Capital-output Ratio Criterion for Investment in Development Planning
Capital-output Ratio Criterion for investment in development planning
An investment criterion that has often been advocated by various economists is that of capital output ratio. That is, in choosing among investment projects and in determining priorities, capital-output ratios of different investment projects be compared. Those investment projects (for their technical forms) should be selected that minimize the capital-output ratio. If capital-output ratio of investment A (3:1) is less than the capital-output ratio of investment B (5: I), then, in developmental planning investment A must get priority over investment B.
The underlying assumption of this criterion is that products in which capital investment is to be made are substitutes of each other. If every project is a substitute of every other, there is no reason why we should not prefer a low marginal ratio of capital to net output. The classic case of substitutability is provided by the problem of choosing between alternative techniques to produce the same commodity. Various examples can be given of it. Additional food grains production can be had either from constructing major irrigation works or by building small irrigation works or by producing and using more fertilizers. Electricity can be produced cither by thermal projects or by hydel projects. Further, more cloth can be produced either in the handloom (khadi-cloth) sector or in the mill sector (mill-cloth).
Criticism of Capital-output Ratio Criterion
But the criterion of capital-output ratio has been subjected to serious criticism. It is maintained that the economic world is not an abode of perfect or very high substitutability. For example, the allocation of investment between agriculture and industry or between consumption goods and investment goods cannot be adjudged on the basis of capital-output ratio, since the degree of substitutability between these products is very limited. Agricultural products and industrial products are complementary rather than substitutes.
Again, what should be compared in choosing among investment projects is not their capital-output ratios, but their contribution to income during a crucial period. The goal of development policy is not the maximum output at a point of lime but a maximum rate of growth over time.
Moreover, capital-output ratio may be one of the criteria when substitutes are involved, but it is not the sole criterion. There are many other considerations too, such as the labor-investment ratio and the effect of investment on income distribution. In a developing country like India where fuller employment and better distribution of income and wealth are also the cherished aims of the Five-Year Plans, these other considerations of any investment project are of paramount importance.