Basic Economic Activities: Capital Formation

Capital Formation is one of the basic economic activities that determine a country's economic development. The other three factors are Production, Distribution, and Consumption, which eventually lead to the capital formation stage.

  

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

• The production of goods and services leads to the distribution of goods that are ultimately either consumed or stocked.
• Distribution of goods to all corners of the economy results in the streamlined consumption of those goods and services.
• Consumption can be controlled at a certain state of satiety, and the excess portion can be diverted into investment for future stocks and capital formation.

So, each economic activity leads to the next stage, and thereby they are interlinked with one another.

Capital Formation

Now, coming to capital formation, there are two types of capital: either working capital or fixed capital.

Working capital is used for running the business. It includes stores and stocks, semi-finished goods, cash and bank balances, etc.

Fixed capital is the foundation of a business. It consists of land, buildings, plant and machinery, etc.

Note:

The creation of capital, or capital formation, refers to the net worth of assets. It is the net value of capital, calculated by deducting all liabilities from assets.

Capital Formation Process

A decrease in expenses and present consumption leads to excess income and excess stocks of produced goods and services. 

Whenever there is more production and less consumption, it leads to capital formation. 

Therefore, restraint on present consumption and the generation of savings are the major sources of capital formation. Overall, production is either consumed or used to create capital.

Consumption plays an important role in capital formation.

• Whenever you refrain from present consumption and save your money, it is generally deposited in banks.
• The banks, in turn, lend that money to producers or invest it in shares and equity funds.
• This investment is again used by producers and businesspeople to purchase machinery and equipment and to start new ventures or increase current production levels. Increased production is possible because of this extra income or savings, which producers use positively.
• This will again boost the economy and can increase both workers' income and consumption levels.
• Increased consumption is a sign of an elevated standard of living and symbolizes a developed economy.

Increased consumption does not always imply that whatever you are producing is consumed entirely.

When the production of goods and services greatly exceeds initial requirements, and since you have more money to spend in developed economies, it is possible to consume more goods at relatively affordable prices and still save sufficient money. 

These savings, in turn, create capital formation.

Capital formation occurs when these savings are deposited in banks and used to invest in shares or to finance producers. 

If the savings are kept idle at home, no capital formation can occur. 

Therefore, idle funds must be used to produce more goods and services, which is considered part of the capital formation process.