1. Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 4 Labor Quality: Investing in Human Capital

2. 4-2 1.Investment in Human Capital: Concept and Data Human Capital includes any activity that increases worker quality and productivity, i.e., education, training, health & migration.

3. 4-3 Investment in Human Capital oExpenditures on education and training can be treated as an investment in human capital just like investments in physical capital. Human capital yields a rate of return (higher earnings) like physical capital. oEducational attainment has been rising in the U.S. In 1970, 36% of the labor force was a high school dropout. In 2008, it was 12%. In 1970, 14% had 4+ years of college, in 2006 29%.

4. 4-4 Age-Earnings Profiles, by Education The male age- earnings profiles indicate those with more education have higher earnings. The age- earnings profiles are steeper for those with more education. Females have flatter age- earnings profiles.

5. 4-5 2. Human Capital Model

6. 4-6 Human Capital Model oThe decision should be made by comparing the costs and benefits (higher earnings) of college. oCosts of attending college The direct costs are the cost of tuition, fees, and books. ∞Room and board are not included since they are needed regardless of whether you go to college. The indirect cost is the forgone earnings you give up while you attending college.

7. 4-7 Age-Earnings With and Without College Age Annual Earnings 65 18 The HH curve is the age- earnings profile if a person does not attend college. The CC curve is the cost- earnings profile if one attends college. The total cost of attending college is the sum of the direct costs (area 1) plus indirect costs (area 2). The benefit of attending college is the increase in earnings due to the college degree (area 3). Whether it is rational to attend college depends on whether the present value of the benefits exceeds the present value of the costs. 22 Incremental Earnings (3) H H C C Indirect Costs (2) Direct Costs (1)

8. 4-8 VpVp =  Ex : where i = 10% VpVp =  Def : Present Value oDiscounting converts the value of future dollars into today’s dollars through the interest rate.  The present value (V p ) of a payment received one year from now is: Payment 1 year from now 1+Interest rate $ 100.00 $ 110 1.10 =

9. 4-9 Present Value VpVp = E0E0 + E1E1 (1 + i) + EnEn (1 + i) n E2E2 (1 + i) 2 + +.....  Costs are represented as negative values of E.  A person should attend college if the net present value (V p ) is greater than 0.  The present value of a future stream of incremental earnings or costs (E) :

10. 4-10 Present Value of Earnings (4) Discounted Value (10 Percent Rate) (3) Incremental Earnings (2) Year (1) PV of $8,000 Investment in Webmaster Training Program (Interest Rate = 10 Percent) Discounted Present Value 0-$ 8,0001.000$ -8,000 1 2 3 $ 3,000 $ 4,000 $ 5,000 0.909 0.826 0.751 $ 2,727 $ 3,305 $ 3,755 $ 1,787 Suppose Melinda is considering taking a webmaster training program that involves direct costs of $3,000 and forgone earnings $5,000. The training program will increase Melinda’s earnings by $3,000, $4,000, and $5,000 for the 3 years she plans on working. Because she can borrow the funds at an interest rate of 10%, we will discount the future expected income at an 10% rate. What is the present value (PV) of this training program? The PV of the training program is positive, Melinda should take the training program.

11. 4-11 Internal Rate of Return VpVp = 0 = E0E0 + E1E1 (1 + r) + EnEn (1 + r) n E2E2 (1 + r) 2 + +.....  A person should attend college if the rate of return (r) exceeds the market interest rate (i).  The internal rate of return, r, is the rate of return at which V p = 0:

12. 4-12 Generalizations oLength of income stream The longer the stream of positive incremental earnings, the more likely the net present value will be positive. ∞As a result, younger people are more likely to attend college oCosts of attending college The lower the cost of attending college, the more likely the net present value is positive. ∞Older people have a higher opportunity cost of attending college, less likely to attend.

13. 4-13 Generalizations oEarnings differential The larger the college-high school earnings differential is, the more likely the net present value is greater. ∞College attendance rose in the 1980s as the college-high school premium increased. oThe Discount Rate (or market interest rate) The larger the Discount Rate (interest rate), the smaller present value of future earnings, so higher interest rates decrease college attendance

14. 4-14 Rate of Return by Country The rate of return per year of college education varies substantially across countries for males.

15. 4-15 College-High School Wage Premium The college- high school wage premium fell in the 1970s for both men and women. The premium fell because of an increase in supply of college graduates due to the baby boom. The premium rose after 1979, due to increases in the demand for college-trained workers because of technology improvements.

16. 4-16 Caveats oWe can’t predict the college-high school wage premium for future graduates. The charts report past differentials. The future differential may be smaller as the high differential may increase future supply. oThese are average earnings of college and high school graduates; the distribution of earnings around the mean is wide. oThe quality of schooling matters as well as the quantity of schooling.

17. 4-17 Private vs. Social Perspective oEducation yields substantial external or social benefits that society reaps. More educated workers have lower unemployment rates. Education raises the amount and quality of participation in the political process. Children grow up in a better home environment if the parents are more educated. The research discoveries of more educated persons yield benefits to society.

18. 4-18 Private vs. Social Perspective oThe social rate of return is higher (lower) than the private rate of return, resources will be underallocated (overallocated) to human capital investments. The private and social rate of return are quite similar. Social return for human capital investments is comparable to that for physical capital, indicating that US does not over invest in formal schooling.

19. 4-19 1. Suppose the net present value of an educational investment is highly positive. What can you infer about the investment’s internal rate of return relative to interest cost of borrowing? Questions for Thought 2. Comment on the following statements: (a) Older workers are less geographically mobile than younger workers. (b) An economic recession tends to stimulate college enrollments. (c) The age-earnings profiles shown earlier, clearly indicate that people with more education earn more than people with less education; therefore, personal spending on education is always a good investment.

20. 4-20 3. Human Capital Investment and the Distribution of Earnings The willingness to invest in formal schooling o determines future earnings o determines the earnings distribution o depends not only on expected time in the labor market but also on ability, discrimination and access to financing

21. 4-21 The Returns to Formal Schooling Years of Schooling Rate of Return The marginal rate of return to education declines as additional schooling is acquired. Investment in education is subject to the law of diminishing returns. The increases in knowledge decline with each additional year of schooling. The return also falls because the explicit cost and opportunity cost of education rises with additional schooling. r

22. 4-22 Demand for Human Capital Years of Schooling r, i Since individuals should increase schooling so that the marginal rate of return of schooling (r) is equal to the interest rate (i). Using the r = i rule, at interest rate i 2, the optimal level of schooling is e 2. At i 3 the optimal level is e 3. r S2S2 e2e2 i2i2 Each equilibrium point (1,2,3) indicates the “price” and quantity demanded of human capital. In other words, the demand for human capital. At i 1 the optimal level is e 1. S1S1 S3S3 i1i1 i3i3 1 2 3, D HC e1e1 e3e3

23. 4-23 Returns to School will differ because of: oInnate ability differences between individuals (High vs. Low) oDiscrimination differences oAccess to and cost of funds differences oIf the returns differ, then investment levels will differ generating income differences

24. 4-24 Ability Differences Years of Schooling r, i Alfonse is low-ability person. He has low mental/physical talents and/or low motivation and self-discipline. His demand for schooling is D A. Bob is a high-ability person. He has a greater demand for schooling at D B because he can better translate schooling into higher productivity and earnings. For a given interest rate, Bob will obtain more schooling which will compound the earnings differential between low and high ability persons. S i A DADA eAeA DBDB B eBeB

25. 4-25 Discrimination Years of Schooling r, i Albert is black and is discriminated against in the labor market. His demand for schooling is D A since he has low ability to convert additional schooling into higher earnings. Brett is white and has a greater demand for schooling at D B as he can reap the benefits of additional schooling. For a given interest rate, Brett will obtain more schooling which will compound the earnings differential between whites and blacks. S i A DADA eAeA DBDB B eBeB

26. 4-26 Access and Cost of Funds Years of Schooling r, i Ann is from a wealthy family and faces a low cost of borrowing funds (i A ). Her optimal level of schooling is e A. SASA eAeA iAiA Betty is from a poor family and faces a high cost of borrowing funds (i B ). Her optimal level of schooling is e B. SBSB iBiB B A DA= DBDA= DB eBeB

27. 4-27 Interactions oThe ability, discrimination, and cost of funds factors that affect schooling levels may interact to cause even larger earnings inequality. If a person faces labor market discrimination, lenders may charge a higher interest rate since they are less certain of getting repaid. ∞Discrimination will reduce both the supply and demand for schooling. ∞Anti-discrimination policies may reduce earnings inequality as a result. ∞Income inequality also reduces supply & demand

28. 4-28 Capital Market Imperfections oThe capital market is biased in favor of physical rather than human capital. Lenders can’t repossess human capital. Young people, who are most likely to invest in human capital, don’t have established credit ratings. Individual returns differ making lending risky oPrivate markets are unlikely to equalize physical and human capital returns leading to underinvestment in human capital.

29. 4-29 oGovernment subsidized loans can equalize physical and human capital returns and also provide access to schooling for those unable to save (i.e., the poor). oWithout aid to the poor, some high ability persons would not acquire enough schooling and poverty would be perpetuated.

30. 4-30 1. Describe the expected effects that college scholarships based on (a) student ability and (b) student need are likely to have on the distribution of earnings. Question for Thought

31. 4-31 4. On-the-Job Training oLike formal schooling, OJT entails both opportunity costs and future benefits which can be analyzed thru the net present value framework. oIf NPV (expected extra revenues – costs of training) are > 0, firm will provide training.

32. 4-32 Costs and Benefits oFirms will invest in on-the-job training if the present value of the benefits of the training exceeds the present value of the costs. oThe costs to the firm include: Direct costs such as classroom instruction and greater worker supervision. Indirect costs such as reduced worker output during training. oThe benefit is greater worker productivity.

33. 4-33 General and Specific Training oGeneral training is training that is usable at all firms and industries. Word processing skills or accounting skills oSpecific training is training that is usable at only at the firm that provides the training. Assembly procedure unique to a firm’s product oMost training is a mixture of general and specific training.

34. 4-34 General Training Wage & Marginal Revenue Product W u and MRP u are the wages and marginal revenue product for an untrained worker. Marginal revenue product is the increase in total revenue associated with the employment of an additional worker. Since general training is usable at other firms, workers must pay for the entire cost of the training. They receive a lower wage (W u > W t ) that is equal to their diminished productivity (MRP t ). After the training period, workers receive a higher wage W p that is equal to their new higher level of productivity MRP p. Training Post Training W u = MRP u W p = MRP p W t = MRP t

35. 4-35 Specific Training Wage & Marginal Revenue Product Since specific training is not transferable to other firms, the employer must pay for the training. After training, the employer gets a return on her training investment by paying a wage less than the worker’s productivity (W u < MRP t ). The employer may pay a higher wage to decrease worker turnover and thus protect her training investment (W p ’ ). Training Post Training W u = MRP u MRP p MRP t During training, the employer pays a wage greater than the worker’s productivity (W u > MRP t ). Wp’Wp’

36. 4-36 Modifications oFaced with a minimum wage, some firms may pay for general training. The firms recoup their expenses by paying workers less than their MRP after the training is completed. ∞This is possible because workers are not perfectly mobile across jobs—there are costs to switching jobs. oWorkers with the most formal education also receive more on-the-job training. They have shown they can receive training more readily and thus less cost.

37. 4-37 Modifications oMen will receive more OJT than women because they’re expected to work more years (no child raising years) oFirms and workers who receive specific training both want life-time jobs to recover investments and to maximize wages. Firms and workers who receive general training will have less interest in limiting job insecurity.

38. 4-38 OJT Empirical Evidence oCollege educated do receive more OJT than those w/o oWorkers in large firms are more likely to participate in OJT than small firms oMost training is general not specific oGeneral training increases productivity but specific training does not

39. 4-39 Empirical Evidence (cont.) oEach year of OJT with current employer increases young worker’s wage 13% oFirms offering OJT attract higher ability workers oMore formal training increases employment stability oOJT differences play only a small role in the gender wage gap

40. 4-40 1. Suppose that after graduation you take a job with an employer that offers to pay full tuition for employees wishing to return to school to get an MBA degree during non-work hours. You are not required to continue working for the firm after getting your MBA. What type of training is this, and who you think actually pays for it? Question for Thought

41. 4-41 5. Criticisms of Human Capital Theory Benefits of formal schooling could be mismeasured Education as Consumption Non-wage benefits Ability Differences Screening Hypothesis

42. 4-42 Investment or Consumption? oNot all education expenditures are an investment because some part is a consumption expenditure. Courses such as music appreciation yield consumption benefits rather than investment benefits. By ignoring the consumption benefits of education, researchers overstate the investment costs of education and understate the rate of return.

43. 4-43 Non-Wage Benefits oStudies that only examine the earnings of high school and college graduates understate the rate of return for two reasons. 1.College graduates have greater fringe benefits as a percent of pay than high school graduates. 2.College graduates tend to work in more pleasant surroundings and have more interesting jobs than high school graduates.

44. 4-44 Ability Problem oThose with more ability (i.e., intelligence, motivation, and self-discipline) are more likely to go to college. Even without a college degree, they would have earned more than those who decided not to go to college. To the extent that the higher earnings of college graduates reflects their greater ability rather than schooling, the rate of return is overstated. ∞Omission of ability biases the rate of return estimates by a small amount.

45. 4-45 Screening Hypothesis oThe screening hypothesis argues that schooling increases earnings not by increasing productivity but by providing a way to identify high-quality workers. Screening does not affect the private rate of return, since college graduates still have higher earnings. ∞The social rate of return is overstated, as screening does not increase productivity, so public investment in education is too high. The empirical evidence is mixed