What Is the Incremental Capital Output Ratio (ICOR)?
The incremental capital output ratio (ICOR) is a frequently used tool that explains the relationship between the level of investment made in the economy and the consequent increase in the gross domestic product (GDP). ICOR indicates the additional unit of capital or investment needed to produce an additional unit of output.
- The incremental capital output ratio (ICOR) explains the relationship between the level of investment made in the economy and the consequent increase in GDP.
- ICOR is a metric that assesses the marginal amount of investment capital necessary for a country or other entity to generate the next unit of production.
- A lower ICOR is preferred as it indicates a country's production is more efficient.
- Some critics of ICOR have suggested that the use of ICOR is limited as it favors developing countries that can increase infrastructure and technology use as opposed to developed countries, which are operating at the highest level possible.
Understanding the Incremental Capital Output Ratio (ICOR)
ICOR is a metric that assesses the marginal amount of investment capital necessary for a country or other entity to generate the next unit of production.
Overall, a higher ICOR value is not preferred because it indicates that the entity's production is inefficient. The measure is used predominantly in determining a country's level of production efficiency.
Some critics of ICOR have suggested that its uses are restricted as there is a limit to how efficient countries can become based on available technology. For example, a developing country can theoretically increase its GDP by a greater margin with a set amount of resources than its developed counterpart can.
This is because the developed country is already operating with the highest level of technology and infrastructure whereas a developing country has room to improve. Any further improvements in a developed country would have to come from more costly research and development (R&D), whereas the developing country can implement existing technology to better its situation.
ICOR can be calculated as:
ICOR=Annual Increase in GDPAnnual Investment
For example, suppose that Country X has an incremental capital output ratio (ICOR) of 10. This implies that $10 worth of capital investment is necessary to generate $1 of extra production. Furthermore, if country X's ICOR was 12 last year, this implies that Country X has become more efficient in its use of capital.
Limitations of the Incremental Capital Output Ratio (ICOR)
For advanced economies, accurately estimating ICOR is subject to many issues. A primary complaint of critics is its inability to adjust to the new economy; an economy ever-more-driven by intangible assets, which are difficult to measure or record.
For instance, in the 21st century, businesses are impacted ever more by design, branding, R&D, and software, all of which are more challenging to factor into investment levels and GDP than tangible assets, like machinery, buildings, and computers; hallmarks of industrial periods.
On-demand options such as software-as-a-service (SaaS) have greatly driven down the need for investments in fixed assets. This can be extended even further with the rise of "as-a-service" models for nearly everything. It all adds up to businesses increasing their production levels with items that are now expensed, and not capitalized, and thus, considered an investment.
Real World Example
As a real world example of using ICOR, take the example of India. The planning commission working group in India put out the required rate of investment that would be needed to achieve different growth outcomes in the 12th Five-Year Plan. For a growth rate of 8%, the investment rate at market price would need to be at 30.5%, while for a growth rate of 9.5%, an investment rate of 35.8% would be required.
Investment rates in India dropped from the level of 36.8% of the gross domestic product (GDP) in the year 2007 to 2008 to 30.8% from 2012 to 2013. The rate of growth during the same period fell from 9.6% to 6.2%.
Clearly, the drop in India’s growth during this period is more dramatic and steeper than the fall in the investment rates. Therefore, there must be reasons beyond savings and investment rates that would explain the drop in the rate of growth in the Indian economy. Otherwise, the economy is getting increasingly inefficient. As of 2019, India's GDP growth rate was 4.23% and its rate of investments as a percentage of GDP was 30.21%.