Labour Economics assignment 1
Chapter Nine Human Capital Theory: Applications to Education and Training
© 2012 McGraw-Hill Ryerson Ltd.
Prepared by Dr. Amy Peng
Ryerson University
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Learning Objectives
Discuss how the decision to invest in human capital (schooling or on-the-job training) can be analyzed as a standard investment decision based on a comparison between the costs and benefits of the investment.
Explain how the most expensive part of an investment in human capital is the opportunity cost of one’s time.
Explain why trying to estimate the monetary return to education by simply comparing the earnings of more- and less-educated workers can be misleading due to the ability bias, or because education is used as a “signal” in the labour market.
Describe how the return to education is quite large and has been increasing over time in Canada.
Discuss the circumstances under which either workers or employers are the ones who should pay for training programs.
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Human Capital Theory
Investments are made to improve productivity and earnings
Costs incurred with the expectation of future benefits
Benefits must exceed costs
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Human Capital Theory
Costs:
Direct costs
books, tuition
Opportunity cost
income forgone
Private costs vs. social costs
Real costs vs. transfer costs
Benefits:
Consumption vs. Investment Benefits
Private benefits vs. social benefits
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Alternative Income Streams
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Earnings
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d
Direct costs
a
Stream A
b
e
Stream B
c
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Stream C
Age
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Age-Earnings Profiles
Common attributes:
Increase with age but at a decreasing rate
Higher for those with more education
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Optimal Human Capital Investment
The optimal investment in human capital is determined by comparing the costs and the benefits of having and additional year of education, using the following concepts:
Marginal costs and benefits of education
Rate of return on investment in education
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Optimal Human Capital Investment
To maximize the net present value of lifetime earnings:
Increase education until…
Present value of benefits of additional year (MB) equals present value of additional costs (MC), or
i = r
where: i = internal rate of return
r = market interest rate
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Optimal Human Capital Investment
Simplifying assumptions:
No direct (consumption) utility or disutility from education
Hours of work are fixed
Income streams associated with education amounts are known
Individuals can borrow and lend at the real interest rate (perfect capital markets)
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Optimal Human Capital Investment
Formal analysis of benefits:
Consider an 18-year-old high school graduate faced with a decision to work or go to college:
The net present value of benefits at age 18 over T – 18 remaining years of work would be:
PV = Y/(1+r)0 + Y/(1+r) 1 + … + Y/(1+r) T-18
T-18
PV = Y + ∑ Y/(1+r) t or, PV = Y + Y/r
t=1
Where, Y = income (constant over working years, T – 18)
r = market interest rate (discount rate)
T = age
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Optimal Human Capital Investment
Cost of Investing one more year in (post secondary) education (MC):
MC = Y + D
Where,
Y = forgone income while attending one more year of school
D = direct cost of one more year of school
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Optimal Human Capital Investment
Total benefit of one more year of school:
PV* = (Y + ΔY)/r – D
Where, ΔY = increase in income due to extra year of schooling (MB)
Optimum quantity (# of years) of education will be achieved when:
MC = MB, or PV = PV*
PV (Y + D) = PV* (ΔY), that is:
Y + D = ΔY/r, or r = ΔY/(Y + D) = i
Where i = the internal rate of return
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Optimal Human Capital Investment
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The net benefit of obtaining education level E equals the difference between benefits and costs, and is maximized
by setting marginal benefit
(MB) equal to marginal cost
(MC).
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Optimal Human Capital Investment
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The individual should invest until the internal rate of return equals the opportunity cost of the investment, given by the interest rate, r.
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Implications of Theory
Investment should be made early in one’s life
Little incentive for individuals experiencing discontinuity in the workforce
Investment in education and progressive tax system
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Factors Influencing Education
Income tax
Increase in progressivity of taxes reduces demand for education
Student loans
Alter marginal cost of education and levels of educational attainment (increase in productivity will benefit both the society and the individual)
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Education as a Filter
Education acts as a signal of the productivity of employees
Higher wages are offered if employers believe that education increases productivity
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Offered Wage and Signalling Cost Schedules
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Wages W(S),
Cost C(S)
Education
CL(S) = S
W(S)
CH(S) = S/2
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2
S*
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Cost of education
Low-ability workers’ cost of acquiring
education is given by CL(s).Their return acquiring s* is given by 2 -CL(s*) < 1, so they are better off not going to school, and accepting the lower wage.
The net benefit of education to the high-abilitied is given by 2 - CH(s*)>1, so they are better off acquiring the
education level s*
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Empirical Evidence: Education and Earnings
Earnings increase with age experience
Increase is most rapid to age 40 or 44 for individuals with the most education
Differential is wider between groups at age 50 than 20–30
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Empirical Evidence: Education and Earnings
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Estimates of Private Returns to Schooling in Canada, 1995
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Human Capital Earnings Function
Estimates the rate of return to education
Controls for other factors that may affect earnings such as ability and experience
Ln Y= α + rS + β1EXP + β2EXP2 + ε
Where:
Y = Earning; α = Fixed component of wage with no schooling; r = i = internal rate of return; S = Years of schooling; EXP = Experience (Age as a proxy); ε = Random variable (motivation, luck, etc.)
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Signalling, Screening, and Ability
Determinants difficult to control
innate ability, motivation, perseverance, tolerance, etc.
Education as Signalling/Screening
Private returns on education
Social returns on education
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Addressing Ability Bias
Natural experiments
Isolate the influence of education from unobserved ability factors
Research on twins
Compulsory school attendance laws
Proximity to college findings
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Increased Returns to Education and Inequality
Variation of returns to schooling over time
Increased returns have coincided with increases in income inequality
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Training
General Training
Skills used in various firms
Firms will offer higher wages for this training
Trainee is willing to bear the cost since higher wages are offered for these skills
Specific Training
Training useful to the firm that provides the training
Trainee is unwilling to bear the cost because there are no higher earnings
Firm does not have to pay higher wages because other firms are not competing for such trainees
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Costs, Benefits, and Financing of Training
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Wa = VMPa
Time
Wages
VMP
costs
benefits
0
VMP*
VMPt
t*
training
Cost and Benefit of Training
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Costs, Benefits, and Financing of Training
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Wa = VMPa
Time
Wages
VMP
Specific training as a shared investment
0
t*
Training
Employer’s costs
Employee’s benefits
VMP*
VMPt
Employee’s costs
Wt
Employer’s benefits
W*
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Costs, Benefits, and Financing of Training
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Wa = VMPa
Time
Wages
VMP
Earnings growth with gradual training
0
VMP*
VMP0
Employer’s costs
Employer’s benefits
Employee’s benefits
Employee’s costs
Wt
W*
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Appropriate Role of Government
Private markets may not provide socially optimal amounts of training:
Imperfect information
Regulatory restrictions
Training subsidies to disadvantaged could:
Increase working hours
Raise wages above the poverty line
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Summary
Investment in human capital
Benefits and costs and return to schooling
Education and alternative age earnings profiles
Education and labour productivity
The human capital earnings function
Education as a signalling factor
Empirical results and the ability bias
On-the-job training
General training vs. specific training
Government training programs
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