§2. The Method of Comparative Advantage

The second (B) investment opportunity principle, that of maximum present value, is of great importance and has many aspects not always recognized as related to one another. Let us restate this maximum value principle in an alternative form, thus: one option will be chosen over another if its income possesses comparative advantages outweighing (in present value) its disadvantages.

To illustrate this alternative method of stating the same principle—which method might be called the method of comparative advantage—let us recur to the example of the land. We found that, when the rate of interest was 4 per cent, the owner would elect the forestry use, since this possessed the greatest present value. If we now compare, year by year, the income from the land when used for forestry purposes with the income which it might have yielded if used in one of the other ways, as for instance farming, we shall see that in some years there is an excess in favor of the forestry use, and in other years a deficiency, as shown in the table on the following page.

Here we see that, in the first four years, there are comparative disadvantages, a differential sacrifice, amounting in the four respective years to $450, $450, $150, $50. These are the disadvantages from the use of the land for forestry purposes as compared with its use for farming, but the disadvantages are offset later by advantages in return amounting to $50 each year perpetually. If prior to the first year listed above the owner has been using the land for farming purposes and was considering the advisability of changing over to forestry, he would think of the disadvantages or sacrifices of $450, $450, $150 and $50 Edition: current; Page: [153] as investments or costs and the advantages of $50 each year in perpetuity as returns on these investments or costs. And he could think of the proposal to substitute the forestry use for the farming use as an opportunity to invest the $450, $450, $150, and $50 for the sake of securing the return of $50 each year thereafter. If, now, we take the total present value, at 4 per cent, of the deficiencies, or investments, of $450, $450, $150, and $50, we shall obtain $1025, whereas the present value of the returns of $50 per annum beginning in five years and continuing in perpetuity will be $1069. Thus the present value (at 4 per cent) of the gains exceeds the present value of the sacrifices or costs by the difference between $1069 and $1025. As reckoned in present estimation, the gains of income outweigh the costs or sacrifices of income. We may say, therefore, that, the rate of interest being 4 per cent, forestry is preferable to farming because of a surplus of advantages over disadvantages reckoned in present value. Thus, the opportunity to invest by Edition: current; Page: [154] switching over from farming to forestry is, if money can be borrowed at 4 per cent, more than worth while.

But if the rate of interest were 4½ per cent, the comparison would be different. The present value of the sacrifices or costs would be $1016, and the present value of the gains or returns $932, showing a preponderance of the sacrifices or costs. That is, if the rate of interest is 4½ per cent, the cost from using the land for forestry rather than farming outweighs the returns. Therefore, when money is at 4½ per cent, the land would not be used for forestry purposes.

The general principle is, therefore, that among the various options open to the capitalist he chooses the most advantageous, or more fully expressed, the one which, compared with any other, offers advantages which in present value at the given rate of interest outweigh the disadvantages. But this is evidently merely another formulation of the original principle that the use chosen will be the one which has the maximum present value at the given rate of interest.

We may summarize the method of comparative advantage as follows: We are constantly confronted with the opportunity to choose one income stream rather than another. We inquire what difference it makes whether one or the other alternative is chosen. We find often it makes two kinds of differences, advantages and disadvantages. If we start with the option which has the more immediate advantages and ask whether it is or is not worth while to give up this option and adopt the other instead, we may call the proposal so to do an opportunity to invest, i.e., to incur certain disadvantages or, as they will hereafter be called, costs, for the sake of certain advantages or, as they will hereafter be called, returns.Edition: current; Page: [155] And we decide whether or not this investment opportunity is worth while by weighing the costs against the returns in terms of present worth, as reckoned by the rate of interest.