What is the Incremental Capital Output Ratio (ICOR)?
The Incremental Capital Output Ratio (ICOR) is a vital tool that elucidates the relationship between the investment level made in an economy and the concurrent rise in gross domestic product (GDP). Essentially, ICOR indicates the additional unit of capital or investment required to generate an additional unit of output.
Key Takeaways
- ICOR links the level of investment with the ensuing GDP growth.
- It evaluates the marginal investment capital needed for producing the next output unit.
- A lower ICOR signifies better production efficiency within a country.
- Critics argue that ICOR’s applicability is limited, especially as it favors developing nations that can capitalize on infrastructure and technological advancements compared to developed countries.
Why ICOR Matters for Economic Efficiency
ICOR fundamentally assesses the marginal amount of investment capital necessary for a country or another entity to generate the next unit of production. Typically, a higher ICOR value indicates inefficiency in production. This metric is invaluable in determining a country’s level of production efficiency.
Critics point out that ICOR’s utility is restricted because countries can only become so efficient based on current technology. Developing nations have more room to enhance their GDP using a set amount of resources compared to their developed counterparts, which operate with the most advanced technology and infrastructure. Improvements in developed nations often require cost-intensive research and development (R&D), whereas developing nations can utilize existing technologies to enhance their productivity.
ICOR is calculated as follows:
ICOR = \frac{\text{Annual Investment}}{\text{Annual Increase in GDP}}
For instance, if Country X has an ICOR of 10, it means $10 worth of capital investment is required to generate $1 of extra production. If Country X’s ICOR was 12 the previous year, it signifies an improvement in capital efficiency.
Challenges and Limitations of ICOR
Accurately estimating ICOR in advanced economies carries numerous challenges. Critics highlight the difficulty in adjusting ICOR to modern economies increasingly driven by intangible assets like design, branding, R&D, and software, which are hard to measure or record accurately.
Intangible assets are more complex to incorporate into investment levels and GDP calculations than tangible assets like machinery and buildings. The rise of on-demand software options, such as software-as-a-service (SaaS), has reduced the need for investments in fixed assets. This trend extends to other ‘as-a-service’ models, resulting in companies boosting production with expensed items instead of capitalizing them as investments.
Real-World Example: Indian Economy
Between 1947 and 2017, India’s economy hinged on planned growth, executed through Five-Year Plans. The 12th and final Five-Year Plan quantified the necessary investment rates to achieve varying growth outcomes:
- For 8% growth, 30.5% investment at market price was needed.
- For 9.5% growth, a 35.8% investment rate was required.
Investment rates in India fell from 36.8% of GDP in 2007-2008 to 30.8% in 2012-2013. During the same period, the growth rate plummeted from 9.6% to 6.2%. The drop in growth rates was more pronounced than the decline in investment rates, signaling other factors at play beyond savings and investment. By 2019, India’s GDP growth rate stood at 4.23%, with investments as a percentage of GDP at 30.21%.
Clearly, the contraction in growth necessitates an examination beyond straightforward investment rates, indicating increasing inefficiency in the economy.
Related Terms: GDP, Capital Investment, Production Efficiency, Research and Development, Tangible Assets, Intangible Assets.
References
- Government of India Planning Commission. “Faster, Sustainable and More Inclusive Growth: An Approach to the Twelfth Five Year Plan”, Page 9-27.
- The Hindu Business Line. “India needs to grow at 9 per cent to achieve PM’s target of $5-trillion economy: EY”.
- The World Bank. “GDP growth (annual%) - India”.
