1. Labor Quality: Investing in Human Capital
Chapter 4
Labor Quality: Investing in Human Capital

2. 1. Investment in Human Capital: Concept and Data
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1. Investment in Human Capital: Concept and Data

3. Investment in Human Capital
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Investment in Human Capital
Expenditures 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.
Educational 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%.

4. Age-Earnings Profiles, by Education
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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.

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2. Human Capital Model

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Human Capital Model
The decision should be made by comparing the costs and benefits (higher earnings) of college.
Costs 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. Age-Earnings With and Without College
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Age-Earnings With and Without College
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.
Annual Earnings C
Incremental Earnings (3) H
Indirect Costs (2) H 18 22 65
Age C
Direct Costs (1)

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Present Value
Discounting converts the value of future dollars into today’s dollars through the interest rate.
The present value (Vp) of a payment received one year from now is: Vp =
Def:
Payment 1 year from now
1+Interest rate Vp =
Ex:
where i = 10%
$ 110
1.10 = $

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Present Value
The present value of a future stream of incremental earnings or costs (E) : Vp = E0 + E1
(1 + i) + E2
(1 + i)2 + En
(1 + i)n +
Costs are represented as negative values of E.
A person should attend college if the net present value (Vp) is greater than 0.

10. Discounted Present Value
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Discounted Present Value
Present Value of Earnings (4)
Discounted Value (10 Percent Rate) (3)
Incremental
Earnings
(2)
Year (1)
PV of $8,000 Investment in Webmaster Training Program (Interest Rate = 10 Percent)
-$ 8,000
1.000
$ -8,000 1
$ 3,000
0.909
$ 2,727 2
$ 4,000
0.826
$ 3,305 3
$ 5,000
0.751
$ 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. Internal Rate of Return
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Internal Rate of Return
The internal rate of return, r, is the rate of return at which Vp = 0: Vp = E1
(1 + r) + E2
(1 + r)2 + En
(1 + r)n E0 +
0 = +
A person should attend college if the rate of return (r) exceeds the market interest rate (i).

12. Generalizations Length of income stream Costs of attending college
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Length 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
Costs 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. Generalizations Earnings differential
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Earnings 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.

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

15. College-High School Wage Premium
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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. Caveats
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We 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.
These are average earnings of college and high school graduates; the distribution of earnings around the mean is wide.
The quality of schooling matters as well as the quantity of schooling.

17. Private vs. Social Perspective
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Private vs. Social Perspective
Education 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. Private vs. Social Perspective
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Private vs. Social Perspective
The 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.

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Questions for Thought
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?
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. 3. Human Capital Investment and the Distribution of Earnings
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3. Human Capital Investment and the Distribution of Earnings

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

22. Demand for Human Capital
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Demand for Human Capital
Since individuals should increase schooling so that the marginal rate of return of schooling (r) is equal to the interest rate (i).
r, i 1
Using the r = i rule, at interest rate i2, the optimal level of schooling is e2. i1 S1 2 i2 S2
At i1 the optimal level is e1. 3 i3 S3
At i3 the optimal level is e3. r
, DHC
Each equilibrium point (1,2,3) indicates the “price” and quantity demanded of human capital. In other words, the demand for human capital. e1 e2 e3
Years of Schooling

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

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

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Cost of Funds
r, i
Ann is from a wealthy family and faces a low cost of borrowing funds (iA). Her optimal level of schooling is eA. B iB SB A iA SA
Betty is from a poor family and faces a high cost of borrowing funds (iB). Her optimal level of schooling is eB.
DA= DB eB eA
Years of Schooling

26. Interactions
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The 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.

27. Capital Market Imperfections
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The 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.
The government may have to intervene by subsidizing human capital loans in order to make the returns on physical and human capital equal.

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Question for Thought
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.

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4. On-the-Job Training

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

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

32. General Training
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Wu and MRPu 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.
Wage & Marginal Revenue Product
Wp= MRPp
Since general training is usable at other firms, workers must pay for the entire cost of the training. They receive a lower wage (Wu> Wt) that is equal to their diminished productivity (MRPt).
Wu= MRPu
Wt= MRPt
After the training period, workers receive a higher wage Wp that is equal to their new higher level of productivity MRPp.
Post Training
Training

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

34. Modifications
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Faced 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.
Workers 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.

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Question for Thought
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?

36. 5. Criticisms of Human Capital Theory
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5. Criticisms of Human Capital Theory

37. Investment or Consumption?
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Investment or Consumption?
Not 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.

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

39. Ability Problem
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Those 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.

40. Screening Hypothesis
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The screening hypothesis argues that schooling increases earnings not by increasing productivity but 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.
The empirical evidence shows screening appears to play a small role.