Incremental Capital Output Ratio (ICOR)
What Is the Incremental Capital Output Ratio (ICOR)?
The incremental capital output ratio (ICOR) is a regularly utilized device that explains the relationship between the level of investment made in the economy and the subsequent increase in the gross domestic product (GDP). ICOR indicates the additional unit of capital or investment expected to deliver an additional unit of output.
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 isn't preferred because it indicates that the entity's production is inefficient. The measure is utilized predominantly in deciding a country's level of production efficiency.
A few pundits of ICOR have suggested that its purposes are restricted because there is a limit to how efficient countries can become based on available technology. For example, a non-industrial nation 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 an emerging nation has room to get to the next level. Any further improvements in a developed country would have to come from more exorbitant research and development (R&D), whereas the non-industrial nation can carry out existing technology to better its situation.
ICOR can be calculated as:
For example, assume that Country X has an incremental capital output ratio (ICOR) of 10. This suggests that $10 worth of capital investment is necessary to generate $1 of extra production. Besides, assuming country X's ICOR was 12 last year, this suggests that Country X has become more efficient in its utilization 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 pundits is its inability to adjust to the new economy — an economy perpetually driven by intangible assets — like design, branding, research and development (R&D), and software — which are hard to measure or record.
Intangible assets are more challenging to factor into investment levels and GDP than tangible assets, like machinery, structures, and PCs.
On-demand options, for example, software-as-a-service (SaaS), have greatly driven down the requirement for investments in fixed assets. This can be extended even further with the rise of "as-a-service" models for nearly everything. Everything adds up to organizations increasing their production levels with things that are presently discounted, and not capitalized, and in this way, thought about an investment.
Example of the Incremental Capital Output Ratio (ICOR)
Somewhere in the range of 1947 and 2017, the Indian economy was started on the concept of planning and carried out through the Five-Year Plans. The 12th Five-Year Plan of the Government of India was India's final Five-Year Plan.
The Planning Commission of India decided the required rate of investment that would be expected to achieve different growth results in the 12th Five-Year Plan. For a growth rate of 8%, the investment rate at market price would should 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 tumbled from 9.6% to 6.2%.
Clearly, the drop in India's growth during this period was more dramatic and more extreme than the fall in the investment rates. In this manner, there must have been reasons past savings and investment rates that would explain the drop in the rate of growth in the Indian economy. In any case, the economy is getting increasingly inefficient: In 2019, India's GDP growth rate was 4.23% and its rate of investments as a percentage of GDP was 30.21%.
Features
- A few pundits of ICOR have suggested that the utilization of ICOR is limited as it favors non-industrial nations that can increase infrastructure and technology use rather than developed countries, which are operating at the highest level conceivable.
- 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.
- The incremental capital output ratio (ICOR) explains the relationship between the level of investment made in the economy and the resulting increase in GDP.
