© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-1

Chapter Nine

Human Capital Theory: Applications

to Education and Training

Created by: Erica Morrill, M.Ed Fanshawe College

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-2

Chapter FocusFactors that determine the market rate

of return to education Is education economically worthwhile? Is education a predictor of greater

productivity?Market signaling and screeningGovernment-funded training programs

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-3

Human Capital Theory Investments are made to improve

productivity and earningsCosts incurred with the expectation of

future benefitsBenefits must exceed costs by a

significant amount

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-4

CostsDirect costs

books, tuitionOpportunity cost

income forgonePrivate Costs/Social CostsReal Costs/Pecuniary or transfer costs

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-5

Figure 9.1 Alternative Income StreamsEarnings

16 18 22

dDirect costs

a

Stream Abe

Stream B

c

fStream C

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-6

Age-Earnings Profiles Increase with age but at a decreasing

rateHigher for those with more education

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-7

Choosing an Income StreamSimplifying assumptions

no direct 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 rates

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-8

Human Capital Investment Decision

Quantity of education maximizes the net present value of lifetime

earnings

Human capital wealth can be distributed by borrowing and lending

Increase education until… present value of benefits of additional year equals

present value of additional costs

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-9

Implications of Theory Investment should be made early in

one’s lifeLittle incentive for individuals

experiencing discontinuity in workforce

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-10

Factors Influencing Education Income tax

increase in progressivity of taxes reduce demand for education

Student loans alter marginal cost of education and levels

of educational attainment

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-11

Optimal Human Capital Investment

Expressed in terms of…. Costs and benefits Marginal costs and benefits Rate of return on investment

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-12

Education and Market Equilibrium

Interaction between individuals’ preferences employers’ preferences

Human capital positively affects productivity of workers

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-13

Figure 9.3 Education and Market Equilibrium

Years of Education

Wage

I

I

UB

EB

UA

EA

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-14

Education as a FilterEducation acts as a signal of the

productivity of employeesHigher wages are offered if employers

believe that education increases productivity

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-15

Figure 9.4 Offered Wage and Signaling

Cost Schedules

WagesW(y)

Education

CL(y)

W(y)

CH(y)

1

2

y*1 2

Cost of education C(y)

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-16

Empirical Evidence Education and Earnings

Earnings increase with age experience Increase is most rapid to age 45 or 55

for individuals with the most educationDifferential is wider between groups at

ages 45-50 than 20-30

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-17

Human Capital Earnings Function

Estimates the rate of return to educationLeast-squares regression of earnings

on educationControls for other factors that may affect

earnings

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-18

Signaling, Screening and AbilityDeterminants difficult to control

innate abilitySignaling/screeningPrivate return on educationSocial return on education

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-19

Addressing Ability BiasNatural experiments

isolate the influence of education from unobserved ability factors

research on twins compulsory school attendance laws proximity to college findings

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-20

Increased Returns to Education and Inequality

Variation of returns to schooling over time

Increased returns have coincided with increases in income inequality

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-21

TrainingGeneral Training Skills used in various firms 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 Trainee is unwilling to bear

the cost because no higher earnings

Firm does not have to pay higher wages because other firms are not competing for such trainees

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-22

Figure 9.7 a Costs, Benefits and Financing of Training

Wa=VMPa

Time

WagesVMP

Costs and Benefits of Training

costs

benefits

0

VMP*

VMPt

t*training

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-23

Figure 9.7 b Costs, Benefits and Financing of Training

Wa=VMPa

Time

WagesVMP

Specific training as a shared investment

0 t*training

Employer’s costs

Employee’s benefits

VMP*

VMPt

Employee’s costsWt

Employer’s benefitsW*

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-24

Figure 9.7 c Costs, Benefits and Financing of Training

Wa=VMPa

Time

WagesVMP

Earnings growth with gradual training

0

VMP*

VMP0

Employer’s costs

Employer’s benefits

Employee’s benefits

Employee’s costs

Wt

W*

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-25

Appropriate Role of Government Private markets may not provide socially

optimal amounts of training imperfect information regulatory restrictions contract problems

Training subsidies to disadvantaged could increase working hours raise wages above the poverty line

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-26

Evaluation of Government Training Programs

Difficulties in evaluation no opportunity to observe earnings in the

absence of training no control group many variables

© 2002 McGraw-Hill Ryerson Ltd. Chapter 9-27

End of Chapter Nine