Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 4

Labor Quality: Investing in Human Capital

4-2

1. Investment in Human Capital: Concept and Data

4-3

Investment in Human Capital

o 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.

o 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%.

4-4

Age-Earnings Profiles, by Education

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

18-24 25-34 35-44 45-54 55-64 65+

An

nu

al E

arn

ings

<12 12 16 17+

• 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.

4-5

2. Human Capital Model

4-6

Human Capital Modelo The decision should be made by comparing

the costs and benefits (higher earnings) of college.

o 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.

4-7

Age-Earnings With and Without College

Age

Annual Earnings

6518

• 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)

4-8

Vp= Ex:

where i = 10%

Vp = Def:

Present Value

o 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:

Payment 1 year from now

1+Interest rate

$ 100.00$ 110

1.10 =

4-9

Present Value

Vp= E0 +

E1

(1 + i)+

En

(1 + i)n

E2

(1 + i)2 + +. . . . .

Costs are represented as negative values of E.

A person should attend college if the net present value (Vp) is greater than 0.

The present value of a future stream of incremental earnings or costs (E) :

4-10

Present Valueof 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 -$ 8,000 1.000 $ -8,000123

$ 3,000 $ 4,000 $ 5,000

0.9090.8260.751

$ 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.

4-11

Internal Rate of Return

Vp= 0 = E0 +

E1

(1 + r)+

En

(1 + r)n

E2

(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 Vp = 0:

4-12

Generalizations

o 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

o 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.

4-13

Generalizations

o 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.

4-14

Rate of Return by Country

14.3

11.09.4

8.4 8.0

5.1 4.4

0.02.04.06.08.0

10.012.014.016.0

United K

ingd

om

United S

tate

s

Canad

a

France

Germ

any

Sweden

Denm

ark

Rat

e of

Ret

urn

(%

)• The rate of return per year of college education varies substantially across countries for males.

4-15

College-High School Wage Premium

1

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

1.9

1973 1978 1983 1988 1993 1998 2003 2008

Rat

io

Male Female

• 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.

4-16

Caveats

o 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.

o These are average earnings of college and high school graduates; the distribution of earnings around the mean is wide.

o The quality of schooling matters as well as the quantity of schooling.

4-17

Private vs. Social Perspective

o 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.

4-18

Private vs. Social Perspective

o 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.

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.

4-20

3. Human Capital Investment and the Distribution of Earnings

4-21

Diminishing Rate of Return

Years of Schooling

Rat

e of

Ret

urn• 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

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 i2, the optimal level of schooling is e2.

• At i3 the optimal level is e3.r

S2

e2

i2

• Each equilibrium point (1,2,3) indicates the “price” and quantity demanded of human capital. In other words, the demand for human capital.

• At i1 the optimal level is e1.

S1

S3

i1

i3

1

2

3

, DHC

e1 e3

4-23

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 DA.

• 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.

• For a given interest rate, Bob will obtain more schooling which will compound the earnings differential between low and high ability persons.

SiA

DA

eA

DB

B

eB

4-24

Discrimination

Years of Schooling

r, i

• 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.

• Brett is white and has a greater demand for schooling at DB as he can reap the benefits of additional schooling.

• For a given interest rate, Bob will obtain more schooling which will compound the earnings differential between whites and blacks.

SiA

DA

eA

DB

B

eB

4-25

Cost of Funds

Years of Schooling

r, i

• Ann is from a wealthy family and faces a low cost of borrowing funds (iA). Her optimal level of schooling is eA.

SA

eA

iA• Betty is from a poor family and faces a high cost of borrowing funds (iB). Her optimal level of schooling is eB.

SBiB

B

A

DA= DB

eB

4-26

Interactions

o 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.

4-27

Capital Market Imperfections

o 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.

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

4-28

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

4-29

4. On-the-Job Training

4-30

Costs and Benefits

o 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.

o 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.

o The benefit is greater worker productivity.

4-31

General and Specific Training

o General training is training that is usable at all firms and industries. • Word processing skills or accounting skills

o Specific training is training that is usable at only at the firm that provides the training.• Assembly procedure unique to a firm’s

producto Most training is a mixture of general and

specific training.

4-32

General Training

Wag

e &

Mar

gina

l Rev

enue

Pro

duct• 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. • 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).

• After the training period, workers receive a higher wage Wp that is equal to their new higher level of productivity MRPp.

Training

Post Training

Wu= MRPu

Wp= MRPp

Wt= MRPt

4-33

Specific Training

Wag

e &

Mar

gina

l Rev

enue

Pro

duct• 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 (Wu < MRPt).

• The employer may pay a higher wage to decrease worker turnover and thus protect her training investment (Wp

’ ). Training

Post Training

Wu= MRPu

MRPp

MRPt

• During training, the employer pays a wage greater than the worker’s productivity (Wu> MRPt).

Wp’

4-34

Modificationso 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.

o 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.

4-35

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

4-36

5. Criticisms of Human Capital Theory

4-37

Investment or Consumption?

o 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.

4-38

Non-Wage Benefits

o Studies 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.

4-39

Ability Problem

o 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.

4-40

Screening Hypothesis

o 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.