Incremental Capital Output Ratio (ICOR)
Candlefocus EditorThe formula for calculating ICOR is quite simple. It is calculated by taking the change in investment expenditure (I) and dividing it by the resulting change in GDP (GDP):
ICOR = Change in Investment Expenditure / Change in GDP
It is a measure of the amount of capital needed to produce one extra unit of output. A lower ICOR ratio is better as it indicates that less investment is required to produce an additional unit of output. This implies that the economy is much more efficient as capital is being used to its fullest potential.
But ICOR is not without criticism. It is often argued that ICOR favors developing nations, where increases in infrastructure, technology, and labor can significantly boost output without necessarily requiring a huge increase in investment. Developed nations, however, are already utilizing their resources to the fullest and so ICOR scores in these countries will be naturally lower reflecting this fact.
More broadly, ICOR can serve as a useful tool for policymakers in gauging how well their economy is doing, and how much further it can be pushed with additional investment. By clamping down on wasteful spending, countries can ensure that their capital investments are providing maximum return, improving the economic health of their citizens.