Capital Formation

Capital Formation >> Microeconomics Assignment

Economic growth depends on several factors. But the two most important factors that determine rate of economic growth are capital accumulation is essential for accelerating rate of economic growth. They need to build roads, factory buildings, machines and tools, tractors, means of irrigation, communication networks and transportation system. To produce more capital goods and build infrastructure, a society has to sacrifice some of its current consumptions. The same is true of making technological progress. Technological changes come from research and development that also required resources. The resources that have to be used for building and making technological advances have to come from the cutting the current production of consumer goods. In fact, the cut in the problem of capital formulation we have to construct such a production possibility curve in which on one axis capital formulation we have to construct such a production measured.

This has been done along the X-axis consumer goods and along the Y-axis capital goods are measured. If the economy is allocating the available resources between capital and consumer goods in such a way that it operates at a point A on the production possibility curve PP, it will be producing OC of consumer goods and OK of capital. Now suppose the society decides to provides more of capital goods. To implement this decision society will have to withdraw some resources from the production of consumer goods will decline. It is clear that if the economy reallocates its resources between consumer and capital goods and shifts from point A to point B on the dependence of production possibility curve PP it will now produce OK2 of capital goods and OC2 of consumer goods has to be reduced.

For poor developing countries where a large part of population is very poor it is difficult to reduce the production of consumer goods such as food and clothing to devote the resources so released for the capital accumulation. Thus the poor developing countries face the dilemma. While progress there is a urgent need to accelerate capital formulation and technological progress they are too poor to release resources by curtailing consumption.

However the evidence of the last half a century shows that with active role of government raising resources through taxes and other means and also getting foreign aid and investment some developing countries have in fact succeeded in accelerating capital formulation and achieving higher rate of economic growth.