Saturday, 3 October 2015

Capital formation - One of the four basic economic activities

The four basic economic activities of any economy are interlinked and each activity leads to the other next activity.

  • Production of goods and services leads to and results in distribution of the goods so produced to their consumption points..
  • Distribution of goods to all corners of economy results in consumption of those goods and services in an effective way.
  • Consumption can be refrained at some point of satiety and then, the extra consumption capacity can be got diverted into investment for future stocks and capital formation.

So, you are able to see how one activity leads to the other activity.and how they can be interlinked.

Now, coming to capital formation, It can be defined as creation of capital- either working capital or fixed capital- by way of purchasing new stocks or plant and machinery or through increasing the present levels of capital. It can be treated as new investments in business or the yearly increases in present stocks or working capital.

The creation of capital or capital formation refers to the net worth of assets after meeting out liabilities. It is the balance value of additions to capital by way of deducting all liabilities from assets.

Decrease in the expenses and in present consumption leads to excess of income and excess of stocks of produced goods and services. So, whenever there is more production and lesser consumption, it leads to capital formation. So, the restraint from present consumption and generation of savings are the major sources of capital formation. The overall production is either consumed or used for creating capital.

Understanding capital formation process

  • Whenever you refrain from present consumption and save your money, it gets deposited into banks generally.
  • The banks in turn lend that money to producers or invests the money in shares and equity funds. 
  • This investment again is used by the producers and businessmen to purchase machinery and equipments and in starting new ventures or to increase the present production levels. Increased production is possible because of this extra income or savings utilised positively by producers. 
  • This will again boost the economy and can increase both income of workers and also the consumption levels. 
  • Increased consumption is a sign of elevated standard of living and symbolises a developed economy.

Increased consumption should not mean that whatever you are producing is consumed entirely. When the production of goods and services are much more than requirements, and since you are having more money to spend in developed economies, it is possible that you can consume more things at relatively affordable prices and still save sufficient money. So these savings again create capital formation.

Capital formation takes place when these savings are deposited into banks and used for investments in shares or for financing the producers. If the savings are kept idle at home, then no capital formation can occur. So it is important that idle funds are utilised for producing more goods and services to be considered as contributing to capital formation process.