Capital Formation – Definition

Cite this article as:"Capital Formation – Definition," in The Business Professor, updated March 7, 2019, last accessed October 20, 2020,


Capital Formation Definition

Capital formation is the growth in the stock of actual capital in the economy over a particular financial period. In other terms, it means the creation of things that enhance more production. This term is mostly used in the study of macroeconomics. It shares similar meaning with the term capital accumulation.

Financial capital, capital goods and human capital all combined lead to Capital formation.

The build-up of human capital, financial capital and capital goods all refer to the accumulation of capital. This concept was used by one Economist by the name Adam Smith in his book The Wealth of Nations where he tried to explain why some nations were financially stable than other countries.

A Little More on What is Capital Formation

Capital formation can be explained using the following two perspectives:

  • •           Liberal economists: They believe that capital formation is the heart of economic prosperity. Savings and investment are the most important elements in the development of nations. When the capital formation is at its peak, it will assist societies to advance economically. These economists do not encourage the concentration of capital.
  • •           Anti-capitalist economists: They believe that wealth accumulation leads to economic imbalance and suffering to the people and have a strong belief in the investment of capital to benefit all the people. These people advocate for the concentration of capital.

Many authors and economists have collected information that is included between these two radicals with different views. These distinctions make it somehow strange.

Adam Smith was one of the economists that referred to this concept in his attempt to explain why some countries were richer than the others. This was captured in his book The Wealth of Nations. According to him, the accumulation of capital led to this economic disparity. Nations would grow richer in the long run if they saved and invested.

The availability of human capital, financial capital and capital goods would lead into this since they will be able to produce more. Karl Marx departed from this concept where he argued that capital accumulation led to the exploitation of workers and economic imbalance. Marx believes that it is primitive to accumulate capital because it does not link direct producers with the means of production. He believes that the accumulation of capital is accompanied by:

  • •           The bankruptcy of the peasants: Because they don’t own the farms.
  • •           The concentration of wealth: Only a few people have wealth.

References for Capital Formation

Academic Research on Capital Formation

  • How responsive is business capital formation to its user cost? An exploration with micro data, Chirinko, R. S., Fazzari, S. M., & Meyer, A. P. (1999). Journal of public economics, 74(1), 53-80. Capital formation is key in the evaluation of tax reforms, monetary policy and deficit reduction. This paper presents few evidence on the user cost elasticity since a lot of evidence has been placed on aggregate data. However, some latest research indicates some little effects on cost elasticity. With over 26,000 observations obtained from a micro dataset, this paper dwells more on the user cost elasticity. The author states that, despite some results depending on some extent on the econometric techniques and specification, some diagnostics lead the author to prefer a precisely estimated elasticity.
  • Capital formation and economic growth in China, Chow, G. C. (1993). The Quarterly Journal of Economics, 108(3), 809-842. This article measures how the capital formation in China has contributed to the growth of China’s major sectors namely agriculture, commerce, transportation, industry, and construction. It also measures the effects of the Great Leap Forward, the Cultural Revolution on inputs, the economic changes on growth, the returns on capital and the impacts of growth in different sectors on relative prices.
  • Hedge funds: Performance, risk, and capital formation, Fung, W., Hsieh, D. A., Naik, N. Y., & Ramadorai, T. (2008). The Journal of Finance, 63(4), 1777-1803. This article discusses risk, performance and hedge funds on capital formation. The author suggests that the alpha-producing funds are unlikely to liquidate and lead into more steady capital inflows as opposed to those funds that don’t deliver alpha. These inflows of capital limit alpha producers so that they cannot deliver alpha in the long run.
  • Tax policy and human capital formation, Heckman, J. J., Lochner, L., & Taber, C. (1998). (No. w6462). This article highlights to us the relationship between tax policy and human capital formation. The author tries to estimate and formulate the general equilibrium models with heterogeneous and endogenous human capital accumulation. The model also tries to explain many features of wage inequality in the US economy.
  • Deficit financing, inflation, and capital formation: an analysis of the Nigerian experience, 1957-1970, Oyejide, T. A. (1972). The Nigerian Journal of Economic and Social Studies, 14(1), 27-43. This paper explains the variance in price levels in Nigeria that occurred between the year 1957-1970. It found out that there exists a positive relationship between capital formation, price level, and deficit financing.
  • The capital formation problem in the United States, Malkiel, B. G. (1979). The Journal of Finance, 34(2), 291-306. This article focuses on the problems of capital formation in the United States.
  • Capital mobility, fiscal policy, and growth under self-financing of human capital formation, Buiter, W. H., & Kletzer, K. M. (1995). (No. w5120). The article establishes the impacts of both financial and fiscal policies on economic growth in closed and open economies in situations where households are constrained by a lack of liquidity of human capital. The author finds out that some policies that hinder physical capital formation are likely to enhance the formation of human capital.
  • Inducing human capital formation: migration as a substitute for subsidies, Stark, O., & Wang, Y. (2002). Journal of Public Economics, 86(1), 29-46. Individuals do not invest much in human capital in situations where productivity is led by an individual’s own capital. It needs to be supplemented by subsidies for the formation of a meaningful human capital. This will make the economy to be socially optimum.
  • International differences in capital formation and financing, Kuznets, S. (1955). Capital formation and economic growth (pp. 19-111). Princeton University Press. This article summarizes the differences that exist between capital formation and financing.
  • Public capital formation and the growth of regional manufacturing industries, Hulten, C. R., & Schwab, R. M. (1991). National Tax Journal, 121-134. The author is concerned with the growth of manufacturing industries and capital formation.
  • Human capital formation, life expectancy, and the process of development, Cervellati, M., & Sunde, U. (2005). American Economic Review, 95(5), 1653-1672. The article is concerned with capital formation in relation to life expectancy and the process of development from environments that are not developed to a level that they can achieve sustained development. It also studies how education contributes to the skills of individuals to achieve optimal returns in relation to the cost of that education. Education is also very key to the development of individuals to maximize capital formation.

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