§4. The Principle of Return over Cost

Now let us restate the forestry-farming-mining comparison in the land example of the preceding chapter in terms of the rate of return over cost.

If the actual market rate of interest is 4 per cent, a person using the land for farming, or thinking of so doing, would find forestry preferable. The change from farming to forestry would cost certain sacrifices of income in the first four years, as specified in Table 6, but would return certain net additions thereafter. The rate of return over cost which would be realized by choosing the forestry rather than the farming use is 4.2 per cent. He would be realizing 4.2 per cent, which is more than the market rate, 4 per cent.

If, however, the market rate of interest were 4.5 per cent, it would not pay to change from farming to forestry; for to do so would return only 4.2 per cent as compared with 4.5 per cent which he could get in the loan market. Edition: current; Page: [159] Our farmer would prefer to invest at 4.5 per cent by lending in the first four years $450, $450, $150, $50 rather than sacrifice these same amounts for 4.2 per cent by giving up farming for forestry. To induce him to make a change, the rate of return over cost must exceed the rate of interest.62

Thus, by employing the concept of a rate of return over cost, we may restate the investment opportunity principle of maximum present value, or the principle of comparative advantage, as the principle of greatest return over cost. So stated the principle is:

Out of all possible options open to a person that particular one is selected, the comparison of which with any other option affords a rate of return over cost equal to or greater than the rate of interest.