LESSON 7

7.1       Capital accumulation/ capital formation

Capital accumulation refers to the process of increasing a country’s stock of real capital intended for the production of more goods and services (over a given period of time).

Or refers to the net investment in fixed assets intended for the production of more goods and services.

Capital accumulation is necessary because it increases resource utilization, the standard of living and it is a basis of economic development.

7.2       Factors determining/influencing capital accumulation

• Level of income of individuals /in the economy. High income levels lead to increase in savings and hence high level of capital accumulation. However low-income levels lead to low savings and thus low level of capital accumulation.
• The level/stock of existing capital stock. Adequate existing capital stock leads to more investment and hence higher capital accumulation. However limited existing capital stock leads to low level of investment, hence low level of capital formation.
• The rate of interest on loans. High rate of interest on loans discourages borrowing for investment leading to low level of capital accumulation. However low interest rate on loans encourages borrowing for investment leading to high level of capital accumulation.
• Demonstration effect in consumption. High demonstration effect-with many people consuming commodities because others are consuming them results into reduced savings and hence low level of capital accumulation. However low demonstration effect encourages savings and hence promotes capital accumulation.
• Rate /level of capital inflow and outflow. High capital inflow and low capital outflow in form of investments, profits, donations result into high level of capital accumulation. However low capital inflow and high capital outflow leads to reduced investment and hence low level of capital accumulation.
• Level of development of infrastructure. Developed infrastructure such as banking facilities, roads encourage savings and investment leading to high level of capital accumulation. However, under developed infrastructure such as poor roads lead to low savings and investment leading to low level of capital accumulation.
• The population growth rate. High population growth rate increases the dependence burden leading to low savings and hence low level of capital accumulation. However low population growth rate reduces the dependence burden leading to high savings and hence high level of capital accumulation.
• Rate of inflation in the country/ level of prices for goods and services. High rate of inflation discourages people from saving and commercial banks from lending due to fear of money losing value and hence low level of capital accumulation. However low rate of inflation encourages savings and borrowing leading to high level of capital accumulation.
• Level of entrepreneurship in the country. Presence of more people who invest in various activities leads to increased production, savings and hence high level of capital accumulation. However low level of entrepreneurship reduces production, savings and hence low level of capital accumulation.
• The size of the market for goods and services. Large market size encourages production which leads to more savings and hence high level of capital accumulation. However small market size discourages production leading to reduced savings and low level of capital accumulation.
• The investment climate/ government policy in relation to resource allocation. Favourable investment climate such as with low taxes, tax holidays, and subsidization of firms encourages production and hence high level of capital accumulation. However, a poor investment climate with high taxes on investors, absence of subsidization discourages production leading to low level of capital accumulation.
• Level of technology in the country. Efficient technology leads to increased production of goods and services, more savings and hence high level of capital accumulation. However inefficient technology limits production, savings and hence low level of capital accumulation.
• The political climate. Political stability encourages investment and savings in the country leading to high level of capital accumulation. However political instability discourages investment and savings leading to low level of capital accumulation.
• Degree of accountability/ level of corruption in the financial sector. Existence of corruption limits the level of investment especially in the public sector leading to low level of capital accumulation. However, absence of corruption promotes investment and hence leading to low level of capital accumulation.
• Level of conservatism/ cultural factors. High level of conservatism / strong cultural beliefs such as preferring of extended family system, low desire for work in preference of social functions (like weddings, drinking etc) leads to low production, low savings and hence low level of capital accumulation. However low conservatism / people preferring small families, low desire for social functions promotes production, savings and hence high level of capital accumulation.
• Time preference of an individual. Time preference refers to the choice an individual makes between saving and consumption currently or in the future. Consuming less and saving more currently promotes investment leading to high level of capital accumulation. However, consuming more and saving less currently limits investment leading to low level of capital accumulation.

Note:

• Capital appreciation—refers to the increase in value of assets or capital goods over time.
• Depreciation—refers to the wear and tear of capital goods during the process of production. Or it is the loss in value of capital goods due to wear and tear during the production process.
• Depreciation allowance/capital consumption allowance—refers to the amount of money set aside to maintain the capital goods and take care of wear and tear.

7.3       Sources of capital

• Both private and public savings are increased so as to widen the base of capital accumulation. (Savings is that part of the disposable income that is not consumed in the current period but put aside for future use).
• Profits/ retained earnings and other forms of proceeds from business ventures form a major source of capital. Profits are used to expand business by re-investment/ ploughing back.
• Floating government securities such as bonds, treasury bills. The government sells securities to the public to raise capital.
• National rotary run by the state is also intended to mobilize capital on voluntary basis through sell of raffles.
• Selling of shares. Firm sell shares to the public and in this way the public contributes capital in order to earn dividends.
• Government facilitates the process of capital formation by widening the tax base thereby increasing tax revenue.
• Attraction of foreign aid. Foreign aid/ grants from bodies (like IMF, IDA) and friendly countries form another source of capital for the recipient country.
• Loan advances. Loans are obtained from financial institutions in order to build up investment capital. However, loans usually require collateral security.
• Trade credits. This involves a business unit obtaining goods from another firm without making immediate payment and payments are made after selling the credit.
• Compulsory savings scheme. This includes motor insurance payments, social security fund and this also forms a source of capital formation.
• Fund raising campaigns. When successfully conducted act as a source of capital.
• Commercial bank system of multi-credit creation.

7.5       Factors determining the MEC /marginal productivity of capital

• The quality and efficiency of co-operant factors of production (such as labour). Efficient co-operant factors of production lead to high MEC since the capital is better utilized while inefficient co-operant factors of production lead to low MEC.
• Government policy on investment/Level of taxation by government. High taxes on investment projects lead to low MEC while low taxes charged on investment projects lead to high MEC.
• Rate of interest charged on capital. High interest rate on capital leads to low MEC while low interest rate leads to high MEC.
• Size of market for commodities/ level of demand for commodities. A large market size encourages productivity of capital while limited market leads to low productivity of capital.
• Level of expected output. Expectation of high output from capital invested leads to high MEC while low output expected leads to low MEC.
• Rate of depreciation of capital goods. High rate of depreciation leads to low productivity of capital since high costs are incurred to replace /repair it while low rate of depreciation leads to high productivity of capital.
• Price level of commodities. High price level of output leads to high MEC while low price level of output leads to low MEC.

Level of excess capacity. Presence of high excess capacity leads to high MEC since more resources are available to be utilized while limited excess capacity leads to low MEC.