2. The Theory of Human Capital
What Is Human Capital?
Human capital may be considered as any investment in a person that improves both market and non-market skills in anticipation of monetary or non-monetary returns.
The importance of human capital theory is the idea that expenditures on education and training are investments individuals make in themselves to increase their market skills, productivity and earnings.
Human capital theory focuses on individual differences in years of schooling, and length of job training among others in exploring earning differentials.

3. What is human capital cont.
According to Becker, any activity that entails a cost (in the form of current cost) which raises productivity in the future can be analyzed within the framework of investment. Investment theory with respect to human’s investment includes education, training, migration, health care, etc. However, education and training have received the most attention in labour economics.

4. Costs and Benefits of Human Capital Investment
There are two types of costs associated with human capital investment. These are private and public costs.
Private cost has three main components, these are:
Psychological costs – this is the cost in terms of the stress and anxiety the individual goes through in the course of his/her education or learning process.
Social costs – these are costs that the individual incurs as he/she forgoes leisure activities in the bid to achieve higher educational levels.
Monetary costs – this takes into consideration the direct financial expenditure on text books and school fees, among others, as well as foregone earnings had the individual chosen to work instead of going to school

5. Cost/ Benefit Cont.
Public cost, on the other hand, involves direct government expenditure on education, subsidies on educational inputs, salaries, infrastructure provision, subsidies on student loans among others.

6. Cost/ Benefits Cont. Benefits
The acquisition of human capital has various benefits to both the individual involved and the society at large. Therefore, we have social and private benefits. While the former accrues to the entire society, the latter is enjoyed by the individual who makes the investment decision.
Social benefits have two major components.
With highly trained individuals, society is assured of a skilled and highly productive labour force. In addition, such a society can boast of a literate and knowledgeable electorate as well as a responsible citizenry to put government on its toes in order to deliver.
There is the likelihood that government can raise more tax revenue. This is because tax systems are usually progressive such that as you earn more, you are likely to pay more. Thus, the educated who usually earn more than the less educated are likely to pay more taxes than the latter.

7. Cost Benefit Cont.
To the private individual, the benefits can also be grouped into pecuniary/monetary and non- pecuniary.
Pecuniary/monetary benefits include earnings of individuals from education. This involves higher earnings over the lifetime of the individual due to the investment in education.
Non-pecuniary benefits include the prestige, respect, self-confidence as well as the ability to take part in open discussion that comes along with achieving a higher level of education.

8. The Investment Decision
There are two separate decision rules for determining the profitability of investment in education namely, the net present value approach and the internal rate of return approach.
The Net Present Value
The theory of human capital investment assumes that people are utility maximizers and take a lifetime perspective when making choices about education and training. They are therefore assumed to compare the near-term investment costs (C) with the expected future benefits when making a decision.

9. NPV Cont.
In the case of education and training investments by workers, the expected returns are in the form of higher future earnings, increased job satisfaction over their lifetime, and a greater appreciation of nonmarket activities and interests. Calculating the benefits of an investment over time requires us to progressively discount benefits lying further into the future.
Thus, the idea behind the concept of present value is that, a cedi today is worth more than a cedi tomorrow. That is, it gives the value now of an entire stream of benefits or costs.
The present value of a stream of yearly benefits (B1, B2 …) over time N can be calculated as

11. NPV cont Where Bi = benefits in year i or time t,
r = discount or interest rate,
n- number of years or time period.
Investment in additional schooling is attractive if the present value of future benefits exceeds costs:

13. NPV Cont.
Utility maximization requires that the individual continue to make additional human capital investments as long as the equation above holds until the benefits of additional investment are greater or equal to additional costs.
Decision rule
The individual compares the net present value of each income stream and selects the highest. The choice results in human capital investment that minimizes the discounted value and maximizes lifetime benefits. Thus, for an individual to pursue university education than entering the labour market with senior secondary education, the present value of his lifetime earnings with university education must exceed the present value of his lifetime earnings from senior secondary education.

14. INTERNAL RATE OF RETURN (IRR)
The internal rate of return of a given an investment may be defined as that rate of discount which reduces the NPV of the future stream of income generated by an investment to zero. It is calculated by equating the discounted value of the net benefits from the investment to the initial capital outlay and solving the resultant equation rate for the discount rate r*

16. The decision rule is that if the generated discount rate from the investment (r*) is greater than the predetermined rate i.e.
If r* < r we reject the investment
If r*> r we accept the investment
If r* = r we are indifferent
Returns to education by Psacharopulos

17. The Stopping Rule/ Equilibrium Human Capital Investment
All levels of education are associated with positive internal rate returns . Why some stop at JHS, SHS, Undergraduate , graduate level etc.?
Within the neoclassical framework, we can use the notion of utility maximization and equilibrium demand and supply of human capital investments to answer these questions.

18. The stop rule … Cont.
Assume a rational individual maximizes utility over his entire lifetime, where there are only two periods, present and future.
Let us also assume that this individual has the same fixed amount of resources equivalent to OB of present consumption and OC of future consumption, as shown in diagram
The individual could increase his future consumption by investing or deferring some part of present consumption.
The rate by which present consumption (investment) can be transformed into future earnings is shown by the curvature of the transformation curve. It is obvious that the marginal returns to human capital investment declines as more present consumption is invested.

19. Cont.
Ie. The marginal rate of return on schooling schedule, MRR, is a declining function of the level of schooling.
This decline may be attributed to three main reasons.
The law of diminishing returns to capital, which implies that the more capital we already have the less each additional capital contributes to productivity.
The declining payback period, that is the more time is spent in school the smaller the working life left to recoup the cost of education.
Since earnings rise with human capital the more time we wait not working the greater the foregone earnings.
DIAGRAM

20. Diagram 1

21. Diagram shows that when the individual makes no investment in education, as at the point N, present and future consumption are equal, that is OB=OC. We assume that additional future consumption beyond OC can come only through investment in human capital.
The curves labelled I and II are the indifference curves representing the individual’s preference between present and future consumption.
The slope of the transformation curve (EN) measures the rate at which the individual can exchange present consumption for future consumption, while the slope of the indifference curve measures the rate at which the individual is willing to exchange present consumption for future consumption.

22. Equilibrium occurs at the point K on indifference curve III where out of the resources available for present consumption an amount of AB (=NF) is sacrificed to obtain an increase of CD (=KF) in future consumption; that is NF is the investment cost and KF is the return to that investment.
At the point K the marginal rate of substitution between present and future consumption, given by the slope of the indifference curve III, is equal to the marginal rate of return on the investment, given by the slope of the transformation curve.

23. This equilibrium point represents one point on the individual’s demand curve for human capital investment.
Supposing the individual was given different amounts of resources for consumption and different transformation curves, we will obtain a number of similar points, from which the individual demand curve for investment can be derived as shown in diagram (see Dh –demand for human capital in next diagram)

24. Diagram 2

25. Demand Supply Side
In diagram 2 the demand curve for human capital investment Dh shows that the marginal rate of return to K1 cedis spent on human capital is r1 and the total earnings is approximated by the area Or1KK1.
A reduction in the cost (the price) of investment will lead to greater quantity demanded; however greater investment will also mean lower marginal rates of return, resulting in successively smaller increments to earnings. Hence the downward sloping nature of the demand curves.

26. On the other hand, the supply curve Sh in diagram 2 shows the interest that must be paid to acquire each cedi invested in human capital. It is upward sloping because the individual can obtain larger amounts of investment funds (through borrowing) only at higher rates of interest.

27. Cont.
For example, at the elementary school level, an individual can obtain all the funds from his or her parents at zero interest because the amount required is small relative to family resources.
At the secondary school level a greater amount of funds is required, and one’s parents may have to borrow from relatives and friends at some positive rate interest part of which the individual might have to repay in one way or the other.

28. At the university level, the individual might have to take a substantial amount of government loans at a high cost including the cost of finding guarantors.
Given the demand and supply for human capital, as shown in diagram 2 the individual will be in equilibrium at the point A where the rate of return to investment in human capital is equal to the interest cost of financing it.

29. Cont
At the point K1, for example, marginal rate of returns r1 exceeds the marginal cost of funds i1 , therefore it will be profitable to invest more. At the point B1, marginal cost i2 exceeds the marginal return r2 , and it will be rational to reduce investments. Since the demand and supply situations will differ for different individuals the optimal or the equilibrium level of education will also be different, with some desiring only JSS, others SSS and still others university education.

30. Implications of Human Capital Theory
Individual time-preference and education: the importance of time preference in this analysis is that individuals who attach greater weight to present consumption are less likely to pursue higher education than those who are forward looking. That is, future- oriented people are more likely to go to college than present-oriented people, all other things being equal. Present-orientation applies to people who do not weigh future outcomes heavily. Thus, in terms of applying the net present value in investment decision making, the individual uses a high discount rate. In calculating investment returns using the present value method, if the discount rate (r) is large, then the benefits associated with college will be lower than if r is small.

31. Implications Cont
Age and education: Younger people will be more likely to acquire higher education than older people. Hence younger people tend to dominate older people in the university and other higher levels of education because of the following reasons;
They have a longer working time than the aged so that the their earnings will be greater than the old .
The opportunity costs and social responsibilities for the young are much lower than the old.
Thus, there is a likelihood that younger people have a greater tendency to obtain higher education or engage in other forms of training activity relative to older people.

32. Implication Cont. Cost of education:
The higher the cost of education the less likely it is for people to acquire higher education. This is because higher education enrolment is likely to go up if the cost comes down. The major monetary costs of higher education are forgone earnings and the direct costs of tuition, books, and fees. Thus, if foregone earnings or tuition costs fall, other things being equal, it is expected that enrolment will increase. This can be done through scholarships, study leave and others. Higher unemployment also tends to increase the demand for education. The psychic cost which is related to the individual’s ability to learn also affects human capital investment. High ability makes learning pleasant, making it attractive for those with higher ability to invest more in education. Higher ability also influences the returns to education. For the same amount of investment expenditure, those with higher ability can achieve higher educational levels than those with low ability, all other things being equal.
The costs of higher education are an additional reason why older people are less likely to attend than younger ones. As workers age, their greater experience and maturity result in higher wages and therefore greater opportunity costs of higher education.

33. Other factors that affect higher or lower demand include: Labour market discrimination Quality of Schooling Home environment-well furnished homes against poorly furnished homes

34. Labour force Continuity
Human capital theory predicts that those who anticipate interruptions in their working life are likely to invest less in their education than those who expect to have uninterrupted working lives. For example, there is a major difference in the incentives of men and women to make human capital investments. This is attributable to the length of work life over which the costs of a human capital investment can be recouped. Evidence suggests that women can be expected to work fewer years than men. To the extent that there is a shorter expected work life for women than for men, it is caused basically by the role women have historically played in child-rearing and household production.

35. Implications Cont. Earning differentials:
Human capital theory predicts that the demand for higher education is highly correlated with increases in lifetime earnings that come along with it. Higher education is demanded because people perceive earning differentials between higher education and a lower level. In fact, it is the benefits one expects to receive that are critical to this decision, and the expected benefits for any individual may be uncertain. Thus, when there is rising difference in earnings between two levels of education, they will invest in higher education because:
Higher earnings are needed to compensate for the cost accompanying higher education;
People with more education have shorter work life and therefore require higher earnings to be able to recover the cost.
The earnings associated with higher education should be sufficiently higher in order to ensure significant gap between the net returns from different levels of education so as to entice people to invest in education.