Almost all economists lay emphasis on capital formation as the major determinant of economic growth. It means that society does not apply the whole of its current 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 efficacy of productive effort. The essence of the process then, is the diversion of a part of society’s currently available resources to the purpose of increasing the stock of capital goods so as to make possible an expansion of consumable output in the future.
A proper definition must include capitalforbusiness both material and human capital. Capital formation consists of both tangible goods like plants, tools and machinery and intangible goods like high standards of education, health, scientific tradition and research”. According to another school of thoughts, domestic capital formation would include not only additions to constructions, equipment and inventories within the country, but also other expenditure, except those necessary to sustain output at existing levels. It would include outlays on education, recreation and material luxuries that contribute to the greater health and productivity of individuals and all expenditures by society that serve to raise the morale of employed population”. Thus the term covers material as well as human capital.
It (or accumulation) is regarded as one of the important and principal factors in economic development. The vicious circles of poverty in underdeveloped countries can be broken through capital formation. Due to low levels of income in such countries, demand, production and investment are deficient. This results in the deficiency of capital goods which can be removed by capital formation. The supplies, of machines, equipment and tools increase. The scale of production expands. Social and economic overheads are created. It leads to the fuller utilization of available resources. Thus capital formation leads lo increase in the size of rational output, income and employment thereby solving the problems of inflation and balance of payment; and making the economy free from the burden of foreign debit.We discuss below the importance of capital formation in detail.
The main purpose of economic development is to build capital equipment on a sufficient scale to increase productivity in agriculture, mining, plantations and industry. Capital is also required to construct schools, hospitals, roads, railways, etc. In fine, the essence of economic development is the creation of economic and social overhead capital. This is possible only if there is a rapid rate of capital formation in the country, that is, if a smaller proportion of the community’s current income or output is devoted to consumption and the rest is saved and invested in capital equipment. The central problem in the theory of economic development is the process of raising domestic saving and investment from 4-5 percent to 12-15 percent of national income.
Investment in capital equipment not only increases production but also employment opportunities. Capital formation leads to technical progress which helps realize the economies of large-scale production and increases specialization. It provides machines, tools and equipment for the growing labor force. Thus capital formation also benefits labor.
Capital formation leads to the expansion of market. It helps remove market imperfections by the creation of economic and social overhead capital, and thus breaks the vicious circles of poverty both from the demand side and the supply side.
Further, it makes development possibly even with increasing population. In overpopulated underdeveloped countries the increase in per capita output is related to the increase in capital-labor ratio. But countries aiming at raising the capital-labor ratio have to face two problems. First,the capital-labor ratio falls with increase, in population so that large net investment is needed to overcome the diminution of capital-labor ratio. Second,when population is increasing rapidly, it becomes difficult to have sufficient savings for the required quantity of investment, reason being that a low per capita income keeps the propensity to save at a low level in such a country. The only solution to these problems is a rapid rate of capital formation.
Underdeveloped countries are faced with the problem of balance of payments because they mostly export primary products like raw-materials and agricultural products, and import almost all types of manufactured, semi-manufactured and capital goods. Domestic capital formation is one of the important solutions to this problem of adverse balance of payments. By establishing import-substitution industries, the imports of manufactured and semi-manufactured goods are reduced. On the other hand, with the increasing production of all types of consumer and capital goods the composition of exports changes. Along with agricultural products and industrial raw materials, the exports of manufactured articles also start. Thus it helps in solving the problems of balance of payments.
A rapid rate of capital formation gradually dispenses with the need for foreign aid. In fact, capital formation helps in making a country self-sufficient and reduces the burden of foreign debt. When a country borrows from foreign countries for long periods, it imposes a heavy burden on the future generations. With every loan the debt charges increase day by day which can only be repaid by levying more or/and higher taxes. The burden of taxes increases and money flows out of the country in the form of debt repayments. Therefore, it is capital formation that brings freedom from foreign aid, reduces the burden of foreign debt and makes the country self-sufficient.
The strains of inflationary pressure on a developing economy can be removed to a considerable extent by increased capital formation. The output of agricultural products and manufactured consumer goods tends to increase with a rise in the tale of CP. On the other hand, when income increases with capital formation, it raises the demand for goods. In the short run, it is not possible to match this increased demand by increase in supply and this results in the development of inflationary pressure in the economy. It is, however, a steady rise in the rate of capital formation in the long-run that augments the supply of goods, controls inflation and brings stability in the economy.
Capital formation also influences the economic welfare of a country. It helps in meeting all the requirements of an increasing population in a developing economy. When capital formation leads to the proper exploitation of natural resources and the establishment of different types of industries, Levels of income increase and the varied wants of the people are satisfied. They consume a variety of commodities, their standard of living rises and their economic welfare increases.
Lastly,an increase in the rate of capital formation raises the level of national income. The process of capital formation helps in raising national output which in turn raises the rate and level of national income. Thus the rise in the rate and the level of national income depends on the increase in the rate of capital formation. Thus it is the principal solution to the complex problems of underdeveloped countries, and is the main key to economic development.