Labor Quality: Investing

in Human Capital

By: Dr. Saud Ahmad

 Objectives
After reading this chapter, you should be able to:
• Explain the meaning of investment in human capital.
• Use the human capital model to analyze decisions to invest
in human capital.
• Use a supply and demand of human capital to explain the
unequal distribution of earnings.
• Explain general and specific training and their effects on the
human capital investment decision, wages, and worker
retention.
• Critically evaluate the human capital model.
 INVESTMENT IN HUMAN CAPITAL:
CONCEPT AND DATA
• When a person (or a person’s parents or society at large) makes a
current expenditure on education or training, it is anticipated that the
individual’s knowledge and skills and therefore future earnings will be
enhanced. That expenditures on education and training can be treated
as investment in human capital.
Data reveal three things:
• Expenditures on education and training are substantial.
• The educational attainment of the labor force has increased dramatically over
the past several decades.
• Investments in education result in an enlarged flow of earnings. This tendency
is reflected in the age–earnings profiles
 THE HUMAN CAPITAL MODEL
The monetary costs incurred in the purchase of a college education are
of two general types:
• Direct or out-of-pocket costs in the form of expenditures for tuition, special
fees, and books and supplies.
• The indirect or opportunity cost of going to college is the earnings you give up
by not entering the labor market.
Expenditures for room and board are not included as a part of direct
costs because you would need food and shelter regardless of whether
you attended college or entered the labor market.
The economic benefit of investing in a college education is an enlarged
future flow of earnings.
 THE HUMAN CAPITAL MODEL
Age–Earnings Profiles with and without a
College Education
If an individual decides to enter the labor market
after graduation from high school at age 18, the
age–earnings profile will be HH in comparison
with the CC profile if she or he had gone to
college. Attending college entails both direct
costs (tuition, fees, books) and indirect costs
(forgone earnings). But on entering the labor
market at age 22, the college graduate will enjoy
a higher level of annual earnings over her or his
working life. To determine whether it is
economically rational to invest in a college
education, we must find its net present value by
discounting costs and benefits back to the
present (age 18).
 Discounting and Net Present
Time Preference
Value
• Why do dollars earned (or expended) have a different value a year, or two or three years, from
now than they have today?
• Most individuals prefer present consumption to future consumption because, given the
uncertainties.
Present Value Formula

E values represent a stream of incremental earnings, i is interest rate and V is net

present value.
• the decision to invest in a college education entails both costs and benefits (enhanced
earnings). How can both be accounted for? The answer is to treat costs as negative
earnings. Thus, the “earnings” for the four years the individual is in college (E0, E1, E2,
and E3) will be the negative sum of the direct and indirect costs incurred in each of
those years. For each succeeding year until retirement, incremental earnings will be
positive.
 Net Present Value
Decision Rule: Vp > 0
The relevant investment criterion or decision rule based on this
calculation is that the individual should make the investment if its net
present value is greater than zero. A positive value tells us that the
present discounted value of the benefits exceeds the present
discounted value of the costs, and when this is so—when benefits
exceed costs—the decision to invest is economically rational. If the net
present value is negative, then costs exceed benefits and the
investment is not Economically justifiable.
 Internal Rate of Return
• An alternative means of making an investment decision involves
calculating the internal rate of return, r, on a prospective investment
and comparing it with the interest rate i. By definition, the internal rate
of return is the rate of discount at which the net present value of a
human capital investment will be zero.

Decision Rule: r = i
• The investment criterion or decision rule appropriate to this approach
involves a comparison of the internal rate of return r with the interest
rate i. If r exceeds the market i, the investment is profitable and should
be undertaken. For example, if one can borrow funds at a 10 percent
interest rate and make an investment that yields 15 percent, it is
profitable to do so. But if r is less than i, the investment is unprofitable
and should not be undertaken.
 Generalizations and Implications
Length of Income Stream
• Other things being equal, the longer the stream of post-investment
incremental earnings, the more likely the net present value of an
investment in human capital will be positive. Alternatively, the longer
the earnings stream, the higher the internal rate of return. A human
capital investment made later in life will have a lower net present
value (and a lower r) simply because fewer years of work life and,
hence, of positive incremental earnings will remain after completion
of the investment.
Costs
• Other things being equal, the lower the cost of a human capital
investment, the larger the number of people who will find that
investment to be profitable.
 Generalizations and Implications
Earnings Differentials
• Not only is the length of the incremental earnings stream critical in
making a human capital investment decision, but so is the size of that
differential. The generalization is that other things being equal, the
larger the college–high school earnings differential, the larger the
number of people who will invest in a college education.
 Question for review

Why Older people are less likely to invest in human capital?

 Answer
Our age–earnings profiles reveal that earnings rise with age. Thus, the
opportunity cost of attending college will be greater for the older
worker; and other things being equal, the net present value and the
internal rate of return associated with human capital investments will
be lower. In other words, there are two reasons older people are less
likely to invest in a college education: (1) The length of their future
earnings stream will be relatively short, and (2) their opportunity costs
of attending college will be high.
 Private versus Social
Perspective
• Most economists believe that education entails substantial external or
social benefits; that is, benefits accruing to parties other than the
individual acquiring the education. From a social perspective, these
benefits should clearly be included in estimating the rate of return on
human capital investments. What are these social benefits?
• More educated workers have lower unemployment rates than less educated
workers. Society might benefit from investing in education by having to pay less in
taxes for social welfare programs, crime prevention, and law enforcement.
• Political participation and, presumably, the quality of political decisions might
improve with increased literacy and education.
• There may be intergenerational benefits: The children of better-educated parents
may grow up in a more desirable home environment and receive better care,
guidance, and informal preschool education.
• The research discoveries of highly educated people might yield large and widely
dispersed benefits to society.
 Why is our distinction between private and social
rates of return on human capital
investments significant?
• The difference between the private and the social perspectives is of potential
importance because efficiency demands that the economy’s total investment
outlay be allocated so that rates of return on human and physical capital should
be equal at the margin.
• If a given amount of investment spending is currently being allocated so that the rate of
return on human capital investment is, say, 12 percent, while that on physical capital is
only 8 percent, society would benefit by relocating investment from physical to human
capital.
• The distinction between the private and social perspectives is important has to
do with policy. The social or external benefits associated with education provide
the rationale for subsidizing education with public funds. In the interest of
allocative efficiency, the size of these public subsidies to education should be
determined on the basis of the magnitude of the associated social benefits.
 HUMAN CAPITAL INVESTMENT
AND THE
Why
DISTRIBUTION OF EARNINGS
do people vary significantly in the amounts of human capital they
acquire?
Diminishing Rates of Return
1. Investment in human capital (education) is subject to the law of
diminishing returns. The extra knowledge and skills produced by education
or schooling become smaller and smaller as the amount of schooling
increases. This means that the incremental earnings from each additional
year of schooling will diminish, and therefore so will the rate of return.
2. As additional education is undertaken, the attendant benefits fall and the
associated costs rise so as to reduce the internal rate of return.
• The opportunity cost of one’s time increases as more education is acquired.
• The private direct costs of schooling increase.
 Demand, Supply, and
Equilibrium
Deriving the Demand for Human
Capital Curve
Application of the r = i rule reveals that
the marginal internal rate of return curve is
also the demand for human capital curve.
Each of the equilibrium points (1, 2, 3)
indicates the financial price of investing (i)
on the vertical axis and the quantity of
human capital demanded on the horizontal
axis. This information about price and
quantity demanded constitutes the
demand curve for human capital.
 Differences in Human Capital
Investment
Ability Differences, Discrimination: Uncertainty of
Earnings
If Bowen has greater ability to translate schooling into
increased labor market productivity and higher earnings
than Adams, then Bowen’s demand curve for human
capital (DB) will lie farther to the right than Adams’s (DA).
Given the interest rate, it will be rational for Bowen to
invest in more education than Adams. Similarly, if Adams
and Bowen have equal ability but discrimination reduces
the amount of incremental income Adams can obtain from
additional education, it will be rational for Adams to invest
in less education than Bowen.
 Differences in Human Capital
Investment

Access to Funds and Human Capital Investment

If Bowen has access to financial resources on more favorable
terms than Adams, it will be rational for Bowen to invest in a
larger amount of education.
 Differences in Human Capital
Capital Market Imperfections
Investment
• The capital market may include certain biases or imperfections causing it to favor investment in
physical, rather than human, capital. Such biases are termed capital market imperfections.
• Funds may be less readily available, or accessible only on less favorable terms, for investment in
human capital as compared to real capital or the purchase of consumer durables.
The relative unsuitability of the capital market for educational loans has one or two important
consequences.
• Because of the problems and uncertainties just noted, financial institutions may choose not to make
human capital loans.
• If it is in the social interest to achieve a balance or equilibrium between investment in real capital
and human capital, then the government may have to offset the imperfections by subsidizing or
providing human capital loans. Ideally, an equilibrium between investment in real and human
capital would occur when the last dollar spent on human capital contributes the same amount to
the domestic output as the last dollar expended on real capital. But the higher interest rates
charged for educational loans will restrict expenditures on human capital so that the relative
contribution of the last unit to the national output will exceed that of the last unit of real capital.
This indicates that investment resources are being under-allocated to human capital. This rationale
in part lies behind the loan guarantees and financial resources that government has provided to
stimulate educational loans.
 Question for review

In equilibrium, the marginal rates of return, r, for those with more ability to
extract earnings from formal education and those with less ability are equal.
So why do people with greater ability get more formal education?
 Answer

The marginal rate of return, r, is indeed the same for each person at the optimal
level of education. Both r’s equal the cost of borrowing, i. But the person with
more ability has a greater r at any particular level of education, leading that
person to obtain more education than the individual with less ability.
 ON‐THE ‐ JOB TRAINING
Many of the usable labor market skills that workers possess are acquired not through formal schooling but rather through
on-the-job training.
Costs and Benefits
• In deciding whether to provide on-the-job training, a firm will weigh the expected added revenues generated by the
training against the costs of providing it. If the net present value of the training investment is positive, the firm will invest;
if it is negative, it won’t. Alternatively, the firm will invest if the internal rate of return of the investment exceeds the
interest cost of borrowing.
• For employers, providing training may involve such direct costs as classroom instruction or increased worker supervision,
along with such indirect costs as reduced worker output during the training period. Workers may have to accept the cost
of lower wages during the training period.
• The potential benefit to firms is that a trained workforce will be more productive and will therefore make greater
contributions to the firm’s total revenue. Similarly, trained workers can expect higher wages because of their enhanced
productivity.
• General training refers to the creation of skills or characteristics that are equally usable in all firms and industries. Stated
differently, general training enhances the productivity of workers to all firms.
• Specific training is training that can be used only in the particular firm that provides that training. Specific training
increases the worker’s productivity only in the firm providing that training.
• The distinction between general and specific training is important for at least two reasons. First, it is helpful in explaining
whether the worker or the employer is more likely to pay for on-the-job training. Second, it is useful in understanding
why employers might be particularly anxious to retain certain of their trained workers.
 CRITICISMS OF HUMAN CAPITAL
Investment or Consumption?
THEORY
• it is not correct to treat all expenditures for education as investment because, in fact, a portion of such outlays are
consumption expenditures. The decision to attend college, for example, is based on broader and more complex
considerations than expected increases in labor productivity and enhanced earnings. there is no reasonable way to
determine what portion of the expense for any particular education program is investment and what part is
consumption. Ignoring the consumption component of educational expenditures and considering all such outlays as
investment, empirical researchers understate the rate of return on educational investments. In other words, by
overstating the investment costs we understate the return on that investment.
Nonwage Benefits
• The fringe benefits associated with the jobs obtained by college graduates are more generous—both absolutely and as a
percentage of earnings—than those received by high school graduates. By ignoring fringe benefits, empirical studies
understate the rate of return on a college education. Second, the jobs acquired by college graduates are generally more
pleasant and interesting than those of high school graduates. This means that a calculated rate of return based on
incremental earnings understates the total benefits accruing from a college education.
The Ability Problem
• Critics of human capital theory contend that other things in fact are not likely to be equal. It is widely acknowledged that
those who have more intelligence, more self-discipline, and greater motivation—not to mention more family wealth and
better job market connections— are more likely to go to college. One can argue that although college graduates earn
higher incomes than high school graduates, a substantial portion of that incremental income is not traceable to the
investment in a college education.
 CRITICISMS OF HUMAN CAPITAL
The Screening Hypothesis
THEORY
• Education affects earnings not primarily by altering the labor market productivity of students but by grading and labeling
students in such a way as to determine their job placement and thereby their earnings.
• It is argued that employers use educational attainment—for example, the possession of a college degree—as an
inexpensive means of identifying workers who are likely to be of high quality. A college degree or other credential thus
signals trainability and competence and becomes a ticket of admission to higher-level, higher-paying jobs where
opportunities for further training and promotion are good.