What Is the Incremental Capital Output Ratio (ICOR)?
Let me explain what the incremental capital output ratio, or ICOR, really is. It's a tool I often see used to show the link between investments in an economy and the resulting boost in gross domestic product, or GDP. Essentially, ICOR tells you how much extra capital or investment you need to create one more unit of output.
Key Takeaways on ICOR
You should know that ICOR directly connects investment levels to GDP growth. It acts as a metric to evaluate how much marginal investment capital a country or entity requires to produce the next unit of output. I prefer a lower ICOR because it means the production process is more efficient. However, some critics point out that ICOR's usefulness is limited, as it tends to favor developing countries that can expand infrastructure and adopt new technologies, unlike developed nations already at peak efficiency.
Understanding the Incremental Capital Output Ratio (ICOR)
ICOR assesses the marginal investment capital needed for generating the next unit of production in a country or other entity. Overall, you don't want a high ICOR value, as it signals inefficient production. This metric is mainly used to gauge a country's production efficiency.
Critics argue that ICOR has restrictions because there's a ceiling on efficiency based on current technology. For instance, a developing country can potentially grow its GDP more significantly with the same resources compared to a developed one. This happens because developed countries are already using the best technology and infrastructure, leaving room only for expensive research and development improvements. In contrast, developing countries can simply adopt existing technologies to enhance their situation.
How to Calculate ICOR
You can calculate ICOR using this formula: ICOR equals annual investment divided by the annual increase in GDP.
Take Country X as an example. If its ICOR is 10, that means you need $10 of capital investment to generate $1 of additional production. If last year it was 12, then Country X has improved its capital efficiency.
Limitations of the Incremental Capital Output Ratio (ICOR)
For advanced economies, estimating ICOR accurately comes with several challenges. A major criticism is that it doesn't adapt well to the new economy, which is increasingly driven by intangible assets like design, branding, R&D, and software—these are hard to measure and record.
Intangible assets are tougher to include in investment levels and GDP calculations than tangible ones, such as machinery, buildings, or computers. On-demand services like software-as-a-service have reduced the need for fixed asset investments. This trend extends to various 'as-a-service' models, allowing businesses to boost production through expenses rather than capitalized investments.
Example of the Incremental Capital Output Ratio (ICOR)
From 1947 to 2017, India's economy was structured around planning via Five-Year Plans, with the 12th being the last one. The Planning Commission figured out the investment rates needed for various growth targets in that plan. For an 8% growth rate, you'd need a 30.5% investment rate at market prices, and for 9.5% growth, it would be 35.8%.
India's investment rates fell from 36.8% of GDP in 2007-2008 to 30.8% in 2012-2013, while growth dropped from 9.6% to 6.2%. The growth decline was sharper than the investment drop, suggesting factors beyond savings and investments affected it. Otherwise, it points to increasing inefficiency: In 2019, India's GDP growth was 4.23% with investments at 30.21% of GDP.
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