Theory of Employment

Study Note - 4
THEORY OF EMPLOYMENT
This Study Note includes
• Labour
• Population Theories
• Unemployment
• Concept of Employment
• Capital
• Capital Formation

4.1 LABOUR

Definition

Labour is an important ingredient of production. Without labour, the other factor inputs cannot
be activated Labour helps production in two ways – As a producer and as a consumer. Things
are produced because they are consumed. Labour is defined as “any exertion of body and
mind undertaken wholly or partly with some object other than the pleasure derived from the
labour itself”. Thus labour includes both manual and intellectual, and the exertion of body or
mind should be not for pleasure but for earning money.

Features of Labour –

Labour as a factor of production has some characteristics that distinguish it from other factors.
Labour is a perishable factor. A day’s labour lost cannot be recovered. Hence the workers often
are exploited because they cannot preserve their labour power for future.

Secondly labour cannot be separated from labourer. Labour sells his work and he himself
remains his property.

Thirdly labour is a mobile factor. Apparently workers can move from one job to another or
from one place to another. But, in reality there are many obstacles in the way of free movement
of labour from job to job or from place to place.

Fourthly highly skilled labour are specific factors while highly unskilled workers are nonspecific
in the sense they can be used for any type of manual work.

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Another feature of labour is that the supply of labour in terms of hours of work decreases when
wage rates are high. For this the individual supply curve of labour is backward bending after a
point. Thus while the supply of commodities increases when their price rises, the individual
labour supply (in terms of hours of work) decreases with an increase in the price of labour.

4.2 POPULATION THEORIES

A. Malthusian Theory of Population Growth

In 1978, Thomas Robert Malthus expressed his views on the population growth in his “Essay
on the Principle of Population”. His arguments on the pattern of population growth in an
economy are as follows :

(1) In any country, total population grows at a faster rate than the total food grain
production. According to him, the production of foodgrains increases at an
arithmetical progression (e.g., 2,3,4,5,6 etc.) while population grows in geometrical
progression (e.g., 2, 4, 8, 16, 32 etc).

(2) Within a short period, the total population becomes larger than the size of the
foodgrain production i.e., foodgrain production per capita comes down to a low
level. At this stage, the country is said to be overpopulated.

The signs of such overpopulation, according to Malthus, are as follows :

(a) Large-scale poverty;

(b) Large-scale starvation and malnutrition; and
(c) Emergence of various diseases and epidemics.

He also believes that this excess pressure of population is automatically reduced

due to some natural calamities like floods, droughts, wars etc. In this way, the nature
through its own forces, tries to maintain a balance between the population and
foodgrains productions. These are called positive checks. Malthus also believes that
the people should also take some preventive measures to check such growing
pressure of population. (For instance, population control methods, prevention of
early marriage etc.), These are called the preventive checks.

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Malthus’s doctrine is illustrrated below :

Malthus Theory of Population

Population increases in Food increases in

a GP - 1,2,4,8,16,32........ AP - 1,2,3,4,5,6,........

Imbalance leads to
overpopulation

Corrected by

Preventive Checks - late Positive Checks - misery,

marriage, moral restraint etc war, famine, flood etc

Critical Evaluation :

The population theory of Malthus has been criticized from different angles.

(1) Population may not grow in a geometrical progression : Many economists are of the
view that population may not grow in a geometrical progression. In fact, population
of different developed countries of the world has increased at a slow pace during
the late 19th and 20th centuries. Thus, there is an interdependence between the level
of economic development achieved and the population growth in a country.

(2) Law of diminishing product may not be operative : Malthusian theory shows that the
production of foodgrains in a country grows in an arithmetical progression. The
implicit logic behind such argument was the operation of the law of diminishing
marginal productivity. That is to say, given the supply of cultivable land, growing
population pressure on land leads to an increase in production at a decreasing rate.
However, this law of diminishing product may not be operative if better seeds,
fertilizers, irrigation, agricultural implements, etc. are introduced in agriculture.

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 Thus, the Malthusian theory has not taken into account the technological revaluation
in agriculture.

(3) Growth rate of foodgrains production may be higher : The rate of growth of population
may not be greater than of foodgrains production in a country. For instance,
population of India has increased by about 185 per cent during 1951-2001, but
foodgrains production of India has increased by about 258 per cent during the said
period.

(4) Increased supply of labour facilitates economic growth : The population problem of
a country should not analysed only in terms of foodgrains production. Increased
population not only raises the demand for foodgrains, but also the supply of labour
in a country. If this labour force can be made more skilled and educated then they
contribute to the growth of total output in the country to a great extent. If the country
can produce different export items then the country would be able to import even
foodgrains from abroad, because the import bill can easily be met from the export
earnings.

(5) Overpopulation is not the only cause of poverty : Growing incidence of starvation
may not be the only indicator of overpopulation. This theory shows that a situation
of overpopulation is only responsible for such growing incidence of poverty and
starvation. But, inequality in the distribution of income and wealth can also create
such a situation.

B. Optimum Theory of Population

In 30’s a new theory of population was worked out which is known as the Optimum
Theory of Population. The core of the theory is a concept called “Optimum Population”. It was
held that for every economy there is an optimum level of population growth. IT is the level
where ‘maximum returns’ can be obtained. The Optimum Population simply is the size of
population that a country can support without any stress and strain. Thus in this theory the
danger of over population was considered not in the context of food supply but the total wealth
of a country. The test of over population or under population were not the shortage or surplus
of foodgrain but the maximization of national wealth and welfare.

If at any time the actual population of a country exceeds its optimum point the country will
face different economic problems and its returns will be less than maximum. On the other
hand, if the actual population is less than optimum, National output will also be less because of
under-utilisation of productive capacity. Only when actual population is equal to optimum
population that the country will enjoy the greatest good of the greatest number.

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A formula for estimating deviation of actual population from the optimum has been suggested.

A -O
It is
O

An economy is said to be under populated if A < O and Overpopulated when A > O. Only
when A = O that resources of the economy are used in the best possible way to secure the
highest possible return for manpower.

One feature of this Theory is that unlike Malthusian theory it is not pessimistic about the growth
of population. The Theory highlights the fact that population may help or hinder economic
development of a country depending upon the availability complementary resources. Further
unlike Malthusian theory, it is not narrow. It does not consider the growth of population with
the growth of food supply. Instead it considers demographic growth with the growth of national
resources as a whole. Moreover the Theory is important in another respect. It suggests that
under population is as much harmful as overpopulation for a country. Malthus only considered
the dangers of overpopulation ignoring the case of under population. The Rich countries of the
World are nowadays suffering from the problem of under-population and this is one of the
vital reasons for which they cannot fully utilize their productive capacity.

The most important problem of this Theory is that it is very difficult to ascertain what is the
optimum number of population that a country can support. Even if the optimum can be
determined, it will vary from time to time because of any change in the resource composition,
technology, trade of an economy so the concept of optimum as envisaged in this theory is not
a static one. It will vary from time to time and from country to country. Further the term
Optimum may be interpreted in many ways. It may mean the size of population that maximizes
the average product or income per head. It may also mean the size of population that maximizes
net social welfare or it may mean the size of population that maximizes total product. The
theory however considers Optimum Population as the maximum population that is supportable
with existing resources of a country.

C. Theory of Demographic Transition

Almost all demographers (who study demography or population theories) and social scientists
agree that population growth in every country passes through many stages. Each stage has its
own peculiarity. This theory indicates that particular types of demographic phases are associated
with particular stages of industrialization. On the basis of the economic history of many countries
of the world, this theory wants to establish that movement of a country from a traditional
agricultural system to a highly industrialized urban economy, also signifies its travel from a
stage of high fertility (and mortality) to a state of low fertility (and mortality).

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According to Prof. O.P.Walker, there are five stages of such demographic transition:

1st Stage : At this stage, both the death rate and the birth rate remain very high, but the
former exceeds the latter. As a result, population does not increase to a great
extent. This is called a high stationary stage.
2nd Stage : At this stage, the birth rate does not come down but the death rate starts falling
due to improvements in health facilities. As a result, population increases rapidly.
This is called an early expanding stage.
3rd Stage : Both birth and death rates decrease at this stage. Though the birth rate exceeds
the death rate, the distance between them becomes less. This happens when the
country attains a certain level of agricultural development and steps towards
urbanization. This is called the late expanding stage. Here the population size
grows slowly.
th
4 Stage : At this stage, the death rate reaches its lowest and at the same time birth rate
also comes to a low level. Growth in population becomes stagnant. But, unlike
the first stage, it is called low stationary stage.
5th Stage : At this stage, the death rate becomes more than the birth rate, and it may be
regarded as a declining stage.

While reviewing these stages, Prof. Thompson and Notestein opined that the first and
fifth stages were unusual. According to them, only the three intermediate stages are
relevant. They named these three intermediate stages (viz., the second, the third and the
fourth stages) as the pre-transition stage, transition stage and post-transition stage
respectively. The explanation of Karl Sax about the demographic transition also shows
four stages of such transition also shows four stages were similar to the explanation given
by Walker about the first four stages of transition in his own theory.

Now, we can give a diagrammatic representation of these theories of demographic transition

(Fig. 4.1) Y

Death Rate
Birth / Death Rate

A
Birth Rate

C
B

I II III
X
0 T0 X T1 Y T2 Time (T)
Fig 4.1

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In Fig. -2, the time paths of birth rate and death rate have been shown. Population growth is
determined by the gap between these two curves. The first stage (stage I) of demographic
transition becomes visible up to the time period To. Similarly, the second (stage II) and the third
(stage III) stages of demographic transition are discernible within the time horizon ToT1 and
T1T2 respectively. Let us assume that points X and Y represent two countries having the same
current rate of population growth (i.e., AB = CD). But, it is observed that, incase of country Y,
population growth will soon slow down because the falling death rate has almost reached its
minimum and has been accompanied by a falling birth rate. However, in country X, the
population is expected to rise in future because of the increase in the gap between birth rate
and death rate. Thus, two countries having the same observed population growth rate at present,
may indicate radically different future prospects.

4.3 UNEMPLOYMENT

Employment

The classical economists were not very much concerned with employment or unemployment.
It was because they believed in Say’s Law. J.B.Say’s law stated that ‘supply creates its own
demand’ that is every good produced in the market is born with a demand tied round its neck.
From the law follows that there can never be more than frictional unemployment or sectional
overproduction. It was believed that private enterprise would always employ all available
factors of production, provided prices and wages were sufficiently flexible. Thus they ruled
out the possibility of general over production, as the demand for all goods taken together will
always be sufficient to sell them. If it is so, restricting of output in general is not necessary. If a
general over supply is impossible, production will continue upto the point where all factors
are fully employed. It was the logic underlying the assumption of full employment.

The classical economists also believed that one man’s income depended on another man’s
expenditure and that if some people refused to spend a part of their income, the real resources
left over by the former would always be used by some businessman for the creation of capital
equipment. In other words, what is saved is being automatically invested.

In mid 30s the classical conclusions regarding employment were criticised by Keynes and his
followers. At times, there may be deficiency of aggregate demand in the society arising out of
lack of purchasing power in the hands of the people. In such a situation supply cannot create
its own demand. It can create demand but not effective demand. So excess produce may exist
with unsatisfied demand. Demand deficiency may thus throw an economy out of full
employment. This happens in a situation of depression.

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Kenesian Theory of Employment

According to Keynes the aggregate volume of output, during a certain period, depends on the
effective demand of the people. Effective demand of the people depends on total expenditure
for goods and services. The total expenditure is formed of consumption expenditure and
investment expenditure. Total expenditure is equal to total income.

Hence, Y = C + I.

The total of consumption and investment expenditure determined of output and employment.
Hence the determinants of consumption and investment are the determinants of output and
employment.

Consumption expenditure means spending of money for purchasing goods and services for
utility. Investment expenditure, on the other hand, implies spending for new capital asset.
Consumption according to Keynes depends upon objective and subjective factors. Income is
the most important factor influencing consumption c = f(y). The definite relation that exists
between income and consumption is known as Consumption Function. When income increases
consumption expenditure also increases but not by full amount. In other words, consumption
is less than unity (c<1) but greater than zero (c>0). That part of additional income people do not
spend for consumption is their savings. Therefore dY = dc + ds.

Not only does current consumption depends on current income but on past savings as well.

Investment Function

Investment expenditure is normally business sector’s expenditure with the aim of

securing profit. Expected profitability of a given dose of investment depends on the
margin between Return from and cost of investment. The cost of investment is the cost
of credit viz. Rate of interest. The volume of investment varies inversely with rate of
interest (r).
Y A I
So, dI / dr < 0. C+
P Y=
Consumption & Investment (C+I)

Q C+I
M
R C

N
C

450 Y1 Y2 X
0 Income (Y)
Fig.4.2

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Let OX axis measures income and OY measure consumption and investment expenditures. OA
curve is a straight line on OX and OY at angle of 45o. In view of this all points on it are equidistant
from OX and OY axis. So at all points on this curve Y = E = C + I. CC curve shows the amount
of consumption at each level of income. C + I curve shows the total expenditure. At OY1, total
expenditure is MY1 while consumption expenditure NY1. So MY1 – NY1 = MN represents
investment expenditure.

At the point M, C + I curve intersects OA (Y = C + I) curve so that OY1 = MY1 that is total income
is equal to total expenditure (MOY1=OMY1) Since M is on OA, OY is equal expenditure curve
and the 45o line a stable equilibrium of income and output (consumption good and investment
good).

Is it the point of full employment? It may be or its may be not. Suppose at OY1 level of income
the output produced is not sufficient to absorb all factors. At OY2 level of income all factors
may be employed provided C + I curve shifts upward and intersects OA curve. The shortage in
total expenditure required to be fulfilled is RQ. This needs either more consumption expenditure
or more investment or both.

Unemployment - Causes and Forms

Unemployment arises when even with the willingness to work at the current
wage, people are unable to get a job. It is involuntary in nature. Unemployment may be voluntary
also when a person is unwilling to work (idle rich) or unable to work at the current wage rate.

According to classical economists, the main cause of unemployment is rigidity of wages. If

wages were sufficiently flexible, all people will be employed. A general wage cut is what they
prescribed for achieving full employment or near full employment. Like the price of any
commodity, if the price of labour falls its demand will increase. Logically it follows that,
according to classical writers, all unemployment is voluntary because man is not willing to
accept current wage as being too low.

Lord Keynes views on unemployment can be explained by his general theory of employment.
Employment depends upon effective demand made up of consumption expenditure and
investment expenditure. A deficiency of demand due to fall in expenditure (C + I) will cause a
fall in output and employment. When the deficiency is high, the economy will experience large
scale unemployment and depression, as happened in the 1930’s Great Depression. Keynes
advocated more government investment to overcome the shortfall in private spending that is,
deficiency of demand.

As has been stated earlier people are said to be unemployed when they remain jobless despite
their eagerness to work at the current wages. Although there are general explanations for this
state of affairs, there are specific reasons for various forms of unemployment as well.

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In agricultural economies, one may find seasonal and disguised unemployment. Crop cultivation
is a seasonal occupation. A particular crop is grown during a particular season and not
throughout the year. So after harvest, men are thrown out of employment till the next season.
Two broad causes of such unemployment are (i) single cropping (ii) no off-season employment
opportunity.

Besides agriculture, this type of joblessness can be found in some non agricultural activities as
well where demand is of a seasonal nature or it varies erratically (woolen goods, umbrella,
dock labour). The seasonally unemployed men may take up some other non farm job for the off
season. A farmer, for example, may make mat or basket when there is no pressure of crop
cultivation.

In traditional agriculture, another type of unemployment can be seen. It is disguised

unemployment causing much harm to poor economies. It implies that a large part of the
workforce engaged in agriculture could be removed without reducing total output. It is
applicable in case of family farming where all family members (that multiply generation after
generation) grip a given plot of land and if some of them do not participate total product
would not diminish. In other words, many members marginal contribution or marginal product
is zero. They are surplus labour.

C
Total Product

X
0
A
Units of Labour

Fig. 4.3

OX represents units of labour and OY total crop produced. OC is total product curve. Upto OA
units of labour total product will go on increasing with more employment. After that (OA) all
units of labour are unemployed as their employment do not increase total product. As they are
not producing anything additional, they are unemployed. But this unemployment is not visible
in the naked eye as they are going to cultivate.

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The causes of such joblessness are –

(a) family farming

(b) existence of surplus labour
(c) lack of alternative job facilities.

The growth of capitalist sector can absorb such surplus manpower. And rural development
activities initiated by the government can also eradicate this type of unemployment.

Industrial nations face generally two types of unemployment; technological and cyclical
Technological unemployment arises out of a change in the techniques of production from labour
intensive to capital intensive. Further the industrial sector also faces a type of unemployment
called cyclical unemployment. In times of recession and depression industries experience a fall
in the volume of production. Therefore the demand for labour also decreases. Even some of the
workers already employed are thrown out of employment. Another type of unemployment is
Frictional unemployment. Such unemployment happens when the workers leave one job to
get a better one. So it is also temporary. There is also Natural rate of unemployment that every
country faces. Some men everywhere remain jobless for some reason.

4.4 THE CONCEPT OF FULL EMPLOYMENT

The concept of Full employment has been variously defined by different writers. Sir William
Beveridge has defined it as having always more vacant jobs than men. Lord Keynes says it the
absence of involuntary unemployment. So defined, the concept of full employment is compatible
with

(a) voluntary un employment,

(b) frictional un employment.

Thus a full employment economy is one which has the minimum of involuntary un employment
in transition from one job to some other. It implies a situation whereby the labour market
transforms from a buyers market to a sellers market.

The Policies for achieving Full Employment

The classical economists believed that an economy achieves full employment automatically. If
supply creates its own demand, as stated by Say, an stated by Say, an economy can go on
producing till all factors are fully absorbed, provided wages and prices are flexible. Thus general
over production and unemployment were ruled out. A state of full employment was supposed
to be inevitable. There may be under employment equilibrium. It is the level of income (OY1) in
total income is equal to total expenditure of goods and services (Y = C + I). A M, C + I curve
intersects the 45o curve. That is equilibrium point but at that level of income, the economy is
under full employment.

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Then, how to achieve full employment? Graphically if C + I curve shifts upwards and intersect
Y = C + I curve at a point (P) that level of income (OY2) all labour may be fully employed. It is
how full employment may come about (see graph 4.1)
It thus appears that the way to achieve full employment is a constant increase in total expenditure
(C + I) whose deficiency keeps an economy at less than full employment. Any policy for realizing
this goal should attempt to raise total spending. When private spending for consumption and
investment goods are inadequate, the government is called upon to play a more positive role
i.e. to spend more by printing new money.
Role of Government
A vigorous “monetary fiscal mix” i.e., a combination of monetary policy and fiscal policy is
essential for lifting an economy from depression and unemployment to full employment.
Anti cyclical monetary policy
It is formulated by the Central bank. It is known as Cheap Money Policy. Money is said to be
‘cheap, when it can be obtained at a very low rate of interest. If liquidity preference function
remains unchanged, an increase in total money supply (cash + credit) will go to reduce interest
rate. Naturally investment expenditure of the private sector will go up. A fall in interest rate
will lead to a rise in price of bonds, securities etc. This will increase household sector’s investment
in financial assets too. The Net National Product, in effect, will go up. Increase in money supply
may continue till NNP reaches the full employment level.

So long there are unemployed factors, injection of more money will lead to an increase in
output and employment. Investment of created money will activate the idle factors. In this way
once the economy reaches full employment zone, any more increase in money will lead to
inflationary price rise. At less than full employment, investment may activate idle resources.
So an increase in NNP. But at full employment there lies no such scope.

Thus an increase in investment may generate an ‘output effect’ at less than full employment
situation and ‘price effect’ after (or at) full employment level of output.

Y P Price Curv
F
C D Q
Price Output

B
Output Curve
A

M1 M2 M3 M X
0
A
FIG 4.4

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In this graph OX represents money supply and OY NNP. The ray passing through the origin is
Price Curve. OQ is Total Product curve. Upto OM increases in money supply will to on increasing
output (AM1, BM2, CM3 ……) Once full employment is achieved (DM) the curve becomes
inelastic (DQ) Henceforth more money will lead to proportionate increase in price.

Fiscal Policy

Government’s tax and expenditure policy for realizing the goal of full employment is
compensatory in nature. It seeks to compensate the shortfall in private spending (C + I) which
is supposed to be the cause of deviation from full employment. Fiscal policies need to be two
edged – taxing less and spending more. Taxing less is same as ‘leaving more in the hands of the
people’ so that they can spend more. Expenditure by government for public works or welfare
activities may raise private effective demand, also.

The new and excess government outlay injected into body economy may generate an income
more than the initial sum pumped in. Hence, Keynes advocated creation of “new” money by
the government. The easiest way to do so is to borrow money from central bank against its
securities. This method is known as Deficit Spending.

Limitations

1) It may retard private investment. Easy and cheap credit may be harmful to the
business sector as they will find no incentive to raise resources internally.
2) More spending by the government may raise the effective demand of ‘few’ and the
effective demand of many may remain unchanged. So the character of effective
demand is as important as its level.
3) A vast public expenditure may not achieve full employment of labour for shortage of
some complementary resources like technical personnel, foreign exchange etc.

4.5 CAPITAL

Definition

Unlike Land and Labour, Capital is not an original factor of production. It is said to be a produced
means of production. It is means of production produced by labour on resources supplied by
Nature. As a factor of production, Capital thus depends upon both Land and Man. It is known
as producers’ goods – goods that help further production.

In a broad sense, Capital implies physical goods like machines and tools that render repeated
service in production. It also means money capital and debt capital consisting of equity and
bonds which yield income. Thus capital includes all those physical and financial assets that
yield an income or aid the production of income. Man invests in Capital assets for the sake of
obtaining income repeatedly. Nowadays man is also considered as a sort of capital. Just as

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physical and finance capital brings income after their owner invest fund, so also investment in
human capital in the form of education makes a man skilled worked and he earns more
repeatedly.

As an agent of production capital increases the productivity of labour. Man can produce more
when he uses sophisticated machines and tools. Not only does its use raise the volume of
output but secures continuity in production also. Further the use of capital makes production
‘round about’. Labour first produces capital goods like machines and tools and then with the
help of such goods, consumption goods are produced. Capital helps in bringing about continuity
in production.

Growth of Capital

Physical Capital and Financial Capital are essential for production. The more the stock of capital,
the more will be the volume of production in an economy. This highlights the need for the
growth of capital in a country.

Capital grows out of savings. It implies generation of surplus – a surplus of income over
consumption. The size of the surplus that forms capital is the difference between current income
and current consumption. Therefore the growth of capital depends on the size of income and
the proportion of income spent for consumption.

Surplus is generated from household sector, corporate sector and the Government sector. Of
these the role of the household sector in generating surplus is very much important in most of
the countries of the world.

Saving may be of three types—voluntary saving, involuntary saving and forced saving Generally
the households save a part of their current income voluntarily in the sense that they may not
save it also if they so like. Some times savings becomes involuntary. In a period of inflation, as
prices of goods used by household increases so with their fixed income they can now consume
less than before. Naturally there is saving but it is not voluntary. Thirdly, people are forced to
reduce consumption out of a given income if a large part of the income is taken away by the
Government in the form of direct taxes. It is the case of forced saving.

Saving of the house hold sectors are related to family income and family consumption
expenditure. It is only when people abstain from current consumption, that they are able to
save and such saving helps the growth of capital. The propensity to save of the household
sector depends upon a variety of factors. The business sector also creates surplus. The surplus
of the capitalist sector is reinvested in physical assets for further production and employment.
According to Lewis the growth of capital is low in poor countries not because their people are
poor but because their capitalist sector is so small. Growth of capital thus depends upon the
growth of large scale industries that generate large amount of surplus for further investment.

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4.6 CAPITAL FORMATION

Capital formation means the process whereby a nation creates capital assets that generate a
continuous flow of income in future. The creation of such capital assets involves large scale
investments and such investable resources come from surplus. Thus the essence of capital
formation is creation of surplus or savings. Surplus generation is possible only when the nation
does not use the entire production for current consumption but keeps a part of it for future
production thus capital formation needs current sacrifice for future prosperity that is to-day’s
pain for tomorrow’s gain.

In a word Capital Formation is the process of creation of savings and its productive investment.
In a wider context the formation of capital thus not merely means the growth of savings and
investment but a qualitative change in man’s attitudes and motives that may help development
in the long run. Prof. W.W. Rostow opined, “capital formation is not merely a matter of
maximizing profit. It is a matter of a society’s effective attitude towards science, applied science,
risk taking as well as the adaptability of the working force”. Thus capital formation has a
quantitative as well as a qualitative aspect. The former is the growth of investment resources
while the latter involves a qualitative change in human resources.

Steps in Capital Formation

Capital formation is a long drawn process. It passes through three important stages.

The first step in Capital formation is Creation of Surplus. Simply speaking, creation of surplus
means increasing the ratio of saving to income. Out of a given income a country should save
more if it want s to generate surplus. Savings can be increased in two ways.

1. If the level of personal income increases some increase in savings is quite natural.
2. Saving can also increase if people abstain from current consumption to a larger
extent.
While the ability to save depends upon the size of a man’s income, his family liabilities, his
standard of living etc., it also depends upon his willingness to save. The willingness to save is
influenced by some personal qualities that motivate a man to save and these motives may vary
from person to person.

Not only the household sector but also the corporate sector and the public sector can contribute
to the creation of savings. A Budgetary surplus is an important source of surplus generation in
the Government sector. The private corporate sector too can contribute to surplus generation if
they operate with efficiency. Thus the most important condition for Capital Formation is Creation
of Surplus.

The second step is mobilization of the surplus created. It implies the surplus resources should
be activated and they should not remain idle. Mobilisation of savings depends upon the financial
network of an economy. Banks and other financial institutions play an important role in the

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mobilization process. These institutions collect the surplus from the surplus units and lend
them to the deficit units like businessmen, industrialists, traders etc. who are in need of fund.
Thus they play an intermediary role connecting savers with the users of capital. The Financial
systems can mobilize capital actively if they are safe and sound. The interest rate they offer
may induce people to save more and to deposit it with the financial institutions. Thus the
financial system of a country plays an important role in capital formation.

The last step in capital formation is effective investment of the surplus. Funds offered by financial
institutions are taken by those who invest them with the object of earning income, from
investment of such funds in trade, commerce and industry. If the borrowed fund is used for
unproductive and speculative purposes, it may bring windfall profit but without helping the
creation of capital assets for future income. Such investment is not desirable. What is essential
is that money must be invested for productive purposes – purposes from which the investor
can get a continuous earning over a period of time.

Exercise

1. What does the Keynesian Theory of Employment?

2. What is investment functions?
3. Describe the causes and types of unemployment.
4. What is disguised unemployment?
5. What is the meaning of full employment?
6. What is the meaning of monetary and Fiscal policy?
7. Explain the Malthusian Theory of Population. Compare and Contrast this theory
with the Optimum Theory of Population.
8. Define Capital. How does it differ from Land? What are the forms of Capitals?
9. What is meant by Capital formation. Discuss the steps in Capital formation?

ECONOMICS A131