Capital Formation

CAPITAL FORMATION DEWETT 148/154

MEANING – CAPITAL FORMATION  capital formation means increasing the stock of real capital in a country. In other words, capital formation involves making of more capital goods such as machines, tools, factories, transport, materials, electricity etc which are all used for future production of goods.  For making additions to the stock of capital, saving and investment are essential

PROCESS OF CAPITAL FORMATION • In order to accumulate capital goods, some current consumption has to be sacrificed. • If society consumes all that it produces and saves nothing, future productive capacity of the economy will fall as the present capital equipment wears out.

Three stages in Capital Formation •

The process of capital formation consists of the following three stages 2. Creation of savings 3. Mobilization of savings 4. Investment of savings

CREATION OF SAVINGS • Savings are done by individuals or households. They save by not spending all their incomes on consumer goods. When individuals or households save. They release resources from the production of consumer goods. Workers, natural resources, materials etc thus released are made available for the production of capital goods.

Will to save • Apart from the power to save, the total amount of savings depends upon the will to save. Various personal, family and national considerations induce the people to save. People save in order to provide against old age and unforeseen emergencies. Some people desire to save a large sum to start a new business or to expand the existing business. Also, people want to make provision for education, marriage etc.

Voluntary and Forced savings • Savings may either voluntary or forced. • Voluntary savings are those savings which people do of their own free will. • Taxes by the government represent forces savings.

MOBILIZATION OF SAVINGS • Savings of the households must be mobilized and transferred to businessmen or entrepreneurs who require them for investment. • In the capital market, funds are supplied by the individual investors ( who may buy securities or shares issued by companies), banks, investment trusts, insurance companies, finance companies, governments etc.

INVESTMENT OF SAVINGS IN REAL CAPITAL. • For savings to result in capital formation, they must be invested . In order that the investment of savings should take place, there must be a good number of honest and dynamic entrepreneurs in the country who are able to take risks and bear uncertainty of production. • Investment will be made by entrepreneurs only if there is sufficient inducement to invest. Inducement to invest depends on the marginal efficiency of capital ( ie the prospective rate of profit) & rate of interest.

Foreign capital • Capital formation in a country can also take place with the help of foreign capital, ie foreign savings. Foreign capital can take the form of • (a) direct private investment by foreigners, (b) loans or grants by foreign govts, (c) loans by international agencies like world bank • India is receiving a good amount of foreign capital from abroad for investment and capital formation under Five- Year Plans

Deficit financing • Deficit financing ie newly created money is another source of capital formation. By issuing more notes and exchanging them with the productive resources, the government can build real capital. • The method of deficit financing as a source of development finance is dangerous because it often leads to inflationary pressures in the economy.

DISGUISED UNEMPLOYMENT • For example, surplus agricultural workers can be transferred from agricultural sector to non agricultural sector without diminishing agricultural output. The objective is to mobilize these unproductive workers and employ them on various capital creating projects, such as roads, canals, building on schools, flood relief activities. • In this way, the hitherto unemployed labor can be utilized productively and turned into capital.

CAPITAL FORMATION IN THE PUBLIC SECTOR • • • 4. 5. 6. 7. 8.

Capital formation takes place not only in the private sector by individual entrepreneurs but also in the public sector by government. Govt is building dam. Steel plants, roads, machine making factories and other forms of real capital in the country. There are various ways by which govt can get resources for investment purpose or capital formation. They are Direct and indirect taxation Public borrowing Deficit financing Profits of public sector undertakings Loan from foreign countries and international agencies

Low capital formation in Under-developed countries -- Reasons •

In most under developed countries, investment is only 5% to 8% of the national income where as in countries like USA and Japan, it generally varies from 15% to 20% of the national income and even higher. • The main reasons are 3. Domestic savings are low 4. Dynamic entrepreneurs not investing 5. Inducement to invest is very weak

INDIA-why low capital accumulation • We have • “THE WILL TO SAVE • • • • • •

BUT THE POWER TO SAVE IS MISSING” Little margin between production and consumption Inducement to invest is negligible Agriculture in most primitive methods Transport and communication are inadequate Country is not equipped with adequate banking and insurance It suffers from inflation

REMEDIES 1.

Production should be increased in all all spheres by the development of agriculture, trade, industry, transport, banking, insurance etc. 2. Compulsory insurance schemes should be introduced. 3. Provident fund schemes should be extended. 4. Tax relief to industries 5. Stock exchange activities will ensure flow of capital provided it gains confidence from investors 6. Distribution of wealth in the country 7. Small savings should be improved and attractive rates of interest should be provided The above are some of the measures which encourage investment and help capita\l formation.