Topic No: 2

Human Capital

Lecture Map

• Introduction

• Definition of human capital

• Components of human capital

• The human capital theory

• Human capital & Physical capital

• Stages of formation of human capital

• Human capital & Economic growth

Introduction: The Human Capital Revolution in Economics

Rediscovering the role of education to the wealth of nations.

Searching for clues on income distribution Pareto’s remarks (his “Power Law”) dominated

the field of personal income distribution. Due to this many economist believed that the distribution of income followed exogenous forces.

Introduction: The Human Capital Revolution in Economics

• Major contributors:

1. Kuznets, Simon and Milton Friedman. (1945), Income from Independent Professional Practices, National Bureau of Economic Research.

2. Mincer, Jacob (1958), Investment in Human Capital and Personal Income Distribution, Journal of Political Economy, vol. 66(4), pp. 281-302.

3. Schultz, Theodore W. (1961), Investment in Human Capital, The American Economic Review, vol. 51(1), pp. 1-17.

4. Schultz, Theodore W. (1962), Reflexions on Investment in Man, Journal of Political Economy, vol. 70(5, Part 2, Supplement), pp. 1-8.

Introduction: The Human Capital Revolution in Economics

6. Becker, Gary S. (1962), Investment in Human Capital: A Theoretical Analysis. Journal of Political Economy, vol. 70(5, Part 2, Supplement), pp. 9-49.

7. Mincer, Jacob (1962), On-the-Job Training: Costs, Returns, and Some Implications, Journal of Political Economy, vol. 70(5, Part 2, Supplement), pp. 50-79.

8. Becker, Gary S. (1964), Human Capital: A Theoretical and Empirical Analysis, With Special Reference to Education, New York, National Bureau of Economic Research.

9. Mincer, Jacob (1974), Schooling, Experience, and Earnings, National Bureau of Economic Research, New York.

Definition Of Human Capital

• What is capital?• What is human capital?

– Ans: human capital refers to the collection of innate and acquired individual abilities that are substantially durable, persisting over some significant portion of the life of the possessor. Furthermore, the personal attributes referred to under this rubric are restricted to positive “abilities” and “capabilities”. In other words, their nature is such as would normally yield some stream of benefits, by enhancing the possessor’s performance in one or more socially valued activities.

Specific Aspects Of Human Capital

1. Human capital comprises a) innate b) acquired component

2. human capital is non-tradable

3. human capital can be acquired formally or informally

4. Human capital has quantitative and qualitative aspects

5. Human capital can be either general or specific

6. Human capital may not be fully utilized

Components Of Human Capital

Social capabilities(“know-how”, “know-who”):

e.g., diligence, loyalty,cooperativeness, trust, etc.

Flexibility:Multi-task performance,

re-trainability.

Problem-solving,leadership,

managing complex tasks.

Psycho-motorbased skills

("know-how", "can-do").

HumanCapital

LongevityHealth

Physiologicalcondition:

e.g. Strength, eyesight etc.

Proceduralcapabilities

Cognitivecapabilities

("know-why"'know-what")

Tangible Intangible

Creativeness, innovativeness

The Human Capital Theory

• Introduction

• The human capital model

• Generalizations and implication of the human capital model

• Criticisms of human capital theory

Introduction

• The early 1960s witnessed what has been described in the economics literature as the "human investment revolution in economic thought" (Bowman 1966). Expenditures on education, whether by the state or households, have been treated as investment flows that build human capital.

Introduction

• Basic Concepts Of Investment In Human Capital.– When a firm invests in physical capital, it is acquiring

some assets that is expected to enhance the firm’s flow of net profits over a period of time. For example, a company might purchase new machinery designed to increase the out put and therefore sales revenues over, say, the 10-year projected life of the machinery. The unique characteristics of investment is that current expenditures or costs are incurred with the intent that these costs will be more than compensated by for by enhanced future revenues or returns.

• Analogously, investment are made in human capital. When a person (or person’ s parents or society at large) makes a current expenditure on education and training, it is anticipated that the individual's knowledge and skills and therefore future earnings will be enhanced. The important point is that expenditures on education and training can be fruitfully treated as investment in human capital just as expenditure on capital equipments can be understood as investment in physical capital.

Introduction

Introduction

• Once education is treated as an investment, the immediate natural question is: what is the profitability of this investment in order to compare it to alternatives? Such comparison can provide priorities for the allocation of public funds to different levels of education, or can explain individual behaviour regarding the demand, or lack of demand, for particular levels or types of schooling.

• For establishing education investment priorities at the margin the human capital model is the main theoretical foundation. So, now I present the human capital model.

The Human Capital Model

• Decision to invest in college education.

• From purely economic standpoint, a rational decision will involve a comparison of costs and benefits.

The Human Capital Model

• Costs (monetary) of college education:– Direct or out of pocket costs.

• Expenditure on tuition, special fees, and books and supplies.

– Indirect costs.• Opportunity cost.

• Benefits of college education.– Enhanced future flow of earnings.

The Human Capital Model

18 22

Age

Ann

ual

earn

ings H

H

C

C

65

(3)Incremental earnings

(2)Indirect

cost

(1)Directcost

Age-Earnings Profiles with and without college education

The Human Capital Model

• Discounting and net present value.– Compare costs and benefits. But one complication arises

because costs and benefits accrue at a different point in time. This is important because rupees expended and received at a different point in time has different value. A meaningful comparison of the costs and benefits associated with the college education requires that these costs and benefits be compared in terms of common point in time, for example, present.

– So, calculate the net present value of present and future costs and benefits.

The Human Capital Model

• Time preference.

– Why rupees expended or received at different point in time has different value.

• Because of interest payment on borrowed or rented money.

– And interest is paid because of time preference.

• Present Value Formula.

– Vp (1+i) = V1.

)1(1

i

VVp

Extended Discounting Formula

npi

En

i

E

i

E

i

EEV

)1()1()1()1( 33

221

0

4664

321

22019

18 )1()1()1()1( i

E

i

E

i

E

i

EEVp

• Formula for High School Graduate

64

1818)1(n

nn

p i

EV

• More compact formula

Decision Rule & Example

• NPV Decision rule: Vp > 0

• Example– C = 6000

– E1 = 2500

– E2 = 3000

– E3 = 3500

Internal Rate Of Return

• Internal rate of return is that rate of discount which equates the present value of future cost and benefits, or stated alternatively, it is that rate of discount at which the net present value of a human capital investment is 0 (zero)

0)1()1( 11

nn

r

E

r

CNPV

Internal rate of return

Internal Rate Of Return

• IRR Decision rule: r = i

Generalization & Implications

• Length of income:– Longer the length of income higher the internal rate of

return on human capital investment or more likely that the NPV will be positive.

• This explains why it is primarily young people who go to college and why younger people are more likely to migrate.

• It also explains the portion of earnings differentials that has been traditionally existed between women and men.

Generalization & Implications

• Costs.• Other things being equal lower the costs of human capital

investment, the larger number of people who will find that investment to be profitable.

• If the direct or indirect cost of attending college were to fall, we would expect enrollment to rise.

– Illustration: The guaranteeing of student loans by the government eliminates the risk to the lender and lowers the interest charged for borrowed funds to attend college. By reducing the private cost of attending college education, such loans guarantees increased college enrollments.

– Similarly the state of the economy may influence college enrollments through its effects on the indirect or opportunity cost of attending college.

Generalization & Implications

• For example, if recession reduces the earnings that high school graduates achieve, or, alternatively, reduces the probability of obtaining job, the opportunity cost of attending college will fall and enrollments will rise. Lower costs increases the NPV of a college education, making the investment in education “profitable” for some who previously found it to be unprofitable.

Generalization & Implications

• Earnings differentials.– Not only the length of the incremental earnings stream

critical in making a human capital investment decision, but so as the size of that differential. The generalization is that,

• Ceteris paribus, the larger the earnings differential between high school and college graduates, the larger the number of people who will invest in college education.

Criticisms Of Human Capital Theory

• Consumption or Investment

• Non-wage benefits

• The ability problem

• The screening theory

Comparison Of Human Capital And Physical Capital

• Similarities:– Both human capital and physical capital has investment aspect

common in them i.e. investment is required to build and accumulate both human capital as well as physical capital. For both thus the investor has to forgo the present consumption in anticipation of the future enhanced consumption.

– Both have returns. this similarity is a corollary of the first similarity.

– Both have their quantity and quality.– Both depreciates. For example, human health depreciates with

time. And education also depreciates if not used properly.

Comparison Of Human Capital And Physical Capital

– Because both human capital and physical capital depreciates, they both requires maintenances. For example, human health requires frequent care. And training and re-training is required to update the depreciating skills.

– The amortization period for a physical capital is the product cycle and for human capital the same is working life of the individual.

– Both have rental value. Both can be rented away.

Comparison Of Human Capital And Physical Capital

• Differences:– There are major differences in terms of the returns obtained from

the investment in human capital and physical capital. The investment in physical capital has only monetary and market returns whereas investment in human capital has non-monetary as well as non-market returns.

– The returns to human and physical capital tend to behave differently. When individual invest in physical capital, they are return-takers i.e. the owners accepts the return dictated by the market and cannot influence them. Since there are no market for the stock of human capital, investors in human capital become return-maker, as the amount, the quality and the maintenance of their human capital will dictate what the market will be willing to offer for their services.

Comparison Of Human Capital And Physical Capital

– Property rights and marketability: physical capital is tangible, that can be easily seen or touched. It includes machineries, factories, plants, raw materials etc. physical capital can easily be sold and transferred from one owner to another.

– But human capital is inseparable from the human beings and its ownership is restricted to the individual in whom it is embodied. Unlike physical capital, the stock of human capital is not marketable. Only the services that emanate from this stock are market goods.

Comparison Of Human Capital And Physical Capital

– Financing: lenders are more willing to lend funds for the investment in physical capital than in investment in human capital because the former is marketable and continue to be a good collateral. Physical capital can easily be sold, seized, jointly owned and transferred by sale or by inheritance.

– whereas human capital is intangible and in dissociable from its owner. This makes the private finance for the acquisition of human capital harder to obtain.

– The gestation period for physical capital is smaller than for human capital.

– Mobility wise both are different.

Human Capital Formation

– Stages of human capital formation• Primary education• Higher education • On-the-job training• Retraining• Retirement

Human capital and economic growth

• Theoretical background

• Links through which human capital affects economic growth (Chain of reasoning).

Theoretical background

• The classical growth theories predicted that,– economies will stagnate after reaching the high

growth levels. – And there is no continues rise in economic

growth.

Theoretical background

• Neoclassical growth theory of Solow (the Solow growth model) also predicted that economies will stop growing after reaching the steady state growth. But,

• There is way out of this problem, and that way is,– Technology.

• But,– Technology is assumed (it is exogenous and determined

outside the model). SO………problem again. – To solve the problem develop models that explain

technological progress.

Theoretical background

• To solve the problem economists developed,– Endogenous growth model.

• Paul M. Romer, Increasing returns and long run growth, Journal of Political Economy 94 (October 1986): 1002-1037,

• Robert Lucas Jr., On the Mechanics of Economic Development, Journal of Monetary Economics 22 (1988):3-42

– According to this model New Ideas (Human capital) becomes important for growth.

Links of Effects

1. At the macro level human capital can be viewed as a factor of production coordinate with physical capital (Aggregate production function approach)– It’s contribution of growth is greater larger the stock of

physical capital.– Growth of human capital is both a condition and a

consequence of economic growth.– Example: the success of the Marshall Plan in Europe

and the failure of foreign aid to LDC's.

Links of Effects

2. Human Capital and Technology– Human capital activities involve not merely the

transmission and embodiment in people of available knowledge, but also the production of new knowledge which is the source of innovation and of technical change which propels all factors of production. This latter function of human capital generates worldwide economic growth regardless of its initial geographic locus.

– Human capital as a source of new knowledge shifts production functions upward and generates worldwide economic growth.

Links of Effects

3. Human capital and population– Human capital is a link which enters both the causes

and effects of economic-demographic changes.

– Three ways.