Capital | ICSE Class 10 Economics Notes

This note covers the meaning and characteristics of capital, the difference between physical and financial capital with examples, the meaning of capital formation, the stages in the process of capital formation, and why capital formation matters for an economy.

What is capital in economics?

In economics, capital is a produced means of production. It is not a natural gift like land, and it is not human effort like labour. It is a stock of goods that people have already made, and that are then used to make other goods and services.

Definition: capital. Capital is that part of wealth which is used in the further production of wealth; it consists of man-made producer goods such as machines, tools, factories, buildings and raw materials.

The key word is produced. A machine in a textile mill was itself made in another factory. A tractor was assembled in a plant. A road was built by workers using materials. Each of these is then used to produce cloth, crops or transport services. This is why capital is called a produced means of production.

Capital must also be reproducible. If a machine wears out, more machines of the same kind can be made. This separates capital from land, which is a free gift of nature and cannot be increased by human effort.

Finally, capital is productive. It is held because it helps to produce income in the future. A person who buys a machine expects it to add to output. A person who keeps idle cash under a mattress is holding wealth, but not capital in the economic sense, because the cash is not helping to produce anything.

What are the characteristics of capital?

Capital has a set of features that mark it out from the other factors of production. Each feature below follows from the definition of capital as a produced, reproducible and productive stock.

Capital is a produced means of production

Capital goods are made by people. A sewing machine, a computer, a factory shed and a railway line are all the result of earlier production. This is the feature that most clearly separates capital from land, which is given by nature.

Capital is reproducible

Because capital is made, it can be made again. If a firm's machinery is destroyed, new machinery can be built. Land cannot be produced in this way. This is why the supply of capital can be increased over time, while the supply of land is fixed.

Capital is a passive factor

Capital cannot produce anything on its own. A machine lying in a closed factory produces nothing. It needs labour to run it and an entrepreneur to organise its use. Capital is therefore called a passive factor, while labour and the entrepreneur are active factors.

Capital is mobile

Capital can be moved from one place to another and from one use to another. Money can be transferred between banks, and machinery can be shifted between factories. This mobility allows capital to flow towards the uses where it earns the highest return.

Capital is subject to depreciation

Capital goods wear out with use and with the passage of time. A machine loses value as it ages. This loss is called depreciation, and firms must set aside funds to replace worn-out capital.

Capital involves time and risk

Capital goods are used over a long period. A person who invests in a factory must wait for returns, and those returns are uncertain. Capital formation therefore involves both time and risk.

Capital earns interest

The reward for supplying capital is interest. A person who lends money receives interest; a firm that borrows to buy machinery pays interest. This reward is the return to the factor of production called capital.

What are the types of capital: physical and financial capital?

Capital is usually divided into two broad types. The first is the capital that can be seen and touched, and that is used directly in production. The second is the money value that is lent or invested, and that gives the lender a claim on future income.

Physical capital

Definition: physical capital. Physical capital consists of tangible, man-made goods that are used in production, such as machines, tools, factory buildings, vehicles, equipment and raw materials.

Physical capital is also called real capital, because it exists in the real world of goods. It is the stock of producer goods that a firm or an economy owns. Examples include a tractor on a farm, a lathe in a workshop, a delivery van, a warehouse, a blast furnace and a computer used in an office.

Physical capital is further divided into two kinds. Fixed capital is used repeatedly over a long period without being used up in a single act of production: machines, buildings, tools and vehicles. Working capital is used up in the process of production: raw materials, fuel, power and stock of goods held for sale.

Financial capital

Definition: financial capital. Financial capital is money and claims on money, such as bank deposits, shares, debentures and loans, which are used to buy physical capital or to finance production.

Financial capital is not used directly to produce goods. It is a claim, a right to receive money in the future, or a fund that can be converted into physical capital. Examples include cash in hand, a savings account, a fixed deposit, shares of a company, debentures, and a loan taken from a bank.

Financial capital is important because it is the means by which physical capital is bought. A firm that wants a new machine needs money first. Financial capital is therefore the bridge between saving and investment.

Note: Money by itself is not capital in the strict economic sense. It becomes capital only when it is used to buy producer goods or to finance production. A note kept in a drawer is wealth, not capital.

What is capital formation?

Capital formation is the process by which the stock of capital in an economy increases over time. It means adding to the economy's stock of producer goods: more machines, more factories, more tools, more transport equipment and more infrastructure.

Definition: capital formation. Capital formation is the process of increasing the stock of capital in an economy by adding to its producer goods, which requires saving a part of income and investing it in new capital assets.

Capital formation is also called investment. It is not the same as saving, though the two are linked. Saving is income not spent on consumption. Investment is the use of that saving to create new capital goods. Saving without investment does not add to the capital stock.

Capital formation has two sides. On one side is the flow of new capital goods added each year. On the other side is the wearing out of existing capital, called depreciation. If new investment is larger than depreciation, the net stock of capital rises. If it is smaller, the stock of capital falls.

Note: Net capital formation is gross capital formation minus depreciation. Only net capital formation adds to the economy's productive capacity.

Worked example 1. In a year an economy adds new machines, buildings and roads worth ₹800 crore. During the same year its existing capital goods wear out by ₹250 crore. Gross capital formation = ₹800 crore. Net capital formation = ₹800 crore − ₹250 crore = ₹550 crore. The capital stock has grown by ₹550 crore, not ₹800 crore, because ₹250 crore of the new goods only replaced worn-out capital.

What are the stages in the process of capital formation?

Capital formation does not happen in one step. It passes through a sequence of stages, from the creation of saving to the actual building of capital goods. The stages are usually described as three: saving, mobilisation of savings, and investment.

Stage 1: creation of savings

The first stage is saving. People must hold back a part of their income instead of spending it all on consumption. Saving is possible only when income is greater than the minimum needed for subsistence. The ability to save depends on the level of income, the distribution of income, and the willingness of people to postpone present consumption.

Savings come from households, firms and the government. Households save out of their income. Firms save out of their profits. The government saves when its revenue exceeds its expenditure.

Stage 2: mobilisation of savings

The second stage is mobilisation. Savings may lie idle in the hands of many small savers. They must be collected and made available to those who want to invest. Banks, financial institutions and the capital market perform this task. They accept deposits, pool small savings, and lend them to firms and entrepreneurs.

Mobilisation is essential because a saver may not be the person who wants to invest. A teacher's small monthly saving can, through a bank, become part of a large loan to a factory. Without mobilisation, savings would remain scattered and unproductive.

Stage 3: investment

The third stage is investment. The mobilised savings are used to buy or build capital goods: machinery, buildings, tools, vehicles and infrastructure. This is the stage at which the capital stock actually rises. Investment may be undertaken by private firms, by the government, or by both together.

Investment depends on the expected return, the rate of interest, the availability of finance and the general business climate. If the expected return is higher than the cost of borrowing, firms are likely to invest.

1. Income is earned by households, firms and the government.
2. A part of that income is saved instead of being spent on consumption.
3. Savings are deposited with banks and other financial institutions.
4. These institutions lend the pooled savings to firms and entrepreneurs.
5. Firms use the funds to buy or build capital goods such as machines and buildings.
6. The new capital goods add to the economy's stock of capital.

Draw three boxes in a row, labelled Saving, Mobilisation and Investment. Draw an arrow from Saving to Mobilisation, and another from Mobilisation to Investment. Under the last box, write "Increase in capital stock".

Why is capital formation needed?

Capital formation is needed because it is the main route by which an economy grows. Without new capital goods, output can rise only by using more labour or more land, and both are limited. Capital formation allows each worker to produce more.

It raises productivity

More and better machines let a worker produce more in the same time. A farmer with a tractor can plough far more land than a farmer with a bullock cart. Higher productivity means more output from the same number of workers.

It supports economic growth

Growth in national income depends on the growth of the capital stock. A country that invests a larger share of its income in capital goods usually grows faster than one that invests less. Capital formation adds to the economy's capacity to produce.

It creates employment

Building factories, roads, dams and machines creates jobs. Once built, these capital goods also create jobs for the people who operate them. Capital formation therefore supports employment both during construction and afterwards.

It improves technology

New capital goods often embody new technology. A modern machine is more efficient than an old one. Investment in new capital is therefore a way of bringing better techniques into production.

It raises the standard of living

Higher productivity and higher national income allow people to enjoy more goods and services. Capital formation in health, education, transport and housing directly improves the quality of life.

It reduces dependence on foreign aid

A country that builds its own capital stock can finance its growth from its own savings. This reduces its need to borrow from abroad and to depend on foreign assistance.

How are saving, investment and capital formation linked?

Saving, investment and capital formation are closely connected. Saving is the source of funds. Investment is the use of those funds. Capital formation is the result, the rise in the stock of capital goods.

The link is not automatic. If savings are not mobilised, they cannot become investment. If investment is not productive, it does not add to the capital stock. If depreciation is high, gross investment may only replace worn-out capital and net capital formation may be small.

The rate of interest connects the two sides. It is the reward for saving and the cost of borrowing. A higher rate of interest usually encourages saving and discourages borrowing for investment. A lower rate usually does the opposite.

Glossary

• Capital: Produced means of production, such as machines and buildings, used to make other goods and services.
• Physical capital: Tangible, man-made goods used directly in production, such as machines, tools and factory buildings.
• Financial capital: Money and claims on money, such as deposits, shares and loans, used to buy physical capital.
• Fixed capital: Capital goods used repeatedly over a long period, such as machines, buildings and vehicles.
• Working capital: Capital used up in a single act of production, such as raw materials, fuel and stock.
• Capital formation: The process of increasing an economy's stock of capital by saving and investing in new capital goods.
• Saving: The part of income that is not spent on consumption.
• Investment: The use of savings to buy or build new capital goods.
• Mobilisation of savings: The collection of scattered savings by banks and financial institutions for lending to investors.
• Depreciation: The loss in value of capital goods due to wear and tear and the passage of time.
• Gross capital formation: The total value of new capital goods added in a year, before deducting depreciation.
• Net capital formation: Gross capital formation minus depreciation; the actual addition to the capital stock.
• Interest: The reward paid for the use of capital.
• Passive factor: A factor of production, such as capital, that cannot produce without the active help of labour and the entrepreneur.

Common errors and misconceptions

• Misconception: All money is capital. Correct: Money is capital only when it is used to buy producer goods or to finance production; idle cash is wealth, not capital.
• Misconception: Land is capital. Correct: Land is a free gift of nature and is not produced; capital is produced by people.
• Misconception: Capital and wealth mean the same thing. Correct: Wealth is a wider term; capital is that part of wealth which is used in further production.
• Misconception: Saving is the same as capital formation. Correct: Saving is only the first stage; capital formation also needs mobilisation of savings and investment.
• Misconception: Financial capital produces goods directly. Correct: Financial capital is used to buy physical capital, which then produces goods.
• Misconception: Gross and net capital formation are the same. Correct: Net capital formation is gross capital formation minus depreciation.
• Misconception: Capital produces output on its own. Correct: Capital is a passive factor; it needs labour and the entrepreneur to produce anything.

Exam-style questions with model answers

Q1. Define capital and state any two of its characteristics. [2 marks]

1. Capital is that part of wealth which is used in the further production of wealth; it consists of man-made producer goods such as machines, tools and factory buildings.
2. Two characteristics: (a) it is a produced means of production, and (b) it is reproducible, since worn-out capital goods can be made again.

Q2. Distinguish between physical capital and financial capital with one example of each. [3 marks]

1. Physical capital consists of tangible, man-made goods used directly in production, such as a tractor or a factory building.
2. Financial capital consists of money and claims on money, such as a bank deposit, a share or a loan, used to buy physical capital.
3. Physical capital wears out with use and earns profit for the firm; financial capital does not wear out and earns interest or dividend for its owner.

Q3. Explain the three stages in the process of capital formation. [4 marks]

1. Creation of savings: households, firms and the government hold back a part of their income instead of spending it all on consumption.
2. Mobilisation of savings: banks and financial institutions collect scattered savings and make them available to those who want to invest.
3. Investment: the mobilised savings are used to buy or build capital goods such as machines, buildings and vehicles.
4. Result: the new capital goods add to the economy's stock of capital, and net capital formation is gross investment minus depreciation.

Q4. Why is capital formation needed in an economy? Give any four reasons. [4 marks]

1. It raises productivity, because more and better machines let each worker produce more output in the same time.
2. It supports economic growth, since growth in national income depends on the growth of the capital stock.
3. It creates employment, both while capital goods are being built and afterwards when they are operated.
4. It improves technology and raises the standard of living, because new capital goods often embody better techniques and higher output.

Q5. "Capital is a produced means of production." Explain this statement and state two other characteristics of capital. [5 marks]

1. Capital is not a gift of nature like land; it is made by people. A machine in a mill was itself produced in another factory, and a tractor was assembled in a plant.
2. These capital goods are then used to produce other goods and services, such as cloth, crops or transport. This is why capital is called a produced means of production.
3. Capital is reproducible: if a machine wears out, more machines of the same kind can be made, so its supply can be increased over time.
4. Capital is a passive factor: a machine lying idle produces nothing, and it needs labour and an entrepreneur to run it.
5. Capital is subject to depreciation: it wears out with use and age, so firms must set aside funds to replace it.

Q6. Explain the difference between gross capital formation and net capital formation. [3 marks]

1. Gross capital formation is the total value of new capital goods added in a year, before deducting depreciation.
2. Net capital formation is gross capital formation minus depreciation, that is, the actual addition to the capital stock.
3. Only net capital formation increases the economy's productive capacity; if gross investment only replaces worn-out capital, net capital formation is zero.

Q7. State any two features that distinguish capital from land. [2 marks]

1. Land is a free gift of nature and its supply is fixed, while capital is produced by people and its supply can be increased.
2. Land does not wear out with use in the same way, while capital is subject to depreciation and must be replaced.

Key takeaways

• Capital is a produced means of production, made by people and used to make other goods and services.
• Capital is reproducible, passive, mobile, subject to depreciation and earns interest as its reward.
• Physical capital is tangible producer goods such as machines and buildings; financial capital is money and claims on money.
• Fixed capital is used repeatedly over a long period; working capital is used up in a single act of production.
• Capital formation is the process of increasing an economy's stock of capital through saving and investment.
• The three stages of capital formation are creation of savings, mobilisation of savings and investment.
• Net capital formation is gross capital formation minus depreciation, and only net formation adds to capacity.
• Capital formation raises productivity, supports growth, creates employment and improves technology.

Test yourself

What is meant by capital?

Capital is that part of wealth which is used in the further production of wealth. It consists of man-made producer goods such as machines, tools, factory buildings and raw materials.

Give two examples of fixed capital.

A machine in a factory and a delivery van are examples of fixed capital, because both are used repeatedly over a long period without being used up in a single act of production.

Give two examples of working capital.

Raw materials and fuel are examples of working capital, because both are used up in the process of production itself.

What is the reward for capital?

The reward for capital is interest. A person who lends money receives interest, and a firm that borrows to buy machinery pays interest.

Name the three stages of capital formation.

The three stages are creation of savings, mobilisation of savings, and investment in capital goods.

Why is capital called a passive factor?

Capital cannot produce anything on its own. A machine lying idle produces nothing, and it needs labour to run it and an entrepreneur to organise its use.

What is depreciation?

Depreciation is the loss in value of capital goods due to wear and tear and the passage of time. Firms must set aside funds to replace worn-out capital.