family5 humcap
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1.Is education a good investment?
2.Why do some people invest in education while others do not?
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• Any activity with current cost and future benefits can be analyzed like an investment.
• Investment in physical capital (man-made goods) contributes to production of more goods/services– Easily financed
• Investment in human capital (expenditures on education and training) improves quality and/or quantity of production of an individual– Yields a rate of return (higher earnings) like physical capital– Embodied in the person investing– Illiquid asset – can’t sell quickly– Risky: uncertainty regarding life expectancy, potential ability,
returns to a person due to unexpected life events.– Difficult to finance
Investment in Human Capital
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Increase in Educational Attainment
0%
20%
40%
60%
80%
100%
1960 1970 1980 1990 2005
Perc
ent
Percent High School Graduate or More
Percent College Graduate or More
• 1970: 36%• 2006: 12%
of labor force was high school dropouts
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Age-Earnings Profiles of Full Time Workers, 2005
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Age-Earnings With and Without College
Age
Annual Earnings
6518
•High School curve is age-earnings profile if a person does not attend college.
•College curve is age-earnings profile if attends college
•Total cost of college :• direct costs, tuition (1) • indirect costs, lost
earnings (2)
•Benefit of attending college is increase in earnings (3).
22
Future Extra Earnings (3)
High School
College
Indirect Costs (2)Direct Costs (1)
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Age-Earnings With and Without College• Adult student
working full time while earning a degree
• To study or not to study?
• Compare present value of benefits with present value of costs across lifetime
Age
Annual Earnings
6518 22
Future Extra Earnings (3)
High School
CollegeNo Indirect Costs (2)
Direct Costs (1)
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• $100 received 1 year from today– less valuable than $100 today– can put $95.24 in the bank at 5% to get $100 in a
year– $100 = $95.24*(1+0.05)– Future Value = $100– Present Value = $95.24– Interest (Discount) Rate = 5%
• future benefits are discounted to present– using interest rate– farther a benefit is in future, less it is worth today
• compare with current costs
Present Value of Future Income
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PV = Ex:
where i = 10%
PV = Def:
• Discounting converts the value of future dollars into today’s dollars through interest (discount) rate
• Present value (PV) of a payment received one year from now is:
Present Value
Payment 1 year from now
1 + Interest rate
$ 100.00$ 110
1.10 =
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NetPresent Value
of Earnings(4)
Discount1/(1+0.1)
(3)Incremental
Earnings(2)
Year(1)
PV of $8,000 Investment in Webmaster Training Program(Interest Rate = 10 %)
Discounted Present Value
0 -$ 8,000 1.000 $ -8,000123
$ 3,000 $ 4,000 $ 5,000
0.9090.8260.751
$ 2,727$ 3,305$ 3,755
$ 1,787
• Melinda is considering taking a webmaster training program • Costs: tuition $3,000, 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. • She can borrow funds at an interest rate of 10%, so we will
discount future expected income at 10% rate.• Find net present value (PV) of this training program• PV of the training program is positive, Melinda should take
the training program.
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Present Value
PV = E0 + E1
(1 + r) + En
(1 + r)n
E2
(1 + r)2 + +. . . . .
A person should attend college if net present value is greater than 0, or PV (costs) < PV (benefits)
• Differences in time preferences•presented-oriented people have high r
•discount future earnings heavily•PV (benefits) lower for them get less schooling
•future-oriented people have low r•Do not discount future earnings heavily•PV (benefits) higher for them get more schooling
Present value of a future stream of incremental earnings or costs (E)
Costs are negative values of E, benefits are positive
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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.• Women live longer – higher benefits of education• Women have interrupted careers – lower benefits• Younger people – higher benefits
• Costs of attending college – The lower the cost of attending college, the more likely the
net present value is positive.• Older students - higher opportunity cost of attending college
• Earnings differential– Larger college-high school earnings differential - more likely
positive net present value• College attendance rose in 1980s as college-high school premium
increased.
• Women’s investment in education – May include quality of husband (extra benefit)– Total returns may be smaller due to discrimination
Generalizations
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Diminishing Returns to Schooling• Investment in education is
subject to the law of diminishing returns.
• The increases in knowledge decline with each additional year of schooling.
• Rate of return schooling = % change in earnings from extra year in school
• Return to 13th year of schooling = $3,000/$20,000 15%
• Return to 14th year of schooling = $2,000/$23,000 8.7%
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Demand for Human Capital
Years of Schooling
Dis
coun
t ra
te
• People get education until the point where the benefit of one more year equals its cost
•Al has higher discount rate than Bob
•Why?• Al more present-oriented
• Al faces higher cost of borrowing (he is poor)
•Bob chooses to graduate from college
•Al’s optimal choice is not go to college
Benefit ofschooling (return)
rAL
rBOB
1
2
12 16
Cost ofschooling
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Rate of Return Per Year of College Education
17.314.9 13.9
11.49 8.1
6.5
02468
101214161820
Rat
e of
Ret
urn
(%
)
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• Hard to measure returns to education• 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.– High earnings of college graduates reflect both
• greater ability • Schooling
– rate of return to schooling is overstated
Statistical Problem
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• You decision to invest in education yields substantial external or social benefits for society– More educated workers - lower unemployment rates.– Education raises participation in political process.– Children grow up in a better home-environment if
parents are more educated.– Research discoveries of more educated persons
• Positive externality: Benefit to the third party– Immunization, education, inventions – Free markets under-allocate resources to such activities
• Negative externality: Cost to the third party– Air pollution by chemical plant, loud music, drunk
driving– Free markets over-allocate resources to such activities
Private vs. Social Perspective
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General Training• Skills used in various firms• Accounting, word
processing, college degree• Firms will offer higher wage
for this training• Trainee willing to bear the
cost since higher wages offered for these skills
Specific Training• Training useful to the
firm that provides the training
• Costs split by the worker and the firm
On The Job Training
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Implications• In case of specific training• Both worker and firm share returns
– Firm pays worker less than MRP– Worker received more than in other jobs
• Neither worker nor firm want to terminate contract– Worker granted lifetime tenure– Lower overall turnover– “Last hired, first fired” in bad times, lower turnover
among senior workers– Specifically trained workers often go on temporary
layoffs, wait to be recalled
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• Investment or Consumption? • Not all education expenditures are an investment,
some part is a leisure.– 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.
• Non-Wage Benefits• Studies that examine only earnings of high school and
college graduates understate the rate of return for two reasons.– College graduates have greater fringe benefits as % of pay
than high school graduates.– College graduates tend to work in more pleasant
surroundings and have more interesting jobs than high school graduates.
Criticisms of Human Capital Theory
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1.Human capital theory: education improves work productivity
2. Signaling and screening hypothesis: education does not improve worker’s productivity• Productivity depends on individual’s innate abilities
• Employers “screen” applicants to choose more productive/able workers
• Employees - “signal” their high productivity/ability with higher level of education• Education is less costly for higher ability workers• Low ability do not get education
• If an ability test could achieve the same ends, then education is a waste of resources
Criticisms of Human Capital Theory
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Increase in Educational Attainment
0%
20%
40%
60%
80%
100%
1960 1970 1980 1990 2005
Perc
ent
Percent High School Graduate or More
Percent College Graduate or More
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Rate of Return Per Year of College Education
17.314.9 13.9
11.49 8.1
6.5
02468
101214161820
Rat
e of
Ret
urn
(%
)