THE ECONOMIC WEEKLY
Capital Output Ratio—Its Uses and Abuses
The capital/out put. ratio can he used as a rough guide to the rate of growth that can he attained in an
economy with a given rate of investment - and conversely, as an indicator of the savings necessary to attain
a given rate of growth. But there is danger in attaching too much imparlance to it even in this limited
context. The ratio holds good only in the long run; if tells us nothing about the investment in "human capital"
required to bring about a certain rate of growth; and it hides the truth that in an emergency. a given amount
of capital can yield jar greater output than past relationships may indicate.
For determining investment priorities, however, the concept is of no use at all and for choosing between
two rival technologies, it can only be one of the. many criteria that have to be satisfied.
IT has been suggested by Dr A s h ok
M i t r a t h a t the c a p i t a l / o u t p u t r a t i o
is determined p r i n c i p a l l y by the level
of wages and the p r o d u c t i v i t y of
l a b o u r . In a Crusoe-Friday eco-
nomy, where Crusoe sits a n d orders
a n d "feeds" F r i d a y , a n d the l a t t e r
tolls, Crusoe's investment m a y be
identified w i t h -the wages ( i n k i n d )
paid to F r i d a y out of Crusoe's (past)
savings. ( I n v e s t m e n t in the eco-
n o m y w o u l d .be given by F r i d a y ' s
t o i l , valued a t F r i d a y ' s wage.) L i k e -
wise, the o u t l a y on wages by the
entrepreneur could be treated, in the
m o d e r n setting, as the investment by
the entrepreneur; a n d in a K a l e c k i -
type model of the economy where
entrepreneurs are the o n l y savers
there being no savings out of wages
p a i d to w o r k e r s one view of invest-
m e n t w o u l d be a l l outlays necessary
t o b r i n g about production, t o t a l wage
payments ( i n c l u d i n g the wages part
of the cost of intermediate goods) be-
i n g the most i m p o r t a n t constituent of
such outlays. In this view of invest-
ment, the use of machinery a n d
equipment can be a l l o w e d for by
a d d i n g to t o t a l wages paid, the re-
placement cost of copital consumed
in the process of production. Given
the capital equipment a n d employ-
ment, output w o u l d be determined by
labour's dexterity, or labour produc-
t i v i t y . F i n a l l y , since the deprecia-
t i o n of capital is l i k e l y to be of a
s m a l l magnitude as compared to the
o u t l a y o n wages, f o r a l l p r a c t i c a l
purposes the c a p i t a l / o u t p u t r a t i o
w o u l d be given by the level of wages
a n d the p r o d u c t i v i t y of labour. Thus,
one w a y to lower the c a p i t a l / o u t p u t
r a t i o w o u l d be to lower wage rates.
M i t r a ' s i n t e r p r e t a t i o n of the capi-
t a l / o u t p u t r a t i o is based on an " i n -
s t a n t " view of c a p i t a l ; given certain
fixed assets, pr od u ctio n requires the
a p p l i c a t i o n of labour; a n d f o r the
economy as a whole, provision of
wages i n advance o f the f r u i t i o n o f
A s h o k M i t r a : A note on the
C a p i t a l / O u t p u t Ratio, T h e Econo-
m i c W e e k l y , A n n u a l Number, Janu-
a r y 1956, Page 109.
Arun Ghosh
output, m a y be t a k e n to i m p l y a
corresponding saving out of current
income, w h i c h alone makes possible
the act of production.
The m e r i t o f M i t r a ' s f o r m u l a t i o n
is t h a t it exposes the danger of iden-
t i f y i n g a higher c a p i t a l output r a t i o
with greater capital intensity.
T h o u g h under certain circumstances
these t w o may w e l l be associated,
there is no w a r r a n t for the belief
t h a t of t w o processes, the r e l a t i v e l y
more labour intensive method neces-
sarily has a lower c a p i t a l / o u t p u t
ratio. The capital/output ratio
o b t a i n i n g for the t w o techniques w i l l
be given by the t w i n factors (a) the
output accruing f r o m the t w o me-
thods of production, a n d (b) the sum
t o t a l o f savings- i n M i t r a ' s f o r m u l a -
tion, c u r r e n t savings -necessary in
the c o m m u n i t y to produce the requi-
site a m o u n t of output.
W h i l e M i t r a ' s f o r m u l a t i o n helps to
remove this popular misconception,
it falls i n t o an opposite k i n d of
error through, I believe, an a t t e m p t
to seek an explanation of the obser-
ved ''constancy" of the capital/output
r a t i o i n countries l i k e the U S A
where r a p i d increases in labour pro-
d u c t i v i t y have not brought about a n y
reduction in the capital output r a t i o
in the long r u n . because of a s i m u l t a -
neous rise in real wage rates. T h i s
separate issue we must, reserve for
another occasion. The inherent
weakness i n M i t r a ' s f o r m u l a t i o n o f
the concept of the c a p i t a l / o u t p u t
r a t i o can be seen f r o m the f o l l o w i n g
extreme example.
L e t ' X ' be the t o t a l (replacement)
value of capital in an economy a n d
let ' Y ' be the value of net output in
t h a t economy in a given year such
that X 3Y. F u r t h e r , let the expected
life-span of the fixed equipment be
assumed to be 30 years, so t h a t capi-
t a l consumption d u r i n g the year
w o u l d be X / 3 0 . F u r t h e r , let the t o t a l
wage payments be t a k e n as 2 Y / 3 . On
M i t r a ' s view, therefore, the Invest-
m e n t involved in producing an out-
put of ' Y ' w o u l d be given by 2 Y / 3 +
X / 3 0 , or 2 Y / 3 | Y/10, or 23Y/30,
707
June 23, 1956
g i v i n g a c a p i t a l / o u t p u t r a t i o of
077:l. On the other hand, under
the s i m p l i f y i n g assumptions made
above and w i t h o u t entering i n t o
an a r g u m e n t as to the definition of
capital t h e c a p i t a l / o u t p u t r a t i o has
been defined a s 3 : 1 i n the f i r s t
sentence of this paragraph.
H o w does this c o n t r a d i c t i o n arise?
E v e n if we accept, f o r the time be-
i n g , M i t r a ' s concept of capital a n d
of investment it w o u l d be seen t h a t
M i t r a compares i n terms o f m a g n i -
t u d e s - i n v e s t m e n t d u r i n g any g i v e n
period w i t h the t o t a l net output I n
t h a t period, w h i c h has been produ-
ced by labour In conjunction w i t h the
accumulated capital (savings) of the
past, a n d not merely in conjunction
w i t h the savings (investment) of the
c u r r e n t year. It w i l l be conceded
t h a t in a period of depression net
i n v e s t m e n t m a y w e l l f a l l t o zero o r
be even negative, but net o u t p u t w i l l
be a positive magnitude. M i t r a gets
out of this difficulty by a t w i s t of
logic whereby wage payments are
defined as investment, so t h a t we get
a f a i r l y "even" series of the invest-
m e n t / o u t p u t relationship; i n a n y
case, wage payments must be
positive for output to be positive. B u t
f o l l o w i n g M i t r a ' s own logic, w e m a y
well derive the f o l l o w i n g absurd re-
lationship between investment and
output.
Value of gross output
— i n p u t of m a t e r i a l s (inch depre-
ciation )
net output
a l l factor payments ( i n c l u d -
i n g wages and remuneration t o
other factors necessary to b r i n g
about production)
Investment
Hence, investment net o u t p u t a n d
c a p i t a l / o u t p u t r a t i o is a l w a y s u n i t y .
M i t r a does not state this explicit-
l y ; but his thesis, whereby out-
lay - investment by a t w i s t of his
o w n logic, is obviously not intended
to give a definitional equation of the
economic system. T h i s approach to
 June as, 1956
the concept o f c a p i t a l / o u t l a y r a t i o
has, on the other hand, some special
uses; but the usefulness of this con-
cept arises m o s t l y f r o m disproving a
series of popularly accepted notions
a n d beliefs, a n d n o t as a v a l i d con-
cept in itself.
At this stage, it m a y be useful to
ask as to w h a t r e a l l y the c a p i t a l /
output r a t i o really connotes. There
can be t w o w a y s in w h i c h the p r o -
blem can be examined; f r o m the
s t r i c t l y theoretical point of view,
s t a r t i n g w i t h a definition of c a p i t a l
a n d f r o m the operational or measure-
m e n t p o i n t of view. We w i l l here
adopt the l a t t e r m e t h o d by reason
of its greater s i m p l i c i t y ,
Difficulties of Measuring Aggregate
Capital
The value of existing stock or
fixed capital a n d equipment- i.e. of
durable replaceable capital can be
t a k e n either as the gross (Invest-
m e n t ) value of e x i s t i n g capital less
accumulated capital consumption, or
as the replacement value of existing
assets a n d equipment.** There m a y
be differences In the value of physi-
c a l assets as measured in the t w o
ways noted above, a r i s i n g out of
changes in the price level. B u t even
if an adjustment for price changes
were to be made, in measuring the
t o t a l value of the existing stock of
physical assets, t w o difficulties w o u l d
arise: the difficulty of relative price
changes, and of a change in weights,
i n the v a l u a t i o n o f t o t a l output; a n d
more significantly, the lower v a l u a -
t i o n o f e x i s t i n g physical assets i n
the event of a rise in real wage rates.
The first of the above t w o diffi-
culties, i.e. a change in relative
weights, is essentially a problem of
measurement, and reflects the inade-
quacy of usual procedures of index
number construction for d e r i v i n g
a n y "constant price" series. But. the
problem of lower v a l u a t i o n of capi-
t a l in a period of, r i s i n g real wage
rates (or vice-versa) remains. ( I n -
deed, this is one of the lessons w h i c h
One m a y recall Keynes' t r e a t m e n t
of a l l Government expenditure as
Investment, for the purpose of his
m u l t i p l i e r analysis. T h a t was
useful for a given type of analy-
sis; a n d obviously, it was not i n -
tended t o i m p l y t h a t a l l Govern-
ment outlay1 was to be treated as
' 'investment ' in every context.
There have been attempts to l i n k
he gross value of output w i t h
gross investment (cf), for instance,
T h e Economic B u l l e t i n f o r A s i a
a n d the F u r East, November 1955,
p 26), but the precise significance
of this relationship is not v e r y
clear.
emerge f r o m M i t r a ' s analysis o f the
c a p i t a l / o u t p u t r a t i o . ) Since durable
assets have a l o n g life, i n a period
of i n f l a t i o n the m o n e y value of exist-
i n g p h y s i c a l assets tends to be u n -
derstated. T h i s can, of course, be
corrected by a l l o w i n g for price chang-
es. B u t in a period of r i s i n g l a b o u r
p r o d u c t i v i t y (and r i s i n g real wage
rates), the real value of e x i s t i n g
physical assets—produced at a l o w e r
level of r e a l wages—would get u n -
derstated.
It is thus conceptually difficult to
define, and operationally difficult to
measure capital in the aggregate
sense; and hence, correspondingly, to
derive the average c a p i t a l / o u t p u t
r a t i o . F u r t h e r m o r e , for purposes of
projections or f o r planning, the
average c a p i t a l / o u t p u t r a t i o has not
much significance, especially because
of distortions in past relationships
a r i s i n g f r o m v a l u a t i o n difficulties
noted earlier. A n a l t e r n a t i v e f o r m u -
l a t i o n , w h i c h avoids the above diffi-
culties is the m a r g i n a l c a p i t a l / o u t p u t
ratio, w h i c h relates the additions to
output accruing f r o m a d d i t i o n a l i n -
vestments made f r o m year to year.
Marginal Ratio
A number of different f o r m u l a t i o n s
are possible in respect of the m a r g i -
nal c a p i t a l / o u t p u t ratio. To begin
w i t h , i n d e r i v i n g the c a p i t a l o u t p u t
ratio, capital m a y be t a k e n to con-
note not o n l y fixed investments but
also w o r k i n g capital required f o r
production.'' It is obvious t h a t in
c o m p u t i n g the c a p i t a l / o u t p u t r a t i o ,
the requirements of w o r k i n g c a p i t a l
cannot be assumed away; but corres-
pondingly, violent fluctuations i n i n -
v e n t o r y holdings cannot also be i n -
cluded in c o m p u t i n g the c a p i t a l / o u t -
put ratio, w h i c h has some s i g n i f i -
cance only aw an i n d i c a t o r of a l o n g -
t e r m relationship. The remedy for
this lies in t a k i n g the m a r g i n a l capi-
t a l / o u t p u t r a t i o over a number of
years, so t h a t a l l cyclical a n d r a n -
dom fluctuations ( i n inventories as
w e l l as in o u t p u t ) may be evened
out.
F r o m the measurement point of
view, it is easier to take m a r g i n a l
savings as g i v i n g the numerator, a n d
o u t p u t Increases as the denominator.
T h i s procedure saves a number of
a w k w a r d difficulties connected w i t h
T h i s pertains n o t only to the deri-
v a t i o n o f the m a r g i n a l c a p i t a l /
output r a t i o but also the average
c a p i t a l / o u t p u t r a t i o ; but i n the
l a t t e r instance, the importance or
fluctuations in i n v e n t o r i e s — w h i c h
depend to a considerable extent on
speculative considerations — is
minimised.
708
THE ECONOMIC WEEKLY
the v a l u a t i o n of capital or Its q u a n -
t i t a t i v e measurement, a n d a l l o w s f o r
bad investments or investments
abandoned before completion, as Well
as p r e l i m i n a r y expenses on explora-
t i o n , etc. B u t even t h i s procedure
does not a l l o w f o r a number o f diffi-
culties inherent i n a n y analysis o f
the m a r g i n a l c a p i t a l / o u t p u t r a t i o .
Time Lag between Investment and
Return
The first difficulty is connected
w i t h the roundaboutneas of the pro-
cess of production, a n d t h o u g h ap-
parently simple, makes f o r difficul-
ties in i n t e r p r e t i n g the c a p i t a l / o u t p u t
ratio. W i t h v a r y i n g lengths o f the
'gestation' period of investment, t h e
danger of simultaneous association
of investment a n d output is manifest;
w h a t is not so obvious is t h a t under
conditions of competition a l l o w i n g
f o r a certain degree 'of "lumpiness"
of capital -the c a p i t a l / o u t p u t ratio,
adjusted for the discounted value of
output over the expected period of
l i f e of capital, should be equal f o r
a l l investments. I n c o m p u t i n g 'the
c a p i t a l / o u t p u t ratio, therefore, should
allowance be made for the l a g be-
tween investment and the accrual of
output? If no allowance Is made f o r
this lag, investments m a t u r i n g quick-
ly would appear advantageous over
Investments w h i c h may, in the long
r u n , be better. On the other hand.'
no computation of the c a p i t a l / o u t p u t
r a t i o , after a l l o w i n g for such lags,
w o u l d have any meaning. N o t only
w o u l d the concept be vague, b u t the
measurement of the c a p i t a l / o u t p u t
r a t i o w o u l d be nearly impossible.
A n o t h e r difficulty a r e l a t i v e l y
m i n o r one is t h a t in an expanding
economy, the c a p i t a l / o u t p u t r a t i o
must always be r i s i n g . This, again,
follows f r o m the 'lag' between invest-
m e n t a n d the a c c r u i n g output, so
t h a t in a period of expanding Invest-
ment, the c a p i t a l / o u t p u t r a t i o w i l l
a l w a y s tend to rise.
B u t the m a j o r difficulty i n the
measurement of the c a p i t a l / o u t p u t
r a t i o whether the average or the
m a r g i n a l concept be under considera-
Frequently, a capital/output-capa-
c i t y r a t i o is recommended as a
meaningful measure, in order to
determine investment priorities.
T h i s can o n l y relate to physical
output capacity, a n d has some re-
levance i n the l i m i t e d context o f
p l a n n i n g the investment p r o g r a m -
me ( w i t h a l t e r n a t i v e types of
equipment) in a single i n d u s t r y .
B u t obviously, the concept/has no
f u r t h e r use either f o r the economy
as a whole, or even for c o m p a r i n g
sectoral capital/output ratios
( w h i c h , as we w i l l see later, mean
very l i t t l e t h e m s e l v e s
THE ECONOMIC WEEKLY

709
June 23, 1956
t i o n - - i s t h a t the cost of investment
in ' t r a i n i n g ' etc, is seldom or never
treated as p a r t of investment for
reasons of conceptual and of mea-
surement difficulties. W i t h increas-
i n g complexity of the process of pro-
duction, labour has to acquire tech-
n i c a l s k i l l and technical knowledge;
a n d the need to a l l o w for the cost
of t r a i n i n g etc. as an overhead i n -
vestment cost is a d m i t t e d almost
u n i v e r s a l l y . B u t in practice such
allowance is seldom made, if only
because n o t a l l expenditure on edu-
cation can (or should) be regarded
as investment; and by the same
token, expenditure on health, a n d
indeed, even on n u t r i t i v e foods, can
w e l l be regarded as "investment".
(The danger of logical h a i r - s p l i t t i n g
is t h a t s t r i c t l y in theory there can
be no l i m i t to the extent of such
" s p l i t t i n g " of hairs u n t i l they are
reduced to "electrons'' or "protons".)
Use of the Concept
Where does a l l this lead us? We
are s t i l l a long w a y f r o m a satis-
f a c t o r y definition of the c a p i t a l /
output r a t i o , and we seem to be re-
ceding f r o m the position where any
sensible use can be made of this
m u c h boosted concept. A n d since
a l l w o r k a b l e definitions appear to f a i l
us, we m a y enquire whether, and to
w h a t extent, the concept of the capi-
t a l / o u t p u t r a t i o can be of use f o r
policy m a k i n g .
The concept of c a p i t a l / o u t p u t r a t i o
was suddenly "discovered" after
H a r r o d ' s exposition of his model of
the g r o w t h of an economy; a n d the
first use of the concept was to give
the rate of g r o w t h t h a t can be at-
tained in an economy w i t h a given
rate of investment. Leontief extend-
ed this use by t r e a t i n g c a p i t a l as an
"input", in his input-output analysis,
f o r d e r i v i n g the s t r u c t u r a l r e l a t i o n -
ship in any economy between output
of different kinds. There have, of
late, been some attempts to t r e a t the
c a p i t a l / o u t p u t r a t i o as a c r i t e r i o n for
d e t e r m i n i n g investment priorities.
F i n a l l y , it is recommended as a c r i -
t e r i o n for the choice of different
technologies for d e r i v i n g a given out-
put, as M i t r a has done, for instance.
T h a t the c a p i t a l / o u t p u t r a t i o can
be used as a r o u g h guide to the rate
of g r o w t h that, can be a t t a i n e d in an
economy w i t h a given rate of invest-
ment - a n d conversely, as an indica-
t o r of the savings necessary to at-
t a i n a g i v e n rate of g r o w t h few
w i l l deny. B u t as already observed
earlier, there is danger in a t t a c h i n g
too much importance to the c a p i t a l /
output r a t i o even in this l i m i t e d con-
text. The c a p i t a l / o u t p u t r a t i o holds
good (as a constant) o n l y in the l o n g
r u n ; i t tells u s n o t h i n g about the i n -
vestment i n " h u m a n c a p i t a l " requir-
ed to b r i n g about a certain rate of
g r o w t h ; a n d i t hides the t r u t h t h a t
in an emergency, a given a m o u n t of
capital can yield f a r greater output
t h a n past relationships between i n -
vestment a n d o u t p u t m a y indicate.
Factories can be w o r k e d on a second
or t h i r d shift if necessary; the use
of capital can be rationalised; and
the same equipment can give signi-
ficantly different outputs w i t h differ-
ent types of labour. A s h o k M i t r a ' s
concept of " d e x t e r i t y " as a factor in
the capital output r a t i o thus reap-
pears as an i n c o n t r o v e r t i b l e factor
in the equation.
H o w to measure the c a p i t a l / o u t -
put r a t i o even f o r the l i m i t e d pur-
pose indicated earlier? My o w n
preference is to t r e a t output increases
ay a function of the rate of saving,
This has its l i m i t a t i o n s , as we have
seen, b u t m a k i n g allowances for
cyclical v a r i a t i o n s , the above mea-
sure of the c a p i t a l / o u t p u t r a t i o
w o u l d have the t w i n advantages of
measurability and of practical signi-
ficance in the context of changing
prices and labour p r o d u c t i v i t y . No
adjustments are necessary for a
comparison of the rate of savings
w i t h the rate of g r o w t h of the
economy.
Investment Priorities
The use of the c a p i t a l / o u t p u t r a t i o
as a c r i t e r i o n for d e t e r m i n i n g invest-
ment priorities is, however, to put it
m i l d l y , not very correct. F o r the
economy as a whole, the output ac-
c r u i n g directly f r o m any investment
is quite unconnected w i t h the t o t a l
increase in output in the economy
resulting f r o m the investment; for a
private investor, w h a t is relevant is
the discounted net r e t u r n (profit) on
his investment, f o r the entire period
of life of the investment. T h i s is
so obvious t h a t the point need not
detain us any further.
Where a choice is necessary be-
tween t w o r i v a l technologies, the
c a p i t a l / o u t p u t r a t i o can be only one
of m a n y criteria, for the choice of
the best a l t e r n a t i v e . The choice of
technology for p r o m o t i n g develop-
ment, however, is a subject by itself,
and quite a few readers of the
Eonomic Weekly are at present
exercised by the m a n i f o l d aspects of
this problem. Without, d e l v i n g any
deeper i n t o this subject, therefore,
It m a y be well to sum up our con-
clusions on the n o t i o n of the c a p i t a l /
output r a t i o .
The function of capital is to raise
710
THE ECONOMIC WEEKLY
labour p r o d u c t i v i t y . B u t c a p i t a l I
o n l y one of several elements—thoug)
undoubtedly a v e r y i m p o r t a n t ele
m e n t — i n r a i s i n g labour p r o d u c t i v i t y .
There is use in a b s t r a c t i n g c a p i t a l
f r o m the other factors o n l y as an a n -
a l y t i c a l exercise; in p l a n n i n g f o r de-
velopment, the c a p i t a l / o u t p u t r a t i o
fas o b t a i n i n g in the past) tells mere-
ly of the physical asset f o r m a t i o n
necessary for o b t a i n i n g a given out-
put; the concomitant expenditures
on education, t r a i n i n g , etc. w h i c h
are equally necessary to o b t a i n the
given output are not indicated. T h i s
is generally recognised, but. frequent-
l y forgotten when m a k i n g ready
comparisons. I t m a y w e l l h e t h a t
in a given situation, expenditure f o r
raising the level of technical s k i l l ,
as well as expenditures t h a t w i l l "in-
crease general awareness, i n i t i a t i v e
a n d enterprise — howsoever these m a y
be fostered m a y be of greater bene-
fit in r a i s i n g the level of output in
an economy, t h a n the i n t r o d u c t i o n
of isolated pockets of h i g h l y me-
chanised i n d u s t r i a l units. The f a c t
t h a t a few foreign investments have,
in no country, raised the general
level of i n d u s t r i a l development, is
proof of this.
The c a p i t a l / o u t p u t r a t i o is a use-
less concept in the d e t e r m i n a t i o n of
investment priorities; and hence, of
l i t t l e use in actual p l a n n i n g . A s h o k
M i t r a ' s concept of the c a p i t a l / o u t p u t
r a t i o is perhaps more useful in t h i s
connection t h a n capital / o u t p u t r a t i o
as it is generally understood; but
M i t r a ' s concept is not an appropriate
concept of the c a p i t a l / o u t p u t r a t i o
either for a p r i v a t e investor or f o r
the economy as a whole.
F o r practical purposes, a r o u g h
measure of the c a p i t a l / o u t p u t r a t i o
is best derived f r o m the savings
coefficient. It is easy to calculate
the statistical relationship between
the rate of savings and the g r o w t h
of n a t i o n a l income the f o r m e r ad-
justed for external b o r r o w i n g . L i k e
m a n y other simple correlations in
statistics, the relationship m a y n o t
give a correct s t r u c t u r a l equation of
the economic system, but is good
enough for prediction.