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Human Capital:Theory
Lent TermLecture 2
Dr. Radha Iyengar
What is Human Capital? Part of original conception of inputs in
production. Adam Smith said that there were 4 inputs in which we might invest:
1. Machines or mechanical inputs2. Building/infrastructure3. land 4. human capital
Education and “General” Human CapitalWe’re going to study first education
(schooling including college/graduate education)
This is important because it is: Expandable and maybe doesn’t depreciate
(like physical capital) Transportable and shareable (not true with
“specific capital”)
What are we going to study? Theory
Static Model (Card) Dynamic Model (Heckman)
The goal of theory is to motivate the large body of empirical work
Empirics Some talk of methods (identification, diff-in-
diff, IV) Reconciling different estimates Economics of Education (briefly!)
A Static Model of Human Capital
Acquisition(for details see: David Card, “Causal Effect of Education
on Earnings” Handbook of Labor Economics)
Basis of Empirical Estimates Common form of estimation:log( y ) = a + bS + cX + dX2 + e (1)
Usually called a Mincer Regression
Some Empirical Facts1. A simple regression model with a linear
schooling term and a low-order polynomial in potential experience explains 20-35% of the variation in observed earnings data, with predictable and precisely-estimated coefficients in almost all applications.
2. Returns to education vary across the
population with observables, such as school quality or parent’s education
OLS Estimates1. 10 percent upward bias on OLS estimates
of the return to education (based on the most recent, “best” twins studies)
2. Estimates of the return to schooling based on brothers or fraternal twins contain positive ability bias, but less than the corresponding OLS estimate.
Does IV Fix the problem? IV estimates of the return to education
based on family background systematically higher than corresponding OLS
estimates probably have a bigger ability bias than OLS
estimates
IV estimates of the return to education based on intervention in the school system about 20 percent more than the OLS estimates. return to schooling for these subgroups are
especially high, and cannot be generalized to the population.
A Static Model of Education and Earnings Because of its tractability, Card uses a
static model that abstracts away from the relationship between completed schooling and earnings over the lifecycle. (we’ll do a dynamic model next).
Two assumptions: that most people finish schooling and only then
enter the labor force (smooth transition). the effect of schooling independent of
experience (Separability above)
The basics Simple Linear regression first introduced by
Mincer Takes the general form of linearity in Schooling,
quadratic in experience.
Assumptions:1. separability of experience and education. 2. log-earnings are linear in education.
correct measure of schooling is years of education each year of schooling is the same. (more on this later)
(1) )log( 2 edXcXbSay
Wages or earnings? Earnings conflates hours and wages Card reports that about two-thirds of the
returns to education are due to the effect of education on earnings—the rest attibutable to the effects on hours/week and week/year.
The specification in (1) explains about 20-30 percent of the variation in earnings data.
Why use Semi-Log Specification? log earnings are approximately normally
distributed. Heckman and Polachek show that the
semi-log form is the best in the the Box-Cox class of transformations. (we can talk about this more later in the empirical part)
Defining some Terms Let our utility function U(S, y) = log(y) –
h(s) where y is earnings, S is years of schooling, and h(s) is an increasing, convex function. Then, define our discounted present value (DPV) function:
rrsSydtrtSy /)exp()()exp()(
Simple relationship between returns and costs
So that we have h(S) = r*S more generally we could have a convex
h(.) function if the marginal cost of each year of schooling increases faster than the foregone earnings for that year—maybe because of credit constraints)
ResultsOptimal schooling is implicitly defined by
That is there are two sources of heterogeneity:
1. Differences in costs (represented by h(S))2. Difference in marginal returns (represented
by y’(S)/y(S))
(2) )(
)(')('
Sy
SySh
Optimal Schooling a simple specification of these two
components
(define E(b) = b and E(r)= r and k1, k2> 0)
This gives us the optimal schooling expression:
(3a) )()('
1SkbSySy
i
(3b) )(' 2SkrSh i
(4) )/()( 21* kkrbS iii
Interpretation of Equilibrium Individuals do not necessarily know the parameters of their
earnings functions when they make their schooling choices.
bi interpretation: individual's best estimate of his/her earnings gain per year of education, as of early adulthood.
One might expect this estimate to vary less across individuals than their realized values of schooling
the distribution of bi may change over time with shifts in labor market conditions, technology, etc. (Skill Premium)
Some Assumptions treat bi as known at the beginning of the lifecycle
and fixed over time:
assumption probably leads to some overstatement of the role of heterogeneity of bi in the determination of schooling and earnings outcomes.
for simplicity, assume jointly symmetric distribution of b and r.
Returns to schooling From our equilibrium expression (4) can
get expression for returns to schooling
Even in this simple model there is a distribution of returns unless Linear indifferent curves with uniform slope
Linear opportunity curves, with uniform slope0 2 kandirri
0 1 kandibbi
Within vs. Between Variation Within: Eq. (4) as a partial equilibrium description
of the relative education choices of a cohort of young adults, given their family backgrounds and the institutional environment and economic conditions that prevailed during their late teens and early 20s.
Differences across cohorts in these background factors will lead to further variation in the distribution of marginal returns to education in the population as a whole.
Earnings and Schooling Eqn From equation 3A (FOC), we get
Note that individual heterogeneity affects both the intercept and the slope
Defining αi = ai + a0
Use this with eqn (4), to define schooling choice in terms of a, b, and r
(5)
Linear Estimating Function Define λ0 and ψ0 as the parameters from
the linear projection of ai and bi on where is E(Si )
(6a)(6b)
That is:
SS i S
OLS estimates of b Using this notation, we can write the
probability limit of the OLS estimate:
(7)where the avg. marginal return to schooling
in the population is:
SSSkbp OLS 00010blim
Homogeneous Returns Let bi = b and k1 = 0
Then (5) implies the OLS estimate is not consistent, with upward bias of l0 %.
The bias comes from the correlation of ability to the marginal cost of schooling.
0lim OLSbp
Heterogeneous Schooling Reintroducing a heterogeneous b
we get additional bias terms in due to the self-selection of years of schooling.
The size of this bias depends on the importance of the variation in b in determining the overall variance of schooling outcomes.
Sbp OLS 00lim
What did we learn The linear model appears to fit so well because
there is a bias introduced by heterogeneity which is convex and independent of the concavity of the opportunity curve.
More simply put, the concavity from quadratic term in (5) is offset by the convexity from y0 giving an approximately linear relationship.
Understanding Observed Linearity-1 Case 1: gets the standard ability “omitted
variable bias” return to schooling Let ai vary by individual (heterogeneous) b be fixed across individuals. Bias comes from the correlation between
ability and marginal cost of schooling so σra < 0 which implies that λ0 > 0.
Understanding Observed Linearity-2 Case 2:
ai and bi both vary across individuals. cross-sectional upward bias because of self
selection. So depending on the relative variance of these
components will determine the convexity and concavity.
Understanding Observed Linearity-3 Rewrite (5) and reorganize terms:
This is linear if ψ0≈ 2k1
The bigger the contribution of bi to the overall variance of schooling, ψ0 is bigger and the more the convexity
iiii vSuSkSSbc 212
1000i )()()log(y
What about Measurement Error? The downward bias of measurement error is often
thought to offset some if not all of the upward bias in a,b from ability, only be true if the error is not correlated with level of
schooling Unlikely because individuals with high levels of schooling
cannot report positive errors in schooling whereas individuals with very low levels of schooling cannot report negative errors in schooling.
Given this correlation, the measurement error may actually exacerbates the attenuation bias.
IV in a Heterogeneous World
even minor difference in mean earnings between the two groups will be exaggerated by the IV procedure.
For example, natural experiments inference are based on small differences between groups of individuals who attended schools at different times, places, etc. However, the uses of these differences might be difficult to generalize.
IV-2 Define a linear relationship between
returns to schooling and a set of characteristics, Z, i.e.
So the earnings function can be rewritten as:
iiii Zr
iiiiiii ZkbZS 0/)(
kbb iii /)( k/1
IV-3 The big news: In the presence of heterogeneous
returns to education the conditions to get an interpretable IV estimator of very strong. The requirements are that we have individual specific
heterogeneity components that are mean independent of the instrument.
The second moment of the return to education is also independent of the instrument
The conditional expectation of the unobserved component of optimal school choice is linear in b.
Family Background IV-1 The strategy: use variables such as
parents education, characteristics of parents to control for unobserved ability.
The key idea: if a and S uncorrelated then we get an unbiased estimate, otherwise, we get an upward bias
Family Background IV-3 To illustrate this, consider a linear log
earnings function:
linear projection of unobserved ability component on individual schooling and a measure of family background (Fi):
iii aSbay 0log
iiii uFFSSa ')()( 21
Comparing Regressions: Homogeneous Case In order to compare this to the regression of a on
S alone, define:
Using these, we could compare three potential estimators: OLS from univariate regression of earnings on schooling
—bOLS
OLS from bivariate regression of earnings on schooling and family background—bbiv
IV estimator using Fi as an instrument for Si (bIV)
s 210 2SFFs
IVOLSbiv bpbpbpb limlimlim
Comparing Regressions: Heterogeneous case introducing heterogeneity across
individuals in b, so that
we can relate ψ0 as follows
Assuming , ,
iiii vFFSSb )()( 21
)/( 221210 FSFs
011 S 022 S 0F
IVOLSbiv bpbpbpb limlimlim
Siblings/Twins Models The key idea behind this strategy: some of
the unobserved differences that bias a cross-sectional comparison of education and earnings are based on family characteristics
Key Assumption: within families, these differences should be fixed.
Differencing between schooling levels of individuals will yield consistent results.
Defining “Family Effect” Define “pure family effects” model as the
aij=aj and bij=bj
linear projection of a and bi – b on the observed schooling outcomes of the two family members:
iiii uFFSSa )()( 21
iiii vFFSSbb )()( 21
Estimating with “Family Effects” Assuming that bi, S1i, S2i have a jointly
symmetric distribution Earning functions are then:
Taking differences, a within family difference in log earnings model:
12122111111 )()(log iiii eSSSScy
22122121122 )()(log iiii eSSSScy
iiii eSSy 2211log
When Family Effects Models Work With identical twins, it is natural to impose
the symmetry conditions so that λ1=λ2=λ, ψ1=ψ2=ψ and
With these assumptions and the pure family effects specification, all biases from ability and schooling are sucked up by the family average schooling component which differences out.
SSS 21
When Family Effects Don’t Work In the case of siblings, or father-son pairs
it seems less plausible.
Relax the family effects model as follows:
1221211111 )()( iiii uSSSSa
1222211212 )()( iiii uSSSSa
1221211111 )()( iiii vSSSSbb
2222211212 )()( iiii vSSSSbb
Why doesn’t it work For a randomly-ordered siblings or
fraternal twins, it is natural to assume that the projection coefficients satisfy the symmetry restrictions so that λ11=λ22, λ12=λ21, ψ12=ψ21, ψ11=ψ21
From this, the earnings model eqn’s are:
From this system, is not identifiable.
121211111 )log( iiii eSScy
222212122 )log( iiii eSScy
“Family Effect” or OLS Models? Without a “pure family effect” and
symmetric it is only possible to estimate an upper bound measure of the marginal returns to schooling.
there is no guarantee that this bound is tighter than the bound implied by the cross-sectional OLS estimator.
It is possible that the OLS estimator has a smaller upward bias than the within family estimator.
Take-Homes from the Static Model 1 The OLS estimator has two ability biases,
the intercept the slope. The bias in the slope may be relatively small if there is not
much heterogeneity. The necessary conditions for IV estimators to be
consistent is strict many plausible instruments recover only the weighted
average of marginal returns of the affected subgroups. . If the OLS estimator is upward biased, then the IV
estimator is likely even more so
If twins or siblings have identical abilities, then a within-family estimator will recover an asymptotically unbiased estimator
otherwise a within-family estimator will be biased the extent to which depends on the relative
importance the variance in schooling attributable to ability differences in families versus the population.
Take-Homes from the Static Model 2
Measurement errors biases are potentially important in interpreting the estimates from different procedures. OLS estimates are probably downward biased
by about 10% OLS estimates that control for family
background may be downward biased by about 15% or more
within-family differenced estimates may be downward-biased by 20-30% with the upper range more likely for identical twins.
Take-Homes from the Static Model 3
Empirical EstimatesAuthor Instrument OLS IV
Angrist and Krueger Quarter of birth .070(.000)
0.101(0.033)
Staiger and Stock (Quarter of birth)*(state)*(year) .063(.000)
.060(.030)
Kane and Rouse Tuition at 2 and 4 year state colleges and distance to nearest college
.080(.005)
.091(.033)
Card Distance to nearby 4-year college Distance*parent education
-- .097(.048)
Conneely and Uusitalo Indicator for living in university town in 1980
.085(.001)
.110(.024)
Malluccio Distance to local private school or high school
.073/.063(.011)/(.006)
.145/.113(.041)/(.033)
Harmon and Walker Changes in minimum schooling leaving age
.061(.001)
.153(.015)
Does this Explain Differences in Empirical Estimates? -1 Appears that IV-based studies estimate a
return to schooling that’s about 30% more than OLS estimates: Why?
1. Bound and Jaeger: • IV estimate are even further upward biased
than the corresponding OLS estimates by unobserved differences between the characteristics of treatment and comparison groups implicit in the IV scheme..
2. Ability bias is that OLS estimates of the return to schooling are relatively small
• the gaps between IV and OLS estimates reflect the downward bias in OLS estimates attributable to measurement error.
• Most likely: measurement error bias itself seems like it could only explain about 10% of the bias.
Does this Explain Differences in Empirical Estimates? -2
3. Publication bias: only want to publish papers with large and significant point estimates
• Ashenfelter and Harmon cite a positive correlation across studies between IV-OLS gap in estimated returns and the sampling error of the IV estimates.
Does this Explain Differences in Empirical Estimates? -3
4. Underlying heterogeneity: • Factors like compulsory schooling or accessibility
of schools are more likely to affect the schooling choices of individuals who would otherwise have relatively low schooling levels.
• If these individuals have higher than average marginal returns to schooling, then IV estimators based on compulsory schooling or school proximity should yield higher than average marginal returns.
Does this Explain Differences in Empirical Estimates? -4
General Conclusions1. Consistent with summary of the literature from the 60s and 70s
by Grilliches, • the average return to education in a given population is not
much below the estimate that emerges from a simple cross-sectional regression of earnings on education.
• The “best available” evidence from the latest studies of identical twins suggests a small upward bias of about 10% in the simple OLS estimates
2. Estimate of the return to schooling based on comparisons of brother or fraternal twins contain some positive ability bias • less than the corresponding OLS• ability differences appear to exert relatively less influence
on within-family schooling difference
General Conclusions 23. IV estimates of the return to education based on family
background are systematically higher than corresponding OLS estimates and may contain a bigger upward bias
4. Returns to education vary across the population with such observable factors as school quality and parental education
5. IV estimates of the return to education based on interventions in the school system tend to be 20% or more above the corresponding OLS estimates. There is some evidence that this is due to the higher than average marginal returns of the individuals targeted by these programs.
Next Week… Empirical Education Papers
Twins IV estimates
Some Education Production Function What are returns to various Education inputs Will post extra reading on course web-page