CHAPTER

77
Concept The Concept of Capital-Output Ra Capital-Output Ratio
MEANING
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 Rs. 5 crores is essential to secure an output (income) worth Rs. 1 crore. 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 capitaloutput ratio. The average capital-output ratio (ACOR) 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 amount of increase in out-put (income) Y, resulting from a given increase in stock of capital, K. This can be indicated as K/Y. In other words, the average capital-output ratio refers to everything that has been invested in the past and to the whole income. The marginal ratio refers to all that has been added in a recent period to the capital or income.1 The former is a static concept, while the latter is a dynamic one. The term capital-output ratio as used in Economics relates to the incremental or marginal capital1. Tinbergen. Development Planning, p. 79.

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output ratio. This ratio normally ranges R between 3 to 4 and rotates to a period of time. E Since it has a time dimension, it is expressed K F K as recoupment period in the communist D Y countries. The average capital-output ratio and the ICOR are shown in Fig. 1 where output is taken on the horizonal axis and capital on the vertical axis. The average capital-output ratio is measured by the slope of a line from the origin to the function relating capital to total output. In Fig. 1 OKF is such a function and OR is the ray that passes through it at O point K so that the ACOR is KY/OY. The ICOR Y Output is measured by the slope of a tangent drawn Fig. 1 to the function at point K. Thus the ICOR is ED/KD (= 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 capitalintensive techniques the capital-output ratio would be high and in an other sector using labourintensive 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.2 CAPITAL-OUTPUT RATIO IN UNDERDEVELOPED ECONOMIES Various estimates have been made of capital-output ratios in under-developed economies. A group of experts appointed by the United Nations used a ratio ranging from 2:1 to 5:1; Kurihara has assumed a ratio for majority of under developed countries in the order of 5:1; Singer in his model for economic development assumes a ratio 6:1 in the non-agricultural sectors and 4:1 in the agricultural sector and on an average takes a ratio of 5 :1; Resenstien-Rodan estimates that the ratio is at least 3:1 and 4:1;3 while Lewis regards this ratio to lie between 3:1 and 4:1.4 According to H.K. Manmohan Singh, in developed countries the range of capital-output ratio is believed to lie between 2.9:1 and 4:1, and in underdeveloped countries this ratio may be supposed to lie between 1.5:1 and 2:1.5 In India the ICOR on an average works out to 2.4 for the three plan period.6 Capital

2. W .B. Reddaway. The Capital-output Ratio, Indian Economic Review, February, 1960. 3. Meier and Baldwin, op. cit., p. 340. 4. Lewis, op. cit., p. 201. 5. H.K.M. Singh, Demand Theory and Economic Calculation in a Mixed Economy, p. 83, 6. Government of India, Planning Commission, Fourth Five-Year Plan, 1969-74.

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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, the composition of investment, the pattern of demand, the relation of factor prices, the extent of the utilization of social and economic overheads and the impact of industrialization, education and foreign trade on the economy. Let us examine these factors in detail. Availability of Natural Resources. 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. 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. 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 capitaloutput ratio is determined by the proportion of national income invested annually. So it is not surprising, writes Prof. Lewis, that countries which invest much the same proportion of national income have much the same capital-output ratio.7 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. 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. This is because new investment and new technology go together. The technology of the last ten years is embodied in half the capital in the first case, but only in perhaps a third of the capital in the second case.8 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 high and vice versa.
7. Op. cit., p. 202. 8. W.A. Lewis, Development Planning, 1966.

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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. 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. Contrariwise, if the quantity and quality of entrepreneurship are low, the capital-output ratio will be high. Pattern of Demand. The pattern of demand also influences the capital-output ratio. Given the prices and income 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 terylene, nylon, etc., has led to the establishment of plants for their manufacture thereby raising capital-output ratio. 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. Employment Policy. Capital-output ratio further depends on employment policy. In an overpopulated country like India 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. 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. Spread of Education. With the spread of literacy and education, efficiency increases which tends to make a better use of capital equipment whereby the capital-output ratio falls and vice versa. 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 fructify, 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 leads to increasing returns. This further leads to the fullest utilization of existing capital equipment thereby increasing the output. Thus the capital-output ratio is damped. Impact of Export and Import. In order to earn more foreign exchange and to avoid balance of

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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. NATURE OF CAPITAL-OUTPUT RATIO It is, however, not possible to arrive at any definite conclusion about the behaviour of the capitaloutput 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,9 Simon Kuznets10 and Leibenstein.11 This parabolic nature of the capital-output ratio is supported by the following empirical evidence. In the United States the capital-output ratio rose from 2.8 in 1880 to about 3.9 in 1929 and then fell to 3.2 in 1944,12 and to 1.6 in 1960. In the UK, it rose from about 4.5 in 1865 to over 6 in 1895 and stayed almost stable up to 1913,13 when it started declining and was 2.9 in 1952.14 No doubt, these estimates relate to developed economies yet they are a useful guide in understanding the general behaviour of the capital-output ratio in underdeveloped economies. V.V. Bhatt on the basis of his computations of Indian industries and their comparison with the industries of the developed countries comes to the conclusion that the capital-output ratio is on an average about the same in both developed and underdeveloped economies. 15 The experience of a number of countries suggests that on an average the ratio lies between 3:1 to 4:1 and above 4:1 only in periods of slow economic growth. A UN study corroborates that during the ten years ending in 1963 about 70 per cent of the developing countries had an incremental capital-output ratio ranging between 3 and 4.16 We may wind up the discussion thus, In the early stages of economic development two contrary forces operate on the capital-output ratio. On the one hand, there is a vast requirement of basic overhead capital in transport, power, education, etc. Here, due mainly to the long period over which such investment yields its return, the apparent (short run) capital-output ratio is high. On the other hand, there are generally large unexploited backlog of known techniques and available natural resources to be put to work; and these backlogs make for a low capital-output ratio. We can assume formally a low capital-output ratio for the take-off period on the assumption that the pre-conditions have been created. In fact, the aggregate marginal capital-output ratio is likely to be kept high during take-off by the requirement of continuing large outlays for overhead items which yield their returns only over long periods. Nevertheless, a ratio of 3 : 1 or 3.5 : 1 for the incremental capitaloutput ratio seems realistic as a rough bench-mark 17

9. Colin Clark, The Conditions of Economic Progress, p. 580. 10. Population, Income and Capital, International Social Science Bulletin, 1954, No. 2, Vol. 6. 11. Economic Backwardness and Economic Growth, pp. 177-85. 12. Simon Kuznets, op. cit., pp. 169-70 13. Ibid. 14. H.K. Manmohan Singh, op cit. 15. V.V. Bhatt, Employment and Capital Formation in Underdeveloped Economies, pp. 20-59. 16. World Economic Survey1966, op. cit. 17. W.W. Rostow, The Process of Economic Growth, op. cit., p. 211. Italics mine.

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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) Prof. Lewis points 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.18 (2) In under developed 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-output ratio will be low. For it is possible to have a large output with a smaller amount of capital. (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 adduce 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 ignorance of fruitful investment opportunities, capital is unable to move out of the rut 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 in India. (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.
18. W.A. Lewis, op. cit., p.202.

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(6) As an economy moves on the path of economic development, the pattern of demand is likely to exchange 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, under developed 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 Prof. Kurihara, one basic explanation for the needlessly high capital-output ratio of an under developed economy is promotion of more labour-intensive techniques which may reduce output thus necessitating a greater use of capital.19 (9) In under developed countries interest rate is very high and this is another important explanation for the capital-output ratio to be so high in such economies. On the face of it, it sounds paradoxical, for a high rate discourages rather than encourages the use of capital and thus has a tendency to lower the capital-output ratio. Kurihara admits this fact but solves this paradox by applying the reasoning that the expectation of a continuing high interest rate tends to promote less capital-intensive (or more labour-intensive) techniques and, via the latters decreasing impact on output to make for a high capital-output ratio, given a constant wage rate and a constant net profit rate.20 (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. LIMITATIONS 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 ratio can be made only in the light of concrete programmes of development and the technical data regarding costs and output.21 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 arid the actual ratio. For instance, the First Indian Five-Year Plan assumed a marginal capital-output ratio of 3:1 but realized 1.8:1 in practice. (3) The use of capital-output ratio as a tool of economic planning is circumscribed by the presence of underutilization of 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.
19. K. Kurihara, op. cit. pp. 94-97. 20. Ibid., pp. 98-99. 21. Government of India, Second Five-Year Plan, op. cit.

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(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 co-operant factors like technical personnel, entrepreneurship, power, transport, etc., are scarce. The concept is thus impracticable in the context of an underdeveloped economy. (8) Difficulties arise in the measurement of capital and output. Prof. 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. Second, various restrictions and direct controls prevent prices from equalising demand and supply. It requires the use of which is again arbitrary. Third, the specificity, heterogeneity, complementarity and indivisibility of capital in South Asia make aggregation impossible. Fourth, if there are several items on each side of the capital-output ratio, and if those do not change in the same proportion, we are faced with the problem of index numbers, including the indeterminancy introduced by price changes in the planning period and by different income distributions. Fifth, anything that changes the relative prices of capital goods and consumer goods generally, whether from the demand side or the supply side will alter the capital-output ratio, even without any change in physical capital, physical output or technology. In particular, changes in real wages, in the rate of interest and in the prices of imports will change the capital-output ratio, even though neither the composition of capital nor techniques have changed? (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. The sectoral capital-output ratios are high for some sectors like housing, transport, communications,-irrigation and power projects; and low for the agricultural service and consumers goods industries. But it is difficult to calculate these sectoral capital output ratios due to lack of statistical data. Conceptional difficulties also arise in the case of certain items like fertilizer production which can be placed in either the agricultural sector or the heavy industries sector. Thus the overall capital-output ratio which is a made up of sectoral ratios is not a correct estimation for testing the consistency of the developmental plan. Conclusion. 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. It possesses great usefulness as a handy device

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for making rough-and-ready calculations. But Prof. Kindleberger is of the view that in its present rudimentary stage it is hardly a planning device.22 IMPORTANCE IN PLANNING The capital-output ratio is an important and useful concept for purposes of economic planning in an underdeveloped country. This is particularly true where it is necessary to check the consistency of targets for the growth of national income against the additional capital likely to be available from current savings of foreign investment. In order to estimate the financial requirements of growth, it is necessary to have an estimate of the volume of investment needed to attain a given target of output. 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, an 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 (10x2=) 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 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 per cent. Moreover, the importance of capital-output ratio lies in making out the case for obtaining large foreign aid for investment by under-developed 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. 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 resourcers of an underdeveloped country.

22. C.P. Kindleberger, op. cit.