessary to distinguish between growth of capital and growth of technical knowledge.

Lewis is of the opinion that the growth of technical knowledge outside the capitalist sector is important, as it raises the level of wages and reduces the capitalists surplus. But inside the capitalist sector, technical knowledge and capital, work in the same direction to raise the surplus and to increase employment. Capital formation and technical progress result not in raising wages, but in raising the share of profits in national income.

The application of technical knowledge requires new investment and whether new knowledge is capital saving or labour saving. Capital and technical knowledge also work together. Hence, in the present analysis growth of productive capital and growth of technical knowledge are treated as single phenomenon and both tend to raise profits and employment not wages.

(b) Role of private capitalists and state:

According to Prof. Lewis main problem of economic development is to know the process by which a community which was previously saving and investing 4 to 5% of its national income or less converts itself into an economy where voluntary saving is about 12 to 15 percent of national income or more. In the developing countries with surplus labour, only 10 percent of people with the highest income, who receive around 40% of the national income save.

The wage earners and salary classes save hardly 35 percent of national income. The landlords, money lenders, princes, traders, priests etc. are engaged in prodigal consumption rather than in productive investments. It is thus state capitalists and domestic private capitalists who create capital out of profits earned by them. Lewis argued that once a capitalist sector has emerged; then it is matter of time before it becomes sizeable.

On the other hand, if little technical progress is taking place, the surplus will also grow slowly. But in case opportunities for using capital productivity increase rapidly, the surplus will also grow rapidly, it will also emerge with capitalist class.

(c) Role of Bank Credit:

Capital creation is possible not only through profits but it is also created through bank credit. The underdeveloped countries suffer the problems of idle resources and scarcity of capital, in their case credit creation works in the same manner as profits have their impact on capital formation. It will boost both employment and output. Of course, investments financed through bank credit can be inflationary for sometimes. Prices will rise when surplus labour is employed in capitalist sector and is paid out of the created money.

It is because then income will go up but the production of consumer goods output will remain the same. It will be possible only in the short-run till capital goods industries start producing consumption goods. Once the production of consumer goods start, prices will show downward trend.

In another way, inflationary process come to an end, “when voluntary savings increase to a level where they are equal to the inflated level of investment”. Thus with capital formation, there is continuous rise in output, employment and profits. As higher profits lead to higher savings a time may come when savings increase so much that the new investment are financed without the bank credit.

(d) Role of Savings:

Savings play a crucial role in the development of an economy. If the capitalist do not reinvest at larger and larger proportion of their profit, the total production will neither expand nor the opportunities for employment increase. According to Lewis, “The central problem in the theory of economic development is to understand the process by which a community which was previously saving and investing 4 or 5 per cent of its national income or less, converts itself to an economy where the voluntary saving is running about 12 to 15 percent of national income or more. This is the central problem because the central fact of economic development is rapid capital accumulation. We cannot explain any industry revolution until we can explain why saving is increased relatively to the national income”.

The growth of an economy is crucially related to growth of incomes of these people. It is because of their increased savings that the capitalist sector of the economy expands leading, in turn to an expansion of national output and level of employment.

Prof. Lewis observes that savings are to be done by people who receive profits or rents. But in the countries, those receiving rents are highly prone in their consumption and hence there is no savings. Lewis felt that if we take savings increasing as a proportion of national income in any economy, we may take it for granted that this is because the share of profits in the national income is increasing. Thus, saving increases relatively to national income because the income of the savers increases relatively to national income.

The major reason for the poverty of underdeveloped countries is that their capitalist sector is small. If these countries had a larger capitalist sector, profits would be a greater part of their national income and savings and investment would also be correspondingly greater. Prof. Lewis points out that though the increase of the capitalist sector involves an increase in the inequality of income as between capitalist and rest, more inequality of income is not enough to ensure a high level of saving.

The fact is that inequality of income is greater in underdeveloped countries than that in advanced countries because agricultural rents are much higher in the former. Lewis also found that the capacity to save in underdeveloped countries is not as small as generally it is assumed.