§3. The Nature of Investment Opportunity

In the second approximation—which, as we have just noted, contains all that is most typical in the theory of the rate of interest—the distinctive factor is the rate of return over cost or the investment opportunity rate. This is also the most difficult factor to picture, isolate, and disentangle from the rate of interest which it helps determine. Therefore, it is a matter of great importance pedagogically to make that distinction clear. The investment opportunity rate is distinct from the market or loan rate of interest because an investment opportunity is distinct from a loan. Investment opportunity, as here used, does not include a mere loan at the market rate of interest nor any other purchase-and-sale transaction made merely on the basis of the market rate. The definition Edition: current; Page: [498] of investment opportunity is specially framed to exclude mere loans. It is any opportunity of an individual to modify his prospective income other than by merely lending or borrowing (or the equivalent, buying or selling) at the market rate of interest.

Under this definition and the assumptions employed in the theory there can never be any doubt as to whether a given proposed transaction is an investment opportunity or a market loan or purchase. In the case of a market loan or purchase the individual cannot vary the rate of interest by any act of his, such as varying the size of his transactions. Under our assumptions of a perfect market his influence on the market rate is not only unconscious but infinitesimal and therefore entirely negligible in our analysis in which his motivity is of the essence. In the case of an investment opportunity, on the other hand, he can vary the rate of return by varying the size of his operations.

This contrast between the theoretical constancy of the one and the variability of the other, in relation to individual action, is due to the fact that in the public market the individual is a negligible element, while an investment opportunity is more private and personal to him or his group. The former is typified by the purchase, say, of a Liberty bond, or other standard securities. The latter is typified by building a factory, improving a sales organization, deepening the shaft of a mine—cases where the marginal rate of return is under the control of the individual since he sets the margin.

Of course it is true that, in almost every such operation, there are elements of purchase and sale in which the market rate of interest is an implicit ingredient, but as long as the operation is not exclusively a mere market Edition: current; Page: [499] interest affair and contains other ingredients, the rate is subject to variation with the extent of the operation and so is to be called a rate of return over cost. We are here interested in those other ingredients which produce the variability and thus differentiate such a rate from the market rate of interest. They are the non-commercial or non-trading ingredients; they concern production and technique rather than trade. They deal not with the market place, but with nature, environment, and the refractory conditions which surround and hamper us in our efforts to secure income. They exist even when no market exists, when a Robinson Crusoe, a hermit, or an isolated ranchman battles with soil and the elements for his daily bread.

The rate of return over cost, under the law of diminishing returns, is thus far more elementary and primeval than the rate of interest, and however incrusted that rate of return may become with other elements which grow out of modern market conditions it is still the basic objective condition underlying our problem.

Thus the rate of return over cost is distinguished from the rate of interest (1) by varying with the extent of the individual's investment; (2) by being consciously recognized, as thus variable115 and controllable, by the individual; (3) by being, therefore, a personal and individual matter and not altogether a public market matter; (4) by being directly related to producing as contrasted with trading.

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