Meaning of Capital Formation

All the man-made factors used in further production are known as capital. Capital formation (the process of capital formation), therefore, refers to an addition to the stock of capital in an economy over time. It is a long-run process and it increases the productive capacity of an economy. Out of earned or generated income, a certain portion is consumed and the rest is saved. If the saved income is invested in any productive sector then it is known as capital formation in an economy. So, capital formation results from savings.

The capital formation can be seen from both a narrow and broader perspective. In the narrow sense, it is related to expenditure on fixed capital like the plant, machine, tool, etc. over time and in the broader sense, capital formation includes investment in human capital along with physical or material capital. So, capital formation includes the investment of saving in the attainment of physical capital as well as in human capital.

The development of a nation significantly rests on the availability of capital and quality of capital.  Lack of capital is one of the most serious problems that has been faced by developing nations for a long time. So, developing countries lagged in economic development. The higher rate of capital accumulation is based on different factors and increases the capital formation increase in production of goods and services, increase national income, and economic growth. Therefore, capital formation is one of the most significant determinants of development and growth.

The Process

Capital formation includes making more capital or accumulating more capital goods like machines, tools, factories, transport equipment, materials, electricity projects, etc. that all are used in further production or used in the productive sectors. In general, the capital formation process passes through three steps the creation of saving, mobilization of saving, and investment of saving.

Step-I: Creation of Saving

Step-II: Mobilization of Saving

Step-III: Investment of Savings

Creation of Saving

The first step to accumulating capital is to increase the volume of real savings. Saving is done by individuals or households, and the government. The saving of households is based on the level of income and their consumption habits. The higher the level of income, the higher will be the saving and vice-versa. To increase the saving, consumption expenditure needs to be decreased. So, with the rise in the level of income of an economy, saving also increases, and that turns into an increase in the rate of capital formation and economic development. Saving, in general, depends on the ability to save, willingness to save, and facilities for saving.

The ability to save is based on the level of income of people. When the level of income increases, the portion of savings also increases. Similarly, willingness to save depends on the interest, plan of people, wise, prospects of business opportunities, consumption habits, social culture, etc. Saving also depends on the facilities of saving and it depends on the availability of financial institutions such as a bank, finance companies, interest rates offered by banks and financial institutions, etc. Therefore, the creation of savings depends on the ability to save, willingness to save, and facilities of savings.  

Mobilization of Saving

The creation of savings is not sufficient for the accumulation of capital. It is needed to mobilize into business and investment activities. So, mobilization of savings is the process of transferring or moving the savings of people to the businessmen or entrepreneurs for investment. mobilization of saving links the amount of saving to those who want it for investment in productive activities. This process requires the services of different banks and financial institutions to make it move from the surplus units to deficit units. Financial institutions accept the savings from the public and make them available for businesspersons and investors. Therefore, the degree of mobilization of savings depends on the availability, access, and depth of the financial system of the nation, the banking habits of the people, and so on.

Investment of Saving

The final step of capital accumulation is an investment in saving. It is the process of investing borrowed funds into productive sectors and activities by borrowers and banks and financial institutions. This is based on the availability of enthusiast investors who are willing and able to take risks and bear the uncertainty of investment of savings. Therefore, in the end, considering different factors, this step refers to the investment of collected and borrowed funds in productive activities so that real capital in an economy will be added. This is based on the availability of good and sound enterprises, rate of interest, the marginal efficiency of capital, policies of the government, level of economic development, nature of demand in the economy, etc.

Therefore, capital formation is the increase in the stock of capital. It adds capital to the economy and the productive capacity of the economy increases. Having sufficient units of capital provides a significant base for economic progress, expansion, and growth. The process of capital formation includes increasing savings, mobilization of savings, and investment of saving in such a way that will increase the stock of real capital.  

References

Ahuja, H.L (2016). Advanced Economic Theory. New Delhi: S Chand and Company Limited.

Todaro, M.P. & Smith, S.C. (2009). Economic Development. New York: Pearson Education.