Chapter 9: Human Capital Investment Workers are heterogeneous in their productive human capital. Employers pay different wages to workers of different productivity. Therefore, differences in human capital result in wage differentials. Consistent with the law of one wage  Only one productivity-adjusted wages, wage rates per unit of task performed NOT hourly wage rate, marginal revenue product of a unit of effective labor=wage rate  Hourly wage rates are different due to differences in hourly productivity across workers

The essence of human capital (HC) theory Investments in HC are made to improve productivity and hence earnings. Costs are incurred now, but future benefits are uncertain. Gary Becker An investment in human capital made either by workers (e.g., education) or by employers in their employees (e.g., on-the-job training)

Investment in human capital by individuals Q1) Why do people invest in human capital?  Is education a good investment? Q2) Why does greater human capital lead to higher wages?  Positive correlation between education and wages  What is the rate of return on an investment in a education? Q3) Who invest?  Who goes to college? Investment in physical capital vs human capital Similarities: Timing of cost-benefits, depreciation Differences: transferability across people, portfolo

General Rule for Investment decision Present value approach Invest Q1) Is education a good investment? General Rule for Investment decision Present value approach Invest 2) Find the internal rate of return r* such that Invest if r*>the market rate

Application of the theory to investment in a university degree - What is C? What is B? See <Figure 9.2> Monetary costs of college education (C) Direct cost (tuition, books) Opportunity cost (forgone earnings) Monetary benefits of college education (B) Age-earnings profile: <Figure 9.3> increase with age but at a decreasing rate (diminishing marginal returns to experience), and average earnings diminishes after a peak point (less hours, less overtime, as you get older) steeper for those with higher education, peak points appear later in life for those with higher education.

Human capital investment decision - Go to college if the present value of B’s > C????? - Determination of optimal quantity of education  maximizes the net present value of lifetime earnings OR increase education until… present value of benefits of additional year equals present value of additional costs The optimal acquisition of HC <Figure 9.1>

A formal illustration - EH = annual earnings for high school graduates, assumed to be fixed from age 18 throughout 65 EC = annual earnings for college graduate, assumed to be fixed from age 22 throughout 65. Assume that annual earnings and costs occur on the first day of the year. - Go to college if PVC>PVH Calculate PVC and PVH using actual data

A simple numerical example Consider the following two-period model for human capital investment. If an individual chooses not to invest in a off-the-job training program, his/her salaries are $20,000 in period 1 and $21,000 in period 2. By participating in the program , the person would earn no income in period 1. Assume the direct cost of the training to the individual is $2,000, and the interest rate is 5%. On the basis of PV approach, calculate the minimum salary of period 2 to attract individuals into the training program.  $44,100

Predictions of the theory, other things being equal  Costs  - As cost of college education   Demand for college  ; Factors affecting direct costs; fellowships, scholarships, tuition waivers ; Factors affecting indirect costs; more evening classes reduce the opportunity costs of college  Why are college students so young? 18-24 As you go to college later in life, (i)  the opportunity costs of college education  (ii) the benefit-collecting period from college  Little incentive for individuals experiencing discontinuity in workforce As the earnings gap between college and high school   Demand for college  ; A more progressive income tax system would reduce the demand for college education

Who goes to college?  answers to Q3) Different individuals have different discount rates Forward-looking people (risk-takers) tend to attend college. ; have relative low discount rates Present-orientied people (risk-avoiders) tend not to go to college. ; have relatively high discount rates Consistent with a usual investment theory ; fair game, favorable game, unfavorable game ; Although college education is a favorable game  Some risk-avoiders may not invest in college education. ; Even though expected benefits = costs in terms of PV (fair game), some risk-takers may go to college.

Q2) Why does higher education lead to higher wages? to compensate for the costs of college education college graduates have fewer years in the labor force ; 18-65 for High, 22-65 for Col -  Earnings for college graduates accrue later in life ; consider their PV Then, how much wage increase do we expect with an additional year of schooling?  See the following discussion for quantitative assessment of the marginal rate of return of education.

Estimating the Marginal Rate of Return to Education Mincerian wage function Justification? in class Beta2: marginal rate of return to schooling Beta3>0, Beta4<0; concavity Ability bias Graphical explanation? in class Mathematical presentation? See the first class

Coping with ability bias Proxy variables: IQ measure Natural experiment; identical twins <empirical study pp.310-311> Longitudinal evidence <Presentation>

Signaling Model of Education and Earnings Education may provide a signal to employers of an individual’s productivity, when the productivity is difficult to observe. - College graduates earn more than high school graduates not because of what they learned in college but because of what college education tells about the former (college graduates). What does schooling signal? - Cognitive ability, drive, attitude toward future and supervisors Assuming that additional schooling does not enhance productivity, employers can distinguish between low-productivity group and high-productivity group by educational level when the worker’s marginal cost of schooling and productivity are negatively correlated.

Illustration of signaling <Figure 9.7> <Figure 9.8> <Figure 9.9> Empirical evidence sources for positive association of education and earnings 1) human capital; education increases productivity which is valuable to employers 2) signaling; higher education is a signal for greater productivity Testing for signaling effects Signaling exists if is greater for those who have diploma. Signaling effects exist if gamma3 >0.  See <presentation> for evidence of ability bias, human capital, and sheepskin effects.