Capital Formation

Capital formation is a process in which the people of a country reduce a part of their consumption, save money, and invest that money in various productive activities to obtain more wealth. If the saved money is kept idle without being invested in productive work, it does not fall under capital. 

According to a narrow view, capital formation includes only the creation of physical assets. 

According to a broader view, it includes the formation of human capital along with physical capital. 

Primarily, capital formation depends on savings. 

The necessary savings for capital formation depend on the following things:

• Willingness to save
• Ability to save
• Facilities for saving

(a) Willingness to save: 

Savings are the basis of capital formation. For saving, it is not enough to have income; there must also be a willingness to save. If there is no willingness to save, savings cannot be made no matter how much income increases. 

If there is a willingness to save, savings can be made even by cutting down on expenses. A person's willingness to save depends on foresight, love for family, interest rates, habits, etc.

(b) Ability to save: 

Capital formation depends on the ability to save. If the ability to save is high, capital formation will also be high. If the ability to save is low or non-existent, capital formation will also be low or zero. The ability to save depends on a person's income. Those with higher incomes have a higher ability to save, and those with lower incomes have a lower ability to save. 

For example, suppose there are two people named Isha and Nishan. Their monthly incomes are Rs. 30,000 and Rs. 25,000, respectively. If both individuals need Rs. 20,000 for monthly expenses, Isha's monthly savings will be Rs. 10,000. 

Nishan's monthly savings will be only Rs. 5,000. The ability to save depends not only on income but also on spending habits. Some amount can be saved even from a low income if expenses are made in a wise, planned, and economical way.

(c) Facilities for saving: 

Individuals with the willingness and ability to save also need facilities for saving. A proper environment like peace and security is necessary for saving. If the money saved by cutting down on expenses is not safe or is subject to theft and robbery, people will not want to save. 

The establishment and development of banks and financial institutions increase the facilities for saving.

Capital Formation Process

Capital formation is extremely important for the economic development of a country. Capital formation cannot happen in a short period. It has to go through various stages or processes. Capital formation depends on savings, but not all saved money is capital. Savings are converted into capital only after completing a certain process. The process of converting savings into capital is called the capital formation process. The capital formation process is completed in three stages, which can be explained as follows:

(a) Creation of savings: 

Savings are the first stage of capital formation. Capital formation is impossible without savings. Savings are a portion of income that is kept aside by cutting down on consumption. Therefore, savings depend on income. An increase in income leads to an increase in savings, which in turn increases the rate of capital formation and economic development. 

A portion of income that is saved by people is used for the creation of capital goods. Savings depend on other factors besides income, such as the ability to save, willingness, facilities, interest rates, income distribution, tax rates, etc.

(b) Mobilization of savings: 

Mobilization of savings is the second stage of capital formation. Capital formation cannot occur if the saved money is not mobilized for investment. For this, banks and financial institutions should be established in various parts of the country. 

These banks and financial institutions, through their network, reach both small savings scattered in villages and savings collected from cities to suitable places or individuals for investment. 

Therefore, the mobilization of savings in an economy depends on various factors such as banking development or the financial system, or people's banking habits, etc.

(c) Investment of savings: 

Investment is the third and final stage of capital formation. The capital formation process is completed only after mobilizing the collected amount and investing it in productive work. Capital formation cannot occur if banks and financial institutions cannot invest the savings created by the people even after collecting or mobilizing them. 

For investment to happen, there must be an investment-friendly environment in the country. If there are plenty of capable and good entrepreneurs in the country, they will demand funds for investment. Since entrepreneurs and businessmen have to bear risks and invest large sums in industries, the government should create a suitable environment for investment. 

A suitable environment for investment requires the provision of peace and security in the country, the determination of appropriate government policies, and the provision of market and other necessary facilities. 

Only if such a suitable environment exists will all savings be invested, leading to maximum capital formation, and the country will move towards economic progress. 

If the country's environment is good, investors will get more profit from their businesses, and they will be motivated to invest further, as a result of which the capital formation process will continue.

Importance of Capital Formation

Capital formation is indispensable for the economic development of any country. Capital plays an important role in making development dynamic, mobilizing natural resources, and creating additional capital from capital investment. 

The main reason for the slow economic development of developing countries like ours is the lack of capital formation. Even if other resources such as labor and natural resources are available in sufficient quantities, production cannot be increased without capital formation. 

Social development works, construction works, and production works cannot be invested in anywhere until capital formation occurs. Social and economic development is not possible without capital formation.

The size of land cannot be increased according to the increase in population in any country. This leads to a decrease in the productivity of labor. This creates obstacles in economic development. To solve this problem, the productivity of labor must be increased. 

This is possible only when capital formation increases. If capital formation increases, investment increases in various places, leading to an increase in the production capacity of workers. 

Capital formation is considered important for increasing per capita income, increasing investment and production, and improving the living standards of the general public.