The following points highlight the fourteen main reasons for low rate of capital formation in an economy.
Reason # 1. Low Level of National Income and Per Capita Income:
The root cause of capital deficiency in under-developed countries is low level of real national and per capita income which limits to the motives of savings and investments.
Due to lack of desired investments, capital formation has no increase. Hence, due to low production, there is low national and per capita income and, in turn, this forces to low capital formation.
This situation tends to perpetuate itself and the poor countries continue to be poor. The low rate of capital formation is a partial link in a vicious circle in such countries. Unless, the vicious circle of poverty is broken, the rate of capital formation cannot be raised.
Reason # 2. Lack in Demand of Capital:
Another cause of low rate of capital formation in under-developed countries in lack of demand of capital. In the words of Prof. Nurkse, “Low productivity in under-developed countries, people have low real income and, thus, purchasing power is low and so due to low demand, investment has effect which again reduces national income and productivity and rate of capital formation remains low”.
Reason # 3. Lack in Supply of Capital:
Like demand of capital, lack of supply of capital is responsible for low capital formation. However, due to lack of necessary supply of capital in under-developed countries, the process of capital formation is not boosted up. As a result, capital formation remains at low level. Therefore, in the opinion of Prof. Nurkse, Due to low rate of real income per capita in under-developed countries, there is low saving capability, hence, there is less capital. Due to lack of capital, there cannot be established basic business and industries so the production falls down.
Reason # 4. Small Size of Market:
Due to small size of domestic market, investment is not encouraged in poor countries. It does not expand the work of economic development and modern machines cannot be used as extra quantity produced has no market access.
Reason # 5. Lack of Economic and Social Overheads:
Basic overheads like roads, buildings, communication, education, water, health etc. are generally lacked in under-developed countries which react as improper atmosphere for the capital formation and slow process of capital formation.
Reason # 6. Lack of Skilled Entrepreneurs:
Able and efficient entrepreneurs are not available in under-developed countries. It is the only reason for low rate of capital formation. Due to absence of risk-taking entrepreneurs, establishment of industries and expansion is quite limited and industrial diversification is not carried out and no balanced development of economy is possible.
Reason # 7. Immobility of Savings:
Immobility of saving also causes low rate of capital formation. Due to lack of banking and other credit institutions, poor countries have limited financial activities. Whatever, these financial institutions exist, they are of small size and unable to collect the savings from distant places, thus, resulting in no enthusiasm to savings in a society. This creates the problem of hoarding and saving is used for non-productive purposes.
Reason # 8. Backwardness of Technology:
Under-developed countries also face the problem of technical knowledge. Production is carried on old and less productive techniques. As a result, these countries have low productivity and per capita production and income’s low quantity, lowers the standard of the rate of capital formation.
Reason # 9. Demonstration Effect:
Demonstration effect also stands in the path of capital formation. Prof. Nurkse has cited the reason of low rate of capital formation, “due to demonstration patterns of people come into contact with best goods or superior patterns of consumption in which old demands are fulfilled by new goods and new plans, then, they after some time fell unrest and discontent. In this way, their knowledge grows their imagination is stimulated, new desires are awakened. By this their propensity to consume becomes high”.
Besides, there is tendency among people of these countries to follow the higher consumption standard of developed countries. In fact, all these actions occur due to demonstration effect which increases the tendency of consumption based on new ways and goods which limit the desire and capability to save in the society.
Reason # 10. Lack of Effective Fiscal Policy:
Lack of effective fiscal policy or financial policy in under-developed countries also retard capital formation to some extent. Burden of taxation is too much which is out of people’s capacity to bear as their income is quite low. Besides, inflationary circumstances accrue and prices soar extremely high.
This leads to increase in cost price of capitalized goods and not consumption goods by which exported goods in internal market do not hold in external market in competition to best and cheap goods. This creates the problem of unfavourable balance of trade and payment. Thus, these countries have very low rate of economic development and capital formation.
Reason # 11. Lack of Investment Incentives:
Still another cause of the low rate of capital formation is the lack of investment incentives in most of the under-developed countries. This leads to low rate of productivity which, in turn restricts capital formation.
Reason # 12. Deficit Financing:
In modern times, deficit financing is considered a major resource of capital formation. But, if it crosses its limits, then it tends to low rate of capital formation. Whenever, deficit financing is made in the country, it leads to rise in prices and as a result, all commodities become costly. Under this situation, it becomes hard to save as the entire amount is spent. This results in the saving and low rate of capital formation.
Reason # 13. Unequal Distribution of Income and Wealth:
Since there is extreme unequal distribution of income and wealth in most of the under-developed and backward countries which keep the rate of capital formation relatively low. In fact, it restricts real investment in the economy which greatly effects the capital formation.
Reason # 14. Demographic Reasons:
In under-developed countries, the growth rate of population is very high which keeps the rate of capital formation at a low level. It is because most part of their income is spent on bringing up the additional numbers. Thus, there is little scope of saving and as a result, it aggravates the growth of capital formation.