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

The Incremental Capital-Output Ratio (ICOR) is the ratio of investment to growth which is equal to the reciprocal of the marginal product of capital. The higher the ICOR; the lower the productivity of capital or the marginal efficiency of capital. The ICOR can be thought of as a measure of the inefficiency with which capital is used. In most countries, the ICOR is in the neighbourhood of 3. It is a topic discussed in economic growth. It can be expressed in the following formula, where K is the capital-output ratio, Y is output (GDP), and I is net investment.

According to this formula, the incremental capital-output ratio can be computed by dividing the investment share in GDP by the rate of growth of GDP.

As an example, if the level of investment (as a share of GDP) in a developing country had been (approximately) 20% over a particular period, and if the growth rate had been (approximately) 5% per year during the same period, then the ICOR would be 20/5 = 4.