ECO 407: ECONOMIC PLANNING I

PLANNING TECHNIQUE:
THE CONCEPT OF CAPITAL-OUTPUT RATIO

DEPARTMENT OF ECONOMICS

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THE CONCEPT OF CAPITAL-OUTPUT RATIO

The concept of capital-output ratio (or capital coefficient) expresses the relationship between the
value of capital investment and the value of output. It refers to the amount of capital required in
order to produce a unit of output. When the capital-output ratio in the economy is said to be 5: 1,
it implies that a capital investment of N5 billion is essential to secure an output (income) worth
N1billion.

It may thus be defined as a given relationship between the investments that are to be made and
the annual income resulting from these investments.

The capital output ratio is of two types:

The average capital output ratio and the marginal or the incremental capital-output ratio.
The average capital output ratio indicates the relationship between the existing stock of capital
and the resultant flow of current output.

The incremental capital-output ratio (ICOR) expresses the relationship between the amounts of
increase in output (income) ∆Y, resulting from a given increase in stock of capital, ∆K.
This can be indicated as ∆K/∆ Y.

The concept of capital-output ratio is applicable not only to an economy but also to its different
sectors. There are different capital output ratios for different sectors of the economy depending
on the techniques (capital-intensive or labour-intensive) used by them.

In a sector using capital-intensive techniques, the capital-output ratio would be high and in
another sector using labour-intensive techniques the capital-output ratio would be low.

Transport, communications, public utilities, housing and capital goods industries have very high
sectoral capital-output ratios. While capital-output ratios in the agricultural sector, manufactured
consumers’ goods industries and service industries are generally low. The overall capital-output
ratio for a country is the average of the sectorial ones.

Capital-Output Ratio in Underdeveloped Economies

Various estimates have been made of capital-output ratios in underdeveloped economies. A

group of experts appointed by the United Nations used a ratio ranging from 2 : 1 to 5 : 1

Factors Determining Capital-Output Ratio

The size of the capital-output ratio in an economy depends not only on the amount of capital
employed but also on a number of other factors such as:

 the degree and nature of technological advance,

 the efficiency in handling new types of capital equipment,
 the quality of managerial and organizational skill,

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 the composition of investment,
 the pattern of demand,
 the relation of factor prices,
 the extent of the utilization of social and economic overheads,
 the impact of industrialization,
 education and
 foreign trade in the economy.

Let us examine these factors in detail.

1. Availability of Natural Resources. First, capital-output ratio depends on the availability

of natural resources. A country with abundant natural resources has a low capital-
output ratio, for it can substitute natural resources for capital. For example, Norway is a
country which has a very high capital-output ratio because she is not endowed with
natural resources.

2. Growth of Population. Hagen points out that in industrial countries with a rapidly
growing population, the capital-output ratio tends to be low. For population growth
leads to substantial capital saving in social overheads. Further, population growth
absolves an economy from the consequences of errors in investments and 'new
investment does not so gravely cause old investments to obsolesce.' In the case of an
agricultural country, however, population growth has an adverse effect on the capital-
output ratio. If a growing population is absorbed on the cultivable land existing in
abundance then not much of capital is required per unit of output, on the assumption that
people work with simple tools and implements and no extra public utility services are
required. But if the increase in population is concentrated in the towns, more capital will
be required to meet its requirements on more houses, power, water, schools, consumption
goods etc.
3. Amount of Capital Employed. The amount of capital employed in a country is an
important factor in determining the capital-output ratio. Given the average life of capital,
the capital-output ratio is determined by the proportion of national income invested
annually. So it is not surprising, writes Professor Lewis that countries which invest much
the same proportion of national income have much capital-output ratio.
4. Degree and Nature of Technological Advance. If technical progress is accelerated due
to a major innovation, the capital-output ratio will tend to rise. The nature of
technological advance refers to capital-intensive and labour-intensive innovations. If
technological advances are capital intensive in character, the capital output, ratio will
tend to rise. On the other hand, if technological inventions are labour-intensive in nature,
the capital-output ratio will tend to fall.

5. Rate of Investment. Capital-output ratio also depends upon the rate of investment. The
higher the rate of new investment, the higher is the capital-output ratio. A country which
doubles its capital in ten years will have a higher output per unit of capital than a country
which doubles it in twenty years.

6. Efficiency with which New Type of Equipment is Handled. But a low level of
efficiency in handling new capital equipment would lead to waste and as a result the
capital-output ratio would be affected negatively.

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7. Composition of Investment. The pattern of investment in an economy depends upon the
policy of the government. If the government plans a heavy expenditure on public works
and public utilities like railways, power, schools, etc., the capital-output ratio would be
high. It would also be high in the case of the development of basic and heavy industries.
But the capital-output ratio would be low if the pattern of investment is inclined more
towards the development of agriculture and cottage industries which are labour-intensive.

8. Quality of Managerial and Organizational Skill. A country in which the quantity and
quality of managerial and organizational skill is high, the capital-output ratio will be low.
For it is in a better position to use its capital equipment and other productive resources to
the fullest extent and thus a larger output can be had with the existing capital. Contrari -
wise, if the quantity and quality of entrepreneurship are low, the capital-output ratio will
be high.
9. Pattern of Demand. The pattern of demand also influences the capital-output ratio.
Given the prices and incomes in a perfectly competitive economy, changes in tastes and
preferences of the consumers may change the pattern of demand through time. This may,
in turn, have important effects on the demand for capital and on the capital-output ratio.
For example, the demand for synthetic materials and products like nylon, etc., has led to
the establishment of plants for their manufacture thereby raising capital-output ratio.
10. Relation of Factor Prices. A change in factor prices (i.e, wages, interest, rent. etc.)
affects the capital-output ratio to the extent capital can be substituted for other factors of
production. Changes in the rate of interest or wages may affect the demand for capital,
thereby affecting the capital-output ratio. A reduction in the rate of interest, other factor
prices remaining constant is likely to increase investment demand for capital and thus
raise the capital-output ratio. Similarly a rise in the wage level, other things remaining
the same, may raise the capital output ratio if there is a possibility of capital being
substituted for labour.

11. Employment Policy. Capital-output ratio further depends on employment policy. In an

overpopulated country where unemployment exists on a mass scale, the policy of the
State to provide immediate relief to the unemployed will lead to capital investments on
roads water works, land reclamation, hospitals, schools, houses, and other public works.
But if the government policy is towards absorbing the unemployed in large industries
especially in manufacturing industries, the capital-output ratio would be smaller. But less
of capital and labour will be employed in such industries as compared to the public
works.

12. Industrialization. Industrialization tends to raise the capital-output ratio.

Industrialization leads to urbanization. Urbanization involves the movement of works
from the rural areas to the towns which necessitates larger investment in house building
industry, as a result the capital output ratio is pushed up.

13. Spread of Education. With the spread of literacy and education, efficiency increases
which tend to make a better use of capital equipment whereby the capital-output ratio
falls and vice versa.

14. Use of Social and Economic Overheads. In the early stages of economic development
there is a tendency to invest more in social and economic overheads which take a long
time to show on the economy, meanwhile the capital-output ratio tends to be high. But
with the passage of time, fuller utilization of social and economic overheads creates
external economies and lead to increasing returns. This further leads to the fullest
utilization of existing capital equipment thereby increasing the output. Thus the capital-
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output ratio is damped/ low.
15. Impact of Export and Import. In order to earn more foreign exchange and to avoid
balance of payments difficulties, the export sector requires heavy capital expenditure to
push up exports. This tends to raise the capital-output ratio. If the nature of investment is
such that larger quantities of capital equipment are imported and huge expenditures are
incurred on it, the capital-output ratio would be high and vice versa.

16. Nature or Capital-Output Ratio

It is, however, not possible to arrive at any definite conclusion about the behaviour of the
capital-output ratio from the factors enumerated above. But a number of economists have proved
on the basis of empirical data based on developed economies that the capital-output ratio first
tends to rise then declines as development gains momentum and even becomes stable over a
long period. Prominent among these economists are Colin Clark, Simon Kuznets and
Leibenstein

Case for Low or High Capital-Output Ratio in Underdeveloped Countries

Economists, however, differ on the issue whether the capital-output ratio should be low or high
in underdeveloped countries.

Low Capital-Output Ratio. Those who favour a low capital-output ratio advance the following
arguments:
(1) Professor Lewis pointed out that the ratio of capital in existence to annual income is
much lower in underdeveloped countries because their rate of capital accumulation has
been much smaller.
(2) In underdeveloped countries natural resources· are underutilized or unutilized and a
small capital investment will lead to a large output.
(3) Similarly, in an underdeveloped country other productive resources are underutilized
and their productive capacity is low. So when a country starts on the road to economic
progress land, labour, management and existing plant and equipment are brought back
into productive use. Thus their productive capacity increases more than the amount of
capital invested.
(4) The capital-output ratio is lower in those countries where population grows more
rapidly. The reason being that rapid population growth prevents waste of capital by
assuring markets for almost any investment; and a rapid increase in the labour supply
permits capital accumulation without departing from the optimal ratio of labour to
capital.
(5) In view of the shortage of capital and the abundance of labour, there is greater
incentive to use capital saving methods of production in underdeveloped countries.
(6) If in the early stages of development, it is planned to concentrate on agricultural
development and other labour-intensive industries, the capital-out ratio will be low. For it
is possible to have a large output with a smaller amount of capital.

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(7) Since capital is not fully utilized in underdeveloped economies the rate of
depreciation is lower which means longer life of plant and equipment and low capital-
output ratio.

High Capital-output Ratio

Economists who favour a high capital-output ratio for underdeveloped countries gave the
following reasons:

(1) The capital-output ratio is higher in underdeveloped countries because there is much
wastage in the use of capital. Capital is wasted in the sense that manpower is inefficient
in handling and maintaining capital equipment properly. Moreover, due to the ignorance
of fruitful investment opportunities, capital is unable to move out to be utilized in more
productive channels.
(2) The level of literacy and education is extremely low in such countries
with the result that technological knowledge grows very slowly and where
the growth of technological knowledge is slow, capital is less fruitful.
(3) The capital-output ratio is bound to be high in those underdeveloped countries where
a large quantity of capital is needed to tap unutilized or underutilized natural resources.
As is the case with oil exploration.
(4) Moreover, countries with limited natural resources require more substitution of
capital for them.
(5) The capital-output ratio is expected to be high in those countries where population
increases more slowly than in those where it increases rapidly, on the premise that
"capital is likely to yield more if used with a greater rather than with a smaller increase of
labour."
(6) As an economy moves on the path of economic development, the pattern of demand
is likely to change which may necessitate the establishment of more capital-intensive
industries. For example, a change in demand from handmade to machine made goods
would increase the demand for capital.
(7) In the early stages of development, underdeveloped countries have to make large
capital investments in order to provide social and economic overheads such as schools,
hospitals, roads railways, and electricity, etc. Thus, the capital-output ratio is bound to be
high.
(8) According to Professor Kurihara, one basic explanation for the needlessly high
capital-output ratio of an underdeveloped economy is the promotion of more labour-
intensive techniques which may reduce output thus necessitating a greater use of capital.

(9) In underdeveloped countries, interest rate is very high and this is another important
explanation for the capital-output ratio to be so high in such economies. The expectation
of a continuing high interest rate tends to promote less 'capital-intensive' (or more
'labour-intensive') techniques and, via the latter's decreasing impact on output to make for
a high capital-output ratio, given a constant wage rate and a constant net profit rate.

(10) In underdeveloped countries where new plants and enterprises are located away
from the sources of raw materials, capital investment may be larger relatively to output
thereby raising the capital-output ratio.

(11) Lastly, in the initial stages of development certain types of capital investments are
likely to remain underutilized due to the stagnant nature of an underdeveloped economy
thus raising the capital-output ratio.

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Limitations of Capital-output Ratio

The use of capital-output ratio as a tool for estimating capital requirements in underdeveloped
countries is beset with a number of limitations.

(1) "Precise calculations of capital-output ratios can be made only in the light of concrete
programmes of development and the technical data regarding costs and output. But such
data are not easily available in an underdeveloped economy. Concrete programmes of
development are hampered by lack of capital equipment, labour and entrepreneurial
skills, changes in demand, prices and climatic conditions which adversely affect the
output.

(2) The capital-output ratio is not likely to remain constant throughout a plan. It is bound
to change as the development plan proceeds from year to year. As a result, there is wide
disparity between the projected ratio and the actual ratio.

(3) The use of capital-output ratio as a tool of economic planning is constrained by

the presence of underutilization or excess capacity in the use of resources in an
underdeveloped economy. It is, therefore, difficult to calculate the capital-output
ratio accurately.

(4) The capital-output ratio is meant to estimate the total capital requirements of an
economy but fails as a tool for determining priorities among different sectors or
projects in the economy.

(5) The capital-output ratio fails to tell us anything about investment in human capital
required to achieve a certain rate of growth. Investment in human capital is as important
for economic growth as is physical capital.

(6) There is, however, a practical difficulty in calculating the capital-output ratio. It
assumes that there is no change in the general art of production. But it is possible that a
technological innovation may increase output with the same amount of capital or the
same output may be had with less capital thereby changing the capital-output ratio
altogether.

(7) The concept of capital-output ratio is based on the implicit assumption that when
capital increases the supply of cooperant factors also increases. But in an underdeveloped
economy the cooperant factors like technical personnel, entrepreneurship, power,
transport, etc., are scarce.

(8) Difficulties arise in the measurement of capital and output. Professor

Myrdal mentions the following: First, in underdeveloped economies all planned
public investment and estimated private investment are lumped together to arrive
at capital input which is not a correct estimate of capital investments for they are
likely to change.

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(9) During a depression, all increases in capital will be followed by declines in
output and the capital-output ratio becomes a meaningless concept in such a
situation.

(10) Above all, the use of capital-output ratio as a technique for testing the development
plans of a country does not take us very far unless we go behind it. The overall capital-
output ratio is the average of the sectoral ratios. The national output is the sum of
different goods and services produced by various sectors of the economy, each having a
different capital-output ratio.

Despite these theoretical and practical limitations, the capital-output ratio is widely used as a
planning device. Its predictability is weak. But it appears to produce more meaningful results in
the long run than in the short run. It is analytically useful in calling attention to the importance of
capital in economic development.

Importance in Planning

1. The capital-output ratio is an important and useful concept for purposes of economic planning
in an underdeveloped country.

2. The capital-output ratio is thus used to determine the growth rate of an economy. The Harrod-
Domar models of growth are based on this concept.

In formulating a plan, in ICOR is required for the purpose of calculating the growth rate of the
economy. Suppose we want to increase national output by 10 and assume the ICOR to be 2. In
this case the required addition to the capital stock needed for new investment will be (l0x2=) 20.

Assuming the current level of national output to be 1000 and the saving rate 0.04, the domestic
saving will be 40. Now this much of domestic saving can be invested for the purpose of
increasing national output. Given the ICOR of 2, this amount of saving and investment would
increase national output by 20 (=40/2).

This gives the growth rate of 2.0 per cent per annum in national income. We can also calculate
the growth rate of national output (income) by dividing the saving ratio by the ICOR, i.e., 0.04/2
= 0.02 or 2.0 per cent.

3. The importance of capital-output ratio lies in making out the case for obtaining large foreign
aid for investment by underdeveloped countries. Since the domestic saving-income ratio is low
in underdeveloped countries, a higher rate of foreign aid is required for achieving a higher
growth rate, assuming a conventional capital output ratio of 3 to 4.

4. Thus the concept of capital-output ratio is a useful tool which highlights the importance of
capital in development planning, helps in testing the consistency of the desired growth rate and
the resources of an underdeveloped country.

Reference: Jhingan, M. L. The Economics of Development and Planning.