Suppose the government targets an economic growth of 9% for next year and the capital output ratio in India is 4. Here, to realize 9% growth, investment should be increased to 36% (9 x4).
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Incremental Capital Output Ratio (ICOR)
- The incremental capital output ratio (ICOR) is a frequently used tool that explains the relationship between the value of capital invested and the value of output.
- ICOR indicates the additional unit of capital or investment needed to produce an additional unit of output. ICOR reflects how efficiently capital is being usedto generate additional output.
- For example, if the 10% additional capital is required to push the overall output by a percent, the ICOR will be 10.
- Lower the ICOR, the better it is. So a country with ICOR of 3 is better than a country with ICOR of 5.
- A lower capital output ratio shows that only low level of investment is neededto produce a given growth rate in the economy. This is considered as a desirable situation.
- Lower capital output ratio shows that capital is very productive or efficient.
- The Formula the Incremental Capital Output Ratio is
ICOR= Annual Investment/Annual Increase in GDP
Capital output ratio in economic planning
- Capital output ratio has very good use in economic planning.
- It explains the relationship between level of investment and the corresponding economic growth.
- There is a simple equation in economics that shows the relationship between investment, capital output ratio and economic growth.
G = S/V
- Here, G is economic growth, S is saving as a percentage of GDP and V is capital output ratio.