Capital Output Ratio: Concept,

Measurement and Uses

Nirmal Kumar Raut, PhD
Tribhuvan University
March 14, 2018
 Concept
• The amount of capital required to produce one unit of output
(e.g. ICOR1= 5:1 and ICOR2 = 3:1 )
Question: Which one is technically efficient ? Why?

• COR , in general, means the relationship between capital and

output produced by it.
• Note two correlated points:

 Nature of method of production (Capital intensive or labor intensive)

 Amount of investment required given technology and labor productivity

 Higher COR in capital intensive (more investment) method and vice versa.
E.g., transport, communication, public utilities etc vs. agricultural sector.

Nirmal Kumar Raut, PhD

 How to express capital output ratio?
• Average COR:

• Incremental COR:

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Diagrammatic Illustration

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 Importance of ICOR in Planning
• ICOR is an important concept and analytical tool of
both economic growth theory and development
planning.

Nirmal Kumar Raut, PhD

 Which one to use: ACOR or ICOR?
• ACOR is a static concept (measured at particular
point of time) whereas ICOR is a dynamic concept
(measured over time).
• ICOR is more useful than ACOR since we study
the behavior of COR and its usefulness as an
analytical tool for planning and projection.
• Also ICOR reflects the change in technology over
time. (e.g. ICOR2005= 5:1 and ICOR2010 = 3:1 )
• But ICOR is sensitive to cyclical fluctuations.
Nirmal Kumar Raut, PhD
 What about depreciation?
• Gross capital output ratio (Gc ) or net capital
output ratio (Gn).

• Which one is better?

Gross ratio or net ratio?

Nirmal Kumar Raut, PhD

 Issues with Depreciation
• Problem is measuring depreciation charges of different
kinds of capital.
• We usually assume original cost method of
depreciation i.e., a fixed proportion of the initial cost of
capital is deducted every year.
• Ideally, the value of depreciation deducted every year
should equal the value of obsolescence of capital in
that year. In practice, this does not happen.
• Hoffman: Obsolescence follow some kind of normal
distribution while total depreciation charges are
normally a linear function of time. Hence capital is
overvalued.

Nirmal Kumar Raut, PhD

Diagram: Hoffman on Depreciation (I)

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Diagram: Argument against Hoffman
on Depreciation

Nirmal Kumar Raut, PhD

 Estimation of ICOR
• Ideally, COR states the relationship of capital is what is the called
the “capacity” output.
• Capacity output is associated with the full utilization of the existing
stock of capital.
• The intuition is that “any change in ratio assuming constant prices in
capital and output and constant labor productivity will be due to
the change in technology”.
• No upward or downward bias in COR estimation with capacity
output.
 Upward bias: In recession, less output is produced due to
underutilization of capital. Hence COR is high.
 Downward bias: During booms, more output is produced due to
overutilization. Hence COR is low.
 Lack of data on capacity capital - output necessitates
measurement of COR using various methods.

Nirmal Kumar Raut, PhD

 Methods of estimation of ICOR

• Use potential output

• Use capital services rather than
capital
• Usual Method
• Cobb-Douglas Production
function
Nirmal Kumar Raut, PhD
 Method 1: Use potential output
• Potential output is a measure of optimum level of
output which the economy is capable of
producing without having serious instability with
output, employment and prices (given the best
knowledge of technology, the least cost and
nearly full employment).
• Knowles suggests:
Assuming 96% of employment of labor force and use real
GNP i.e., total of goods and services in constant prices.
Calculate Gross ICOR or Net ICOR

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 Method 1…(contd.)
• Potential output is less than capacity output .
Hence potential output will cause upward bias.
(5/10 > 5/15).
• But the bias is normally ignored.
• Question: Why 96% and not 100% of labor force?
 This method can be applied only in developed
countries that has sufficient capital to support
employment of 96% of the labor force.
 In developing countries, capital is scarce and
cannot support 96% of labor force.

Nirmal Kumar Raut, PhD

Method 2: Use capital services and not
capital
• Capital has relatively long productive life.
• Hence it is not correct to consider a piece of
capital as the input to the output produced in
one year only.
• So we should related capital consumption per
unit of time (depreciation plus interest on capital
consumed) to the output in same unit of time.
• But this method does not provide the
information about the amount of capital required
to produce one unit of output. If used, capital
coefficient will be smaller.
Nirmal Kumar Raut, PhD
 Method 3: Usual Method
• Simply express numerator and denominator at constant
prices to avoid the effect of change in prices.
• Output is affected by price more than capital.
• For output, we can use wholesale price index or consumer
price index.
• For capital, we can use Creamer’s composite index.
 weighted index drawn from sample of 15 industries in the
US where separate indices are computed for land and
building, machinery and equipment and working capital.
 Weight being determined by the relative importance of the
items in the capital structure.
 Simple and suitable method.

Nirmal Kumar Raut, PhD

.
Method 4: Cobb-Douglas Production
=
function

• Where A is a efficiency parameter.

• Where indicates the partial elasticity of output with respect to

capital whereas is that with respect to labor.

• The problem is that C-D function assumes unitary elasticity of

substitution implying that marginal productivity of any factor can
never reach zero.
• In developing economy, there is disguised unemployment, Hence
MPk can be zero or even negative.

Nirmal Kumar Raut, PhD

Thank you

Nirmal Kumar Raut, PhD

 References:

• Korayem, K.A.M (1965). The capital output ratio

and economic development: Studies in
Conception and Application, with Special
reference to Planning experience in the U.A.R.
• Jhingan, M.L. (1997). The Economics of
Development and Planning. Vrinda Publication
• Thirlwal, A.P. (2006) Growth and Development
with special reference to developing countries
(8th ed) Palgrave Macmillan
Nirmal Kumar Raut, PhD