Capital formation is one of the important factors in economic development. The vicious circle of poverty in underdeveloped countries can be broken through formation.
Importance of Capital formation –
The countries, which could attain high rates of capital formation, were the countries, which could record high rates of economic development. The capital formation is thus very important.
1. Productivity – Economic growth is possible either by increasing the quantity of inputs i.e. agricultural land or by raising the productivity i.e. production per hectare. Increase in the inputs can grow the GNP but the other increase the per capita income. For the less developed countries (LDC) it is important that they should accept the first alternative i.e. increase in the quantity of inputs because it increases the capital formation.
2. Toil and har
dship – Machines and equipments are the substitutes to land and labour. More often they are invented for the same purpose. More use of machines and equipment needs capital formation.
3. Social overheads – There are man large social projects, which form the precondition for economic development. This type of capital is known as the social overhead capital. It is in the form of roads, railways, irrigation projects, immunization programme, etc. Many of these overheads are useful to the private sector firms.
4. Investment in Human Capital – Expenditure on health, education, training research
and social security is the investment in human capital. But such investment needs a large amount of capital.
5. Development of Science and Technology – Science and technology is always helpful to the economic development. The first steam engine invented is the milestone of economic development. But such scientific and technological inventions and application need lot of capital investment. E.g. satellite communication needs huge capital.
6. Employment – Capital investment generates employment opportunities. Technological progress and capital formation together create more jobs helping large-scale production.
7. Expans
ion of Market –Industrial and economic development were followed by commercial revolution and a revolution in transport. Modernization of transport and commercial and trade practices have led to a widening of the markets. Expansion of market creates a growth in demands and intends increase in production. But this is possible by advanced means of communication, which needs large amount of capital.
8. An Answer to Balance of Payment Problems – Less developed countries are importin
g finished goods and exporting primary products. LDCs always face the deficit in their balance of payments (BOP). The solutions to such problem are either to diversify the industrial structure of the country or import substitution. But both these require capital investment.
9. Coping with Growing Population – Rapidly growing population is the main characteristic of LDCs. That create two problems a) the capital-labour ratio goes on falling. b) Fall in average saving rate, which affects the rate of capital formation. To avoid these downfalls the country requires high rate of capital formation.
10. Self-re
liance – LDCs are more depended on foreign countries. A high rate of capital formation can gradually make the foreign aid and it’s subsequent problems less and makes the country self-reliable by reducing foreign debts.
11. Containing Inflation –LDCs face the price rise problem at the beginning of economic development leading the inflation. Because on the one hand investment level is increased followed by rise in the money income but on the other hand, the supply of goods and services in the market does not increase immediately. The solution to this problem is to raise the rate of saving so that increased income are diverted to capital formatio
n rather than going to the market.
12. Breaking the vicious Circle of Poverty – According to Prof. Nurske, the vicious circle of poverty can be broken through capital formation. Capital formation increases the physical supply of capital goods like machines, tools and equipments, helps a better utilization of available resources, and increases the national output. Such increase is useful to break the vicious circle of poverty.
Reasons for the low rate of Capital Formation
There are three steps in capital formation. They are a) saving b) mobilization (collection) of savings c) investments of these savings. These steps show two sides of capital for
mation i.e. the supply side and the demand side. The reasons of the low rate of capital formation can be discussed in the view of these two sides.
A] Reasons from the supply side
1. Low levels of income – Capital formation takes place out of savings and saving is the function of income. Less income is the characteristic of LDCs. There can be many reasons for low level of income such as population, etc.
2. Low pr
oductivity – Productivity is the source of income for all factors of production. When productivity itself is low it causes low rate of saving and low capital formation. In LDCs low productivity is the result of under utilization of natural resources, labour inefficiencies, limited technological skill, etc.
3. Income inequalities – Rate of savings increases due to income inequalities. But there are two reasons why income inequa
lities in the LDCs do not have the effect. a) Per capita income is less. So the rate of savings could be 3 to 5 per cent. b) The group at the top of the income pyramid consists of landowners and traders who tend to invest in more land, real estate rather than long term industrial investments. This causes the low rate of capital formation.
4. Demographic (population) reasons – The rate of high population is also somehow affects the low capital formation in the LDCs. A country has to spend much amount of entire income on bringing up the growing numbers of people. The high dependency ratio raises the tendency of low rate of savings, which leads to low rate of capital formation.
5. Bu
dgetary policy of the government –Governments in the most LDCs tempt to use deficit budgets as an important source of capital formation, but when deficit financing crosses the safe limits, it becomes inflationary. The high prices due to inflation tend people to spend on their current needs rather than savings.
6. Inadequacies of financial markets – Inadequacies of the money and the capital markets also causes the low rate of capital formation in
B] Reas
ons from the demand side -
1. Lack of enterprise – It is the entrepreneurs who come forward with promises of attractive rates of return on capital which encourage the people to save. But due to social, cultural and economic factors the supply of entrepreneurship is very limited in
2. Undeveloped capital goods industries – A high level of demand for funds to be invested presupposes a well-developed capital goods industry. Such a developed industry has the capacity to propel the demand of machinery and instruments. For this purpose they will borrow the savings collected by the financial institutes. But in LDCS such industry is undeveloped, it can’t propel the demand of capital.
3. Limited market – In LDCs the market is limited due to the limited purchasing power. The capacity of such market is very limited to absorb the additional supplies of commodities. The investors have no incentives to save and to invest more for catering to the
needs of an uncertain and limited market.
4. Factor supply inelasticity – There are many obstacles in the way of mobility of labour such as illiteracy, extended relationship, inability to adopt to new circumstances, etc. Capital and enterprise also lacks mobility. This keeps the factor cost high and disperses away the potential investors.
5. Infra structural gaps – New productive activities have to depend upon the availability of infrastructure and basic amenities like railways, roads, water and the power supply and other facilities. An absence of these facilities can have adverse effect on investors.
6. Econ
omic backwardness – General economic backwardness causes the low rate of capital formation. Low efficiency of labour, low levels of skill formation, prevalence of traditional values all these tend to keep the demand for new capital formation low.
7. Technological backwardness – Technological backwardness acts as a double-edged weapon. On the one hand large traditional sector is using outdated techniques of production, which does not need the modern capital equipment. So the demand remains low. On the other hand these outdated techniques cannot generate high levels of production and causes low rate of income. So the rate of savings remains low.
Vicious
Circle of Poverty
One of the very important reasons for low capital formation is the vicious circle of poverty. Prof. Ragnar Nurrkse says, “It implies a circular constellation (group) of forces tending to act and react upon one another in such a way as to keep a poor country in the state of poverty.” E.g. A poor man may not have enough to eat, being unified, his health may be week. Physical weakness results in low working capacity, which means that he is poor, nor have enough to eat. In other words ‘a country is poor because it is poor.’
The basis of vicious circle is that in LDCs total productivity is low due to deficiency of capital, imperfect market, economic backwardness and under develop
ment. The vicious circle operates both on the demand side and on the supply side.
On demand side: The low level of demand leads to low rate of investment and results in low investment. Hence back to deficiency of capital, low productivity and low income.
On supply side: Low productivity is reflected in low real income. This means there is a low savings lead to low investment and deficiency of capital. This in turn leads to low level of productivity and low income.
The third vicious circle is underdeveloped human and natural resources. Development of natural resources depends
on the productive capacity of the people in the country. If people are backward, illiterate, having lack of technical skill and knowledge, then the natural resources remain unutilized or misutilized which keeps again the people backward.
Thus a country is poor because it is underdeveloped. Because the country is underdeveloped are poor and remains underdeveloped, as it does not have necessary resources for promoting development.
Population Constraint
Theory of Demographic Transition
Population in a country is responsible for providing human resource. The various types of skilled, unskilled, supervisors, managers, etc. are all provided from the population of a country. These are Human resources which are required by every businesses and firms. The population also provides the consumers for various goods and services. It is important to study the composition of population which includes the age structure and population, educational background of the population, income level of the population, etc.
One important theory in the study of population is the theory of Demographic Transition. It tries to explain the relationship between the death rate, birth rate. It tries to explain the effect the economic growth on death rate and birth rate.
The rate of population in a country is influenced by death and birth rate. If both these rates are equal, there would be no population growth. But the birth rate is more than the death rate which leads to increase in population. This effect is explained through this theory.
According to this theory there are three stages related to death rate and birth rate.
First Stage - In the first stage, the population of a country is more or less stable. In this stage both death and birth rates are at a high level. This stage indicates economic backwardness having much low income level. Most of the people are engaged in the primary sector such as agricultural activities. In this stage there is inadequacy of health facilities and lack of education. Due to this the death rate is high at the same time the birth rate is also high because of ignorance and other social factor.
Second Stage – In the second stage there is an improvement in the public health and other facilities. The number of dispensaries and hospitals are more and there is an improvement in the standard of living. Due to this there is a sharp fall in the death rate. However the attitude and social factors of the people donot change to a great extent. So the birth rate continues to be at a high level. As the time goes by the gap between the birth and death rate keep on increasing ultimately leading to population explosion.
Third Stage – In the third stage the birth rate also reduces and matches the low death rate. This is the stage of economic development and industrialization and urbanization. In this stage the spread of education leads to a change in the attitude of the people and this helps to decrease the birth rate. Both death and birth rates are at low level and the rate of growth of population reaches at a zero level. So this stage is known as ‘Zero Population Growth Stage’ which indicates an advanced, mature and developed economy.
In recent times here are a few countries which have gone beyond this point where the birth rate is much low than the death rate leading to negative population growth. E.g.
Reasons for fall in death rate
The death rate in
1. Medical facilities – Medical facilities have recorded considerable progress durig the post-independence period. Epidemics like malaria, small-pox, plague, cholera, etc have either been eradicated or controlled to a great extent. Deceases like tuberculosis and leprosy which were observed as a curse, are under control with the modern drugs. In 1997-98 there were 22400 primary health centers and community health centers and rural hospital were 2600 and 15100 respectively. Medical facilities available for the pregnant women and at the time of labour have made the infant mortality rate low.
2. The Spread of Education – The educatin facilities have spread to a great extent. Schools, libraries have been opened in the rural areas. Due to education, people have become more aware of the importance of clean drinking water, sanitation, etc. Medical advice and aid have replaced superstitions and witchcraft. As a result, the death rate has declined.
3. Improvement in the means of transportation – Improved and fast means of transport has made the quick medical facility for the serious and dying patients. Developed roads have brought the cities close to each other so that the doctors and other medical facilities could be made available in time. At the same time aviation has also been improved which has proved its usefulness in saving the people in natural calamities.
4. Control of famine – Famine was one of the reasons for the mass mortality in the history of
Reasons for high birth rate
Various cause lead the decline in death rates at the same time it is observed that th birth rate is showing a surprising inflation. In 1997, the birth rate per thousand of
Poverty – Comparing to other developed nations
Early marriages – The census of 1991 shows the average age of a man and a woman at the time of marriage 22.2 and 18.3 years. But in the developed countries i.e.
Universality of Marriage – According to Indian customs and traditions it is not fare that one should be bachelor or spinster for whole life. One more thing is that unmarried person is the subject for gossip and teased. So parents are in a hurry to get their son or daughter married.
Illiteracy and ignorance – There is a close relation between education and Planned Parenthood. More is the education less is the number of children. But in
Socio-religious factors – Indian society if full of beliefs and rituals. To peform some sacred rituals a person must be married and that too have children. Otherwise he is banned by the community and kept away from such religious practices. Particularly women are expelled out of the community if she is childless. One can not claim ‘moksha’ if he remains childless. They believe that such man’s forefather also would not be benefited in the heavens. More are the children, more blessed is the father and mother. Such outraged society tends to produce more children.
Effects of growing population on Indian Economy
Growing population affects the development of economy by following ways.
1. Per Capita Income – A rapidly growing population tends to bring down growth of income. Such rapid growth puts a pressure on land and tends a decline in capital accumulation and raises cost of production. All these results in a very slow growth of per capita income.
2. Standard of living - Per capita income is a major determinant of the standard of living of the people. Naturally, the factors affecting per capita income also affect the standard of living. Growing numbers of people need increasingly larger quantities of necessaries of life.
3. Agriculture development – Agriculture being the source of livelihood for majority of Indian population, the growth of population increases the absolute number of people depending on agriculture. The growing population disturbs the land-man ratio because the land is limited. That results in smaller size of holdings. Such small farms cannot produce large quantity of crops to fulfill the need of the nation.
4. Burden of unproductive consumers – Two third of the population of
5. Unemployment – Growing population increased the unemployment and underemployment. The unemployment in
6. Pressure on social infra-structure – A rapidly growing population puts a pressure on social overheads. Moreover an increasing investment in social overheads constitutes a diversion of scarce resources from directly productive assets to less and long run productive human assets.
7. Capital formation – A growing population created the obstacles in capital formation. It raises the propensity to consume and reduces the tendency to save. It also increases the demand for capital because the consumption goods in larger quantities would require more capital. It also causes the diversion of funds to social overheads. So the capital formation is less.
8. Reduction of resources – Growing population creates imbalances between nature and man. Growing human needs are to be fulfilled by using more and more of the natural resources. This creates a threat of collapse of many mineral and other rare resources.
9. Damage of environment – Adverse land-man ratio caused by overcrowding of men pushes men to ecologically sensitive areas like hillsides and tropical forests. They domicile over there and cause the damage of environment.
10. International economic relations – The rapidly growing population leads the country towards the poor country. Emigration and brain drain go against
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