Chapter 7

Human Capital

McGraw-Hill/Irwin Labor Economics, 4th edition

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

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Introduction
People bring into the labor market a unique set of abilities and acquired skills known as human capital Workers add to their stock of human capital throughout their lives, especially via job experience and education

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Education: Stylized Facts

Education is strongly correlated with: - Labor force participation rates - Unemployment rates - Earnings

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Present Value: Borrowing a Technique from Finance

Present value allows comparison of dollar amounts spent and received in different time periods PV = y/(1+r)t r is the discount rate

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Potential Earnings Streams Faced by a High School Graduate

Dollars

wCOL

Goes to College

wHS

Quits After High School

18

22

65

Age

-H

A person who quits school after getting his high school diploma can earn wHS from age 18 until the age of retirement. If he decides to go to college, he foregoes these earnings and incurs a cost of H dollars for 4 years and then earns wCOL until retirement age.

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The Schooling Model

Real earnings (earnings adjusted for inflation) Age-earnings profile the wage profile over a workers lifespan The higher the discount rate, the less likely someone will invest in education (since they are less future oriented) The discount rate depends on: - The market rate of interest - time preferences (how a person feels about giving up todays consumption in return for future rewards)

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The Wage-Schooling Locus

What salary will firms be willing to pay workers for given levels of schooling Three properties: - The wage-schooling locus is upward sloping - The slope of the wage-schooling locus indicates the increase in earnings associated with an additional year of education - The wage-schooling locus in concave

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The Wage-Schooling Locus

Dollars

The wage-schooling locus gives the salary that a particular worker would earn if he completed a particular level of schooling. If the worker graduates from high school, he earns $20,000 annually. If he goes to college for 1 year, he earns $23,000.

30,000 25,000 23,000 20,000

12 13 14

18

Years of Schooling

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Education and the Wage Gap

Observed data on earnings and schooling does not allow us to estimate returns to schooling In theory, a more able person gets more from an additional year of education Ability bias the extent to which unobserved ability differences exist effects estimates on returns to schooling (since the ability difference may be the true source of the wage differential)

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The Schooling Decision

Rate of Discount

MRR Years of Schooling

The MRR schedule gives the marginal rate of return to schooling, or the percentage increase in earnings resulting from an additional year of school. A worker maximizes the present value of lifetime earnings by going to school until the marginal rate of return to schooling equals the rate of discount. A worker with discount rate r goes to school for s* years.

s*

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Schooling and Earnings When Workers Have Different Rates of Discount

Rate of Interest Dollars

wHS rAL

PBO

wDROP
rBO MRR

PAL

11

12

Years of Schooling

11

12

Years of Schooling

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Schooling and Earnings When Workers Have Different Abilities

Rate of Interest Dollars wHS Z Bob

wACE wDROP PACE

Ace

r MRRBOB MRRACE 11 12

Years of Schooling

11

12

Years of Schooling

Ace and Bob have the same discount rate (r) but each worker faces a different wage-schooling locus. Ace drops out of high school and Bob gets a high school diploma. The wage differential between Bob and Ace (or wHS - wDROP) arises both because Bob goes to school for one more year and because Bob is more able. As a result, this wage differential does not tells us by how much Aces earnings would increase if he were to complete high school (or wACE - wDROP).

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Estimating the Rate of Return to Schooling

A typical study estimates a regression of the form: - Log(w) = a*s + other variables w is the wage rate s is the years of schooling a is the coefficient that estimates the rate of return to one added year of schooling

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Some Evidence
In studies of twins, presumably holding ability constant, valid estimates of rate of return to schooling can be estimated Generally, the rate of return to schooling is higher for workers who were born in states with well-funded education systems

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School Quality and the Rate of Return to Schooling

Rate of return to schooling

8 7 6 5 4 3 2 15 20 25 30 35 40 Pupil/teacher ratio

Rate of return to schooling

8 7 6 5 4 3 2 0.5 0.75 1 1.25 1.5 1.75 2 Relative teacher wage

Source: David Card and Alan B. Krueger, Does School Quality Matter? Returns to Education and the Characteristics of Public Schools in the United States, Journal of Political Economy 100 (February 1992), Tables 1 and 2. The data in the graphs refer to the rate of return to school and the school quality variables for the cohort of persons born in 1920-1929.

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Do Workers Maximize Life-Time Earnings?

The schooling model assumes that workers select their level of education to maximize the present value of lifetime earnings The only way to test this hypothesis is if we can observe the age-earnings profile of a worker in two ways: if he chooses college, or if he stops education investments Unfortunately, once a choice is made, we cannot observe the earnings stream associated with the non-choice Thus, using the observed wage differential to determine if the worker selected the right earnings stream yields meaningless results

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Self-Selection Bias
Workers may select themselves into jobs for which they are better suited Therefore, wage differentials may not be associated with education Then what is the point of investing in education?

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Schooling as a Signal
Education reveals a level of attainment which signals a workers qualifications to potential employers Information that is used to allocate a workers in the labor market is called a signal There could be a separating equilibrium - Low-productivity workers choose not to obtain X years of education, voluntarily signaling their low productivity - High-productivity workers choose to get at least X years of schooling and separate themselves from the pack

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Education as a Signal
Dollars Dollars

Costs

300,000 25,001 y 200,000 Slope = 25,001

300,000

Costs

200,000
Slope = 20,000 20,000 y

Years of Schooling (a) Low-Productivity Workers

y (b) High-Productivity Workers

Years of Schooling

Workers get paid $200,000 if they get less than y years of college, and $300,000 if they get at least y years. Low-productivity workers find it expensive to invest in college, and will not get y years. High-productivity workers do obtain y years. As a result, the workers education signals if he is a low-productivity or a high-productivity worker.

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Implications of Schooling as a Signal

Education is more than a signal, it alters the stock of human capital Social return to schooling (percentage increase in national income) is likely to be positive even if a particular workers human capital is not increased

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Post-School Human Capital Investments

Three important properties of age-earnings profiles: - Highly educated workers earn more than less educated workers - Earnings rise over time at a decreasing rate - The age-earnings profiles of different education cohorts diverge over time (they fan outwards) Earnings increase faster for more educated workers

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Age-Earnings Profiles
Men
2000

Weekly Earnings

1700 1400 1100 800 500 200 18 25 32 39 46 53

College Graduates

Some college High school graduates High school dropouts

60

Age

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Age-Earnings Profiles
Women 1200
Weekly Earnings

1000
College Graduates

800
Some college

600 400 200 18 25 32 39 Age 46 53 60

High school graduates High school dropouts

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On-The-Job Training
Most workers augment their human capital stock through onthe-job training (OJT) after completing education investments Two types of OJT: - General: training that is useful at all firms once it is acquired - Specific: training that is useful only at the firm where it is acquired

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Implications
Firms only provide general training if they do not pay the costs If the firm and the worker share the returns to specific training the possibility of separation in the post-training period is eliminated

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The Acquisition of Human Capital Over the Life Cycle

Dollars MC

MR20 MR30

Q30 Q20

Efficiency Units

The marginal revenue of an efficiency unit of human capital declines as the worker ages (so that MR20, the marginal revenue of a unit acquired at age 20, lies above MR30). At each age, the worker equates the marginal revenue with the marginal cost, so that more units are acquired when the worker is younger.

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Age-Earnings profiles and OJT

Human capital investments are more profitable the earlier they are taken The Mincer earnings function: - Log(w) = a*s + b*t c*t2 + other variables - The overtaking age is t* and indicates the time when the worker slows down acquisition of human capital to collect the return on prior investments so as to overtake earnings of those that do not undertake similar investments

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The Age-Earnings Profile Implied by Human Capital Theory

Dolla rs Age-Earnings Profile

Ag e

The age-earnings profile is upward-sloping and concave. Older workers earn more because they invest less in human capital and because they are collecting the returns from earlier investments. The rate of growth of earnings slows down over time because workers accumulate less human capital as they get older.

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Policy Application: Evaluating Government Training Programs

Aimed at exposing disadvantaged and low-income workers to training programs $4 billion (Federal) spending per year Studies of the return to these human capital investments are unclear (self-selection bias)

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Social Experiments
National Supported Worker Demonstration (NSW) The study suggests a 10% return to investments in human capital for workers treated under the program

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End of Chapter 7