Capital FormationB.Com. IV Sem

Indian Economy

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Capital?

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• Capital is defined as produced means of production.

• It is man-made and its supply can be increased by human effort.

• Capital stock of a country consists of machinery, tools, factory buildings and all

kinds of industrial plants, raw materials, partly-finished goods and means of

transport.

• Since the development of an economy crucially depends upon the availability of

these things, we can see that capital is essential factor of development.

• The addition to the capital stock of a country during a given year represents the

capital formation in that year. 3

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Capital is thus not the same as money but refers to assets for the generation of which

‘investment’ of both money and human efforts are required.

A second characteristic of capital is, thus, that the asset must have been created by

‘human efforts’ and not available in a natural form. Thus, although land is the most

important basic resource in agriculture, land itself is not considered capital.

But any investment made on land development would be termed as capital as it

satisfies the criteria of ‘human efforts’ and an ‘asset’ useful in the agricultural

production process.

Economic development is thus a multidimensional phenomenon which is the

result of a combination of social, cultural, political, and economic factors.

It may here be remembered that though capital occupies a central position, to

the process of development yet, we cannot ignore the other factors like

education, effective government, social Justice, attitude of the people to work,

etc.,. These factors play a significant role in the economic progress of a country.

Capital formation is the process of building up the capital stock of a country

through investing in productive plants and equipments.

Capital formation, in other words, involves the increasing of capital assets by

efficient utilization of the available human resources of the country.

Capital Formation

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Definitions

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A United nations study defines “Capital as those goods resulting from

economic activity which are used for the future production of other

goods.”

To quote Ranger Nurkse, “Economic development has much to do with

human endowments, social attitudes, political conditions, and historical

accidents. Capital is necessary but not a sufficient condition of economic

progress".

According to Colin Clark, “Capital goods are reproducible wealth used

for purposes of production.”

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Further, capital can be tangible or intangible.

Tangible capital in agriculture refers to productive physical assets like

tractor, irrigation pumpsets, farmhouse buildings, warehouses,

inventories of inputs, etc.

Intangible capital in agriculture refers to investment made in health,

education and training of farm workers.

Types of Capital and Capital Formation

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Capital used in agriculture can broadly be classified into two categories:

(i) fixed capital and (ii) working capital.

Fixed capital is that capital which lasts for more than one year. It

includes the investment in farm machines such as tractor, pump-sets, and

other assets like tube-wells, land development, farm building, etc.

Working capital is that capital which lasts for less than one year such as

expenses on seeds, fertilizers, wages to the workers, etc.

Types of Capital and Capital Formation

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Capital, on the basis of ownership, is categorized as private and

public.

Capital owned by local, state and central governments, such as,

municipal sewage lines, dams, power projects, roads, canals,

warehouses, market-sheds etc. are public capital.

Any capital owned by private individuals/companies, such as farm

machinery and equipment is termed as private capital. Both public and

private capital is necessary for the development of agricultural sector

Importance of Capital Formation

The importance of capital formation as one of the factors in economic

development is discussed below:

1. Increase productivity of various sectors:

Capital formation increases the stock of material and human capital.

The productivity in agriculture, manufacturing and mineral sector etc

increases.

2. Increase in national income:

Capital formation helps in raising national output which in turn raises

the rate and level of national income.10

3. Increase Employment:

The increased investment in various sectors of the economy leads to

increase employment opportunities in A country.

4. Break the Vicious Circle of Poverty:

It helps in breaking the vicious circle of poverty in the

underdeveloped countries .

5. Expansion of Markets:

Capital formation makes it possible to produce the goods on large

scale. As the good of one industry will be the inputs of other and so on.

Thus the size of the market will be extended.

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6. Control Inflation:

Capital formation increases the supply of goods in the country. It thus helps

in controlling inflation and bringing stability in the economy in the long-run.

7. Self-sufficiency:

A country engaged in capital formation will be able to produce a variety of

goods and make the country self-sufficient. This will reduce a country’s

dependence on foreign countries.

8. Correct Balance of Trade:

Capital formation helps in building import-substitution industries. The

reduced demand of the foreign goods helps in solving the problems of adverse

balance of trade.

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9. Proper Utilization of Natural Resources:

The adequate volume of capital formation makes it possible to utilize the natural

resources of a country to the maximum extent and thus increase the rate of economic

growth rapidly at a higher rate.

10. Technological progress:

Technological progress requires higher rate of capital formation. The

technological improvements helps in getting more output from the same resources.

11. Building up of infrastructure:

The building up of sound infrastructure like road, railways, communication

system, power etc is an vital significance of capital formation which helps in breaking

vicious circle of poverty.

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Importance of Capital Formation in the Economic Development:

Capital Formation Is Vital For Economic Growth.

Capital Resources Of A Country Increase Investment And Needed

Finance For The Industries.Capital Formation Helps In Eradicating The Vicious Circle Of

Poverty.

Capital Formation Increase Investment And Production Activities

Which Results In More Employment Opportunities For The

Masses.

Capital formation helps a country becoming self sufficient and

independent all foreign pressures.

Expenditure on Human Resource Development increases

productivity and efficiency of work which later translates into better

and more production.14

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Sources of Capital Formation

There are two sources of capital formation :

A. Domestic Sources:

a. Voluntary savings by household and business sectors

b. Involuntary saving by transferring resources from

consumers and producers to government through taxation.

c. Government borrowing

d. Use of idle resources

e. Deficit financing

B. External Sources:

a. Foreign aid

b. Restrictions of imports

c. Direct foreign investment

Causes of Low Rate of Capital Formation in Underdeveloped Countries

The additions made to the stock of capital of an

economy directly increase its productive

capacity.

There is much closer positive correlation

between the rate of capital formation and per

capita incomes than between the capital-output

ratio and the level of income of a country.

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Vicious Circle of Poverty:

The low capital formation in underdeveloped countries is attributed to

vicious circle of poverty which operates in underdeveloped countries . it is

because of VCP the incomes, savings, investment and productivity of the

people remains limited and obstructed.

Lack of Proper Infrastructure:

In case of LDCs, there is an acute shortage of infrastructure facilities like

power, transport, communication etc. thus in the presence of inadequate

infra-structure the domestic as well as foreign investors are not prepared to

invest. With this the stock of capital and capital formation remains low.

Causes of Low Capital Formation in Underdeveloped

Countries :

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Inflation:

In UDCs, inflation is a very common phenomenon. Because of

persistent rise in general price level, the real incomes of the

people decrease restricting their saving potentials.

Population Explosion <Higher Birth Rate>:

In case of poor countries not only the volume of population is

very high but the rate of growth of population is also

significantly greater. In such situation all of the incomes have to

be devoted to the rising umber of children and nothing is left

to be allocated for savings.

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Unproductive Expenditures:

In Case Of Ldcs, The Lavish Expenditures Are Made On

Unproductive Fields Both By Individuals As Well As By

Governments. The Individuals Waste Their Precious Savings By

Spending Them On Traditions, Customs And Litigations Etc.

While Government Make Expenditures On Unproductive Fields

For Example Political Purposes. Consequently A Little Surplus Is

Available For Capital Formation.

Unequal income distribution:

In Udcs, The Distribution Of Income And Wealth Is Very

Unequal. The Rich Do Not Care For Saving And The Poor Have

Very Low MPS. Thus Capital Formation Remains Low.

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Tax System:

In Udcs, The Tax Structure Is Also Responsible For Low

Capital Formation. In These Countries The Indirect Taxes

Are Imposed In A Greater Amount Rather Direct Taxes. This

Situation Also Discourages The Saving Potential Of The

People. In This Situation, The Poor And Middle Class Of

The Udcs Hardly Contributes To Savings And Capital

Formation. On The Other Hand, The Businessmen And

Industrialists Are Always Found Hectic Regarding Tax

Evasion.

Problems Of Money Markets:

Money Market Is In Infancy In The Less Developed

Countries Which Is Not Fully Contributing To Capital

Formation.

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Proper Utilization Of Natural Resources:

The Adequate Volume Of Capital Formation Makes It

Possible To Utilize The Natural Resources Of A Country To The

Maximum Extent And Thus Increase The Rate Of Economic

Growth Rapidly At A Higher Rate.

Technological Progress:

Technological Progress Requires Higher Rate Of Capital

Formation. The Technological Improvements Helps In Getting

More Output From The Same Resources.

Building Up Of Infrastructure:

The Building Up Of Sound Infrastructure Like Road,

Railways, Communication System, Power Etc Is An Vital

Significance Of Capital Formation Which Helps In Breaking

Vicious Circle Of Poverty. 21

In order to promote capital formation in the underdeveloped

countries , following suggestions can be given:

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Measures to promote capital formation

in underdeveloped countries

Liberal policy of the government:

The government should have liberal credit, fiscal and

industrial policies. Due to the liberal policy , saving and

investment will be encouraged and capital formation

promoted.

Utilization Of Disguised Unemployed Workers:

If The Disguised Unemployed Workers Are Employed

On Various Projects Like Irrigation, Roads Etc They Can

Be A Fruitful Sources Of Capital Formation.

Privatization Of Financial Institutions:

The Privatization Of Financial Institutions Can Also

Attract Savings Both At The Gross And Higher Level By

Providing Full Range Of Banking Services To Customers.

The Impressive Performance Of The Financial

Institutions Can Help In Mobilizing Resources For

Development.

Saving Drives:

Savings Of Both Types, Voluntary And Involuntary Can Greatly

Help In Capital Formation.

Setting Up Financial Institutions:

The Setting Up Of Financial Institutions In Urban And Rural

Areas Can Greatly Help The People To Deposit Their Savings

In Financial Institutions Rather Than Keeping Them In Homes.

The Small And Larger Amounts Of Saving So Collected Helps

In Raising Funds For Development.23

Foreign Aid:

If The Capital Is Not Adequate For Meeting The

Development Requirements Of The Country, Then To Bridge

The Savings-investment Gap, The Country Has To Reply On

Foreign Aid For Economic Development.

Restrictions On Luxury Imports:

Another Source Of Capital Formation Is The Imposition Of

Restrictions On Luxury Imports. The Foreign Exchange Thus

Saved Could Be Used For Capital Formation.

Public Borrowing:

Public Borrowing Is An Effective Method Of Capital

Formation. Government Raises Loans Through Sale Of

Bonds And Saving Certificates Etc.24

Development Of Capital Markets:

Government Can Divert Resources From Unproductive Channels

By Strengthening The Capital Market In The Country. The

Establishment Of Stock Exchanges Etc Can Go A Long Way In

Capital Formation.

Foreign Earning Through Exports Of Physical Goods:

The Foreign Earning Through Boosting The Exports Of

Physical Goods To The Other Parts Of The World Can Be

Utilized For Capital Formation.

Foreign Remittance:

Foreign Remittance Refers To The Earning By Services Export By

The Inhabitants Of A Country. If The Government Increase

The Search To Find Jobs For The People In Other Countries

They Will Bring Foreign Remittance To The Country Which

Can Be Utilized For Capital Formation.25

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CLASS ACTIVITY

Mention some ways in which capital formation in agriculture can

increase the prospects for agriculture exports.