Process of Capital Formation - The process of capital formation involves three steps.

1. Increase in Savings


• Power and will to save – the power to save and the will to save. The power to save of the community depends upon the size of the average family and the standard of living of the people. Other things being equal if the income of the people increases or the size of the family is small or people get accustomed to a particular standard of living which does not lean towards conspicuous consumption, the power to save increases.


• Perpetuation of income inequalities – Perpetuation of income inequalities had been one of the major sources of capita formation in 18th century England and 20th Century Japan’s most communities. If there is unequal distribution of income the society’s upper level incomes accrue to the businessmen, the traders and the landlords who save more and hence invest more on capital formation.


• Increasing Profits – The essential point is that profits of business enterprises should increase because they know how to use them in productive investment. Prof. Lewis is of the view that the ratio of profits to national income should be increased by expanding the capitalist sector of the economy, by providing various incentives and protecting enterprises from foreign countries.


• Government Measures – Similar to Private house holds and enterprises, the government also saves by adopting a number of fiscal and monetary measures. These measures may be in the form of a budgetary surplus through increase in taxation, reduction in government expenditure, expansion of the export sector, raising money by public loans, etc.


2. Mobilisation of Savings


• The next step for capital formation is mobilisation of savings through banks, investment trusts, deposit societies, insurance companies and capital markets. “The kernel of Keynes’ theory is that decisions to save and decisions to invest are made largely by different people and for different reasons.”


• To bring the savers and investors mutually there must be well grown capital and money markets in the country. In order to mobilise savings, attention must be paid to the starting of investment trusts, life insurance, provident fund, banks, and co-operative societies. Such agencies will not only permit small amounts of savings to be handled and invested conveniently but will allow the owners of savings to retain liquidity individually but finance long-term investment collectively.


3. Investment of Savings


• The third step for capital formation is the investment of savings in creating real assets. The profit making classes are an important source of capital formation in the agricultural sectors of a country.


• They have an aspiration for power and put aside in the form of distributed and undistributed profits and thus spend in productive enterprises. Further there must be a habitual supply of entrepreneurs who are competent, sincere and reliable.


• To execute his economic function, the entrepreneur entail two things, according to Prof. Schumpeter, “first the existence of technical knowledge to produce new products, second, the power of disposal over the factors of production in the form of bank credit. Further, the social, political and economic conditions in the nation must be conducive for the emergence of a growing supply of entrepreneurs.”


• Domestic sources for capital formation are essential to be appendage by peripheral sources. There are two motives for peripheral borrowing, according to Prof. A.J.Brown. “One is that it may be the easiest way of getting hold of capital funds at all and the other that it may be the easiest way of getting foreign currency with which to buy imports which are needed for development.”

Capital Formation as a Socialist Economy

1. The above description is of the option of capital formation in a capitalist economy. In a socialist economy, capital formation is entirely done by the state.

2. Since all the capital and land is held by the state and all the merchandise are produced by it, all rent, interest and profits are received by the state which endow them for creating capital assets.

3. The state decides the rate of capital formation to be attained for each year and takes away a part of the income of the people through fixation of higher prices for products and taxation.

4. In a socialist state, reserves are done on a much larger scale by the state than in a capitalist economy. It is the government which saves out of earnings of taxation and returns of endeavours.

5. The main basis is the turnover tax on consumers’ goods. Then there are profit margins, as the disparity amidst prices of consumers’ goods set and their outlay of production.

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