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CAPITAL FORMATION
AND
ECONOMIC DEVELOPMENT
DEVELOPMENT ECONOMICS
(GS F234)
ABSTRACT
This report examines the relationship between capital formation and economic development. We
explored various econometrics and statistical analytical methods to examine the relationship
between capital good, consumer good, capital formation, and economic development.
The report begins with describing capital and the various means through which capital formation
takes place. Then, we proceed towards finding the relationship between this formed capital and
the development of the economy, both directly as an after-effect and indirectly via the offshoots
of capital formation. In addition to this, the report shows the importance of savings in capital
formation and how current consumption is affected by this. The capital formation also directly
results in employment growth on the demand side and improvement in productivity. Efficiency
in the market increases due to increased competition, which is due to increased capital formation.
INTRODUCTION
There is a mutual relationship between economic development and capital formation. Economic
development accelerates the process of capital formation. It is not possible to achieve the various
objectives of economic development, such as financial stability, reduction in unemployment, and
increased standard of living without capital formation. Capital formation is, hence, an essential
determinant of economic development. However, it is an oversimplification of the concept as
economic development also involves various other factors such as the political, social, cultural,
and entrepreneurial factors.
Capital formation, in a broader sense, includes human resources or non-physical capital such as
public health, visible and invisible capital, etc. The essence of capital formation is about
maintaining and increasing the stock of real capital, which would help in raising the production
level of goods and services. The available resources in society have to be distributed between the
production of consumer goods and capital goods. So, if a higher amount of resources are
invested in the production of capital goods, then the lesser quantity of resources will be left for
the production of consumer goods. Therefore, capital formation involves a sacrifice of present
consumption for higher accumulation and a greater rate of economic growth.
Capital formation accelerates the pace of development with fuller utilization of available
resources. It leads to an increase in national employment, output, and income, which in turn
reduces inflation and balance of payment.
It is not possible to have economic development without making and using tools, machinery,
transportation, etc. which are all capital. Accumulation of capital goods increases the national
income or product. If the population keeps on growing, then the working population won’t have
the necessary tools, machines, and other factors of production, and the capacity to produce would
be adversely affected. Moreover, the higher the quantity of capital per worker, the greater the
productivity of the worker. It increases output and also reduces the cost of production per worker.
Another thing to consider is that it makes large-scale production, specialization, and technical
progress possible.
if saving is not done. If all of the current productive activity is used to produce consumer goods
and no new capital goods are made, the production of consumer goods in the future will
significantly decline. However, savings may not directly result in the production of capital
goods. It must be invested so that we can have capital goods.
The process of capital formation bounds the following three interrelated stages:
1. Encouragement to increase the volume of real savings in the economy, i.e., creation of
savings
2. Mobilization of savings using financial institutions
3. Investment of savings
1. Creation of Savings
The first stage of capital formation is saving. Parsimony forms the basis of capital
accumulation. For Parsimony, we should save more and spend less on consumption.
Households, firms, and government institutions should set aside a part of their current
income or the available resources for future expenditures, or to allocate them for future
investment in capital goods like buildings, capital equipment, new businesses, machines,
roads, schools, hospitals, etc. Sacrificing present wants and enjoyments for the sake of future
results in the creation of more capital. For a country, its level of savings depends on its will
and power to save. The amount of real savings should be increased so that resources that
would have been spent on the production of consumption goods should be set free for
purposes of capital formation. The average level of income and distribution of income
determines the level of savings. Usually, saving is directly proportional to the average level
of income. Implying countries in Western Europe and North America have a higher rate of
saving due to high-income levels as compared to developing and underdeveloped countries.
Savings can be classified as voluntary or forced, depending upon the will to save. Voluntary
savings depend upon the power and will of the people to save. Forced savings are represented
in the form of tax collected by the government. Big ventures and enterprises save by
retaining a part of their profits in the form of undistributed profits. It would be used as an
investment in real capital. Governments save by constituting money collected as taxes and
Graphical relationship between Capital goods and Growth rate
immediately at the first and next formative years. While the medium and long-run dynamics
of capital formation on employment growth are more related to indirect effects. There have
been many scholars who have formatively examined the impact of capital formation on
employment growth. They found that small and particularly new businesses are the primary
employment generation in a country. Their studies initiated many studies concerning the
impact of new business formation on the growth of employment. Subsequent researches have
also found a positive direct effect of new firm formation on regional and local employment
growth.
There are also many forms of indirect effects of new business formation on employment
generation that may have effects on employment, both positive and negative. Setting up a
new business means jobs in a lot of other sectors too- logistics, transportation, resources,
construction, IT, and so on. Hence, there is a lot of positive impact and increased
employment opportunities.
2. Improvement in Productivity
Capital formation via new business formation boosts the economic productivity of an
economy by intensifying competition between the new and existing enterprises. Renewed
competition among these firms leads to the survival of the most productive ones. Even
though overall employment will decline in the long run, new businesses can foster
productivity and provide better services with enhanced efficiency. This effect of the business
formation may not occur immediately and may not be noticeable in the short run, but it will
take place in the medium run. Economic productivity increases due to two different factors.
First, new enterprises intensify competition in the overall market and hence reduce the
market power and monopoly of existing firms and induce them to enhance their
productivities or be forced to leave the market. Secondly, in the future, only those firms that
have a high degree of competitive advantage will enter the market and successfully continue
with their operations, lifting the overall standards of the products.
As mentioned above, new business formation in total has a positive effect on productivity.
Still, this effect can sometimes have an adverse impact in the initial years, probably because
of adjustments to strategies and routines in response to the new entrants in the market. In
general, a positive relationship is quite strong for firms with high-growth ambitions and an
innovative one, and this effect is considerably weaker for firms with low-growth ambitions
who downgrade productivity. The productivity effect describes that competition generally
increases the effective use of the various factors of production and natural resources in an
economy that intensifies economic development.
Indirect Effects Of Capital Formation
Capital formation through new business formation imposes further impacts on economic
development. These rather indirect effects stem from intensified competition between new
entrants and existing firms about the supply-side of the market. Indirect effects of capital
formation could be classified into the following supply-side effects as listed below:
1. Effect through Securing Efficiency
Securing efficiency in an economy can be safeguarded by establishing a market position in
the competitive market. Thus, not only the actual entry, likewise, the very possibility of a
potential entry motivates the existing firms to operate more efficiently. Capital formation via
establishing new business formation induces the existing firms to secure their efficiency and
say in the market. The newly created firms will inevitably put efforts to increase their market
share in the domestic market. Their objectives can only be achieved through the shrinking of
the market position of the existing firms in the economy. Hence as a result of new business
formation, the market power of existing firms will dwindle, and this foreshadowing forces
them to produce more efficiently or leave the market. In such circumstances, only the firms
who produce more effectively than the competitors can grow and prosper, while inefficient
producers are forced to exit the market.
2. Effect through Structural Changes
In principle, new business formation plays a crucial role in structural changes across sectors
and within the manufacturing industry as well as in the relationship of employment growth.
The income level of manufacturing corporations usually accomplishes industrial structural
changes. For example, as the establishment of new manufacturing enterprises increased in the
market and joined the existing firms, the new firms challenge existing firms and enforce
incumbents to improve and evolve their products and production technologies constantly,
thereby driving innovation. The firms that do not have enough financial and knowledge or
aren’t willing to invest resources are not able to undergo necessary internal improvements;
thus, they must leave the market, and the new entrants substitute their place. This process has
been named creative destruction by J.A. Schumpeter.
On the side of the spectrum, the creative and innovative firms that are well-motivated,
equipped with adequate financial and knowledge capital, continue to survive and govern
economic growth by restructuring their products and production technologies. Impacts of
capital formation through new firm formation on structural changes in any economy are
controllable by the conditions on the demand and supply sides.
3. Effect through Amplifying innovation
New business formation theoretically correlates with innovations, especially if the new
business formation has connections to new market creation or new production methods.
There are ample empirical studies concerned with essential changes that have been
introduced by new firms. New enterprises can play a significant role in driving structural
improvement and innovation by exploring new markets in which new firms can produce a
diverse range of goods and services through the innovative entrance.
Furthermore, a new firm can be formed based on exploitation and exploration principles. As
Andrew Schmitz has referred, new firm formation based on exploitation strategy relies on
imitation of an existing business idea, while new firm formation on exploration strategy is
always trying to innovate and find more modern, better ideas. However, it would be better to
use resources into both imitation and direct creation of new knowledge methods. In fact, by
implementing this method, individuals will obtain private benefits via the accumulation of
new knowledge. Hence, Capital formation through new business formation amplifies
innovations by inducing incumbents to explore new markets or new production methods.
4. Effect through Product Diversification
Capital formation dramatically elevates consumer satisfaction and protects the markets
against economic shocks. If the new entry firms introduce new products, or new methods of
production, that are different from the existing firms in the markets. Thus, newcomers
improve economic diversity and result in tremendous accessibility and problem-solving
techniques. Economic diversity increases the probability of growing new suppliers, those
supply goods & services that fit better with the consumers’ needs and preferences. Improved
variety due to finding new suppliers may support and intensify division of labor as well as
promote more innovation in different other sectors of the economy. Hence, new firm
formation creates substantial ripples for economic development. Alternatively, the latest
business formation also can be driven through industrial development.
5. Effects through Industry Development
As per the knowledge spillover theory of entrepreneurship, entrepreneurs increase their
investment based on the knowledge that is created by the existing firms in the economy. For
instance, assume that as a result of the Research & Development activities of existing firms,
new knowledge is created, and the incumbents prevent the commercialization of this newly
created knowledge. In such a circumstance, the entrepreneurs will find avenues to extend
their investment in the encouragement of new firms based on the existing knowledge by
completing the construction of new enterprises based on current knowledge. Then again,
knowledge and routines are spillovers to other sectors of the economy, which causes the
formation of increasingly new businesses in the economy. There are two essential enactments
of this theory. First, in economies with a high expanse of knowledge production, the rate of
new firm development must be steady. Second, new firm formation disseminates information
and indirectly contributes to products’ diversifications in the economy.
The effects stated above are rather indirect and bring about supply-side enhancements.
Therefore, these effects are not only associated with the industry in which the new firms are
created, but also, these effects may be experienced in downstream industries that use the
upgraded supply as an input in their production processes. Moreover, these effects will not
remain limited to the domain in which new business is developed; they also can have
intersections with other fields. Indirect supply-side effects are regarded as the main drivers of
competitiveness enhancement of the industries that may stimulate employment growth and
increase social satisfaction. The supply-side effects are the reasons why we should expect
positive employment effects of capital formation.
CONCLUSION
There exists a direct shared relationship between economic development and capital
accumulation or formation. Without capital formation, it is impossible to achieve the aims of
economic development, such as bridging unemployment, establishing economic stability, and
improving the standard of living for all residents, and so on. On the other hand, economic
development fast-tracks the process of capital formation.
Capital formation is the process of provoking entrepreneurial activities to mobilize the scattered
resources, which require legalizing dormant capacities and knowledge to employ the economic
resources capably, and this process boosts economic development both directly and indirectly.
The study of economic growth is an essential subject of economic development and can be done
both from theory and empirical perspectives, arriving at the same conclusions.
To sum up the relationship between capital formation and economic development, capital
formation is not only a consequence of the investment in capital equipment that leads to growth
in production. Indeed, capital formation provides employment opportunities, improves
technological growth, which in turn supports the economies to realize economies of scale in the
manufacture, and intensifies specialization. Furthermore, capital formation provides
mechanisms, tools, and equipment for human capital development and strengthening. Finally,
capital formation enhances the market and eliminates market imperfections, thereby increasing
consumer satisfaction and social welfare.
BIBLIOGRAPHY
● Capital, Marshall Hargrave
● Capital Formation: Meaning, Process and Other Details, Tushar Seth
● Role of Capital Formation in a Country’s Economic Growth, Supriya Guru
● Capital Formation in an Economy and its Significance, Sanket Suman
● IZA DP No. 6328, Oded Galor, Inequality, Human Capital Formation and the Process of
Development
● Role of Savings, Investments and Formation of Capital in Economic Development - A
Case Study by Radhe Shyam and Maheshwar Yadav
● International Journal of Science, Technology and Research, ISSN: 2319-7063 Dr. Sultan
Taraki, Dr. Mesut Arslan