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 GDP. ICOR indicates the additional unit of capital or investment needed to produce an additional unit of output.
The utility of ICOR is that with more and more investment, the capital output ratio itself may change and hence the usual capital output ratio will not be useful. It 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.
The Formula the Incremental Capital Output Ratio (ICOR) Is
ICOR=annual increase in GDPannual investment
What Does the Incremental Capital Output Ratio Tell You?
Some critics of ICOR have suggested that its uses are restricted as there is a limit to how efficient countries can become as their processes become increasingly advanced. 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.
Any further improvements would have to come from more costly research and development, whereas the developing country can implement existing technology to improve its situation.
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.
- The incremental capital output ratio (ICOR) explains the relationship between the level of investment made in the economy and the consequent increase in GDP.
- The utility of ICOR is that with more and more investment, the capital output ratio itself may change and hence the usual capital output ratio will not be useful.
- Some critics of ICOR have suggested that its uses are restricted as there is a limit to how efficient countries can become as their processes become increasingly advanced.
Example of How to Use the Incremental Capital Output Ratio
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.
Savings rates in India dropped from the level of 36.8% of gross domestic product in the year 2007-08 to 30.8% in 2012-13. The rate of growth during the same period fell from 9.6% to 6.2%. The growth is further expected to fall to the level of 5% in the current financial year with a savings rate of 30%.
Clearly, the drop in India’s growth rate is more dramatic and steeper than the fall in the savings rates. Therefore, there are reasons beyond savings and investment rate that would explain the drop in the rate of growth in the Indian economy. Otherwise, the economy is getting increasingly inefficient.
Limitations of the Incremental Capital Output Ratio
For advanced economies, accurately estimating ICOR is subject to a myriad of issues. A primary complaint of critics is its inability to adjust to the new economy – an economy increasingly driven more 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 their predecessor tangible assets, like machinery, buildings and computers – a hallmark of industrial periods.
On-demand options such as software-as-a-service have greatly driven down the need for investment 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.
Even the ICOR's denominator, GDP, isn't immune to necessary adjustments in for changes in modern economic output measurement.