Productivity, Capital Output Ratio and ICOR.

First let us develop the general concept of average productivity and marginal productivity.

If one acre of land produces 2 Tonnes of food grains, then;

Productivity of Land = Output = 2 Tonne = 2 Tonne/acre

 Input (land) 1 acre Productivity of Labour = Output = 2 Tonne = 0.4 Tonne/labour

 Input (labour) 5 labourer

The above two are basically average productivity.

If by adding one extra labour, production increases by 0.2 tonne, then

Marginal productivity of labour = change in output = 0.2 tonne = 0.2 tonne/labour

 Change in labour 1 labour

Similarly, we can calculate productivity of capital = Output Capital Higher is the productivity of capital, it is good for the economy.

The inverse of “productivity of capital” is Capital/Output ratio.

Capital output ratio is the ratio of capital to output. It measures how much of capital is 

required per unit of output. So, if more capital is required per unit of output, then the  capital is less efficient. Hence, it also measures (average) efficiency of capital (but it is 

inverse).  Capital Output Ratio = Capital

 Output Higher the capital/output ratio, it is bad for economy. If Capital/Output ratio is 3/1, that 

means Rs. 1 unit of output is produced from Rs. 3 units of capital. And if Capital/Output 

ratio is 4/1, that means to produce Rs. 1 unit of output, Rs. 4 units of capital is required. 

So, 3/1 is better than 4/1 for the economy.

We measured capital/output ratio because we are not interested in measuring the 

productivity of capital rather we want to know that in India how much (average) capital is required to produces one unit (Rupee one) of output/GDP.

Our target variable is “output/GDP” and we are always interested in knowing that if we 

have to produce one unit of output then how much capital will be required.

So, now we are more interested in knowing that how much new/additional capital (in 

value/rupee) will be required to increase the output by one more unit (in rupee). This is 

because whenever a new government comes, it tries to attract new investment and hence it

is more interested in knowing that if it has to increase the GDP by one additional unit

then how much additional capital will be required. And for that we have another term 

called Incremental Capital Output Ratio (ICOR). (Our target variable is GDP/Output, so 

we/Govt. is always interested in knowing that how much extra capital will be require to 

produce one extra unit of output rather than the other way around).

Incremental Capital Output Ratio (ICOR) is defined as how much additional capital will be 

required to produce one additional unit of output. 

ICOR = change in capital = (change in capital/GDP) = investment % in GDP

 change in output (change in output/GDP) % change in GDP

ICOR represents how efficiently the new/additional capital is being used in a country to 

produce output.

If ICOR of India = 5, that means India requires Rs. 5 value of extra capital goods to produce 

Rs. 1 of additional output.

Investment % in GDP = “ICOR” X “% change in GDP”

From the above formula, if our ICOR is 5 and we want economic growth of 8% then we will 

have to do 40% investment. But if somehow, we are able to reduce our ICOR to 4 (by 

making ourselves more efficient) then we can achieve the same 8% economic growth with 

just 32% of investment.

The incremental capital output ratio is a catch-all expression. It depends upon a multiple 

number of factors such as governance, quality of labour which again depends on 

education and skill development levels, and technology etc.