Chapter Nine
Human Capital
Theory: Applications
to Education and
Training
Created by: Erica Morrill, M.Ed
Fanshawe College
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-1
Chapter Focus
 Factors
that determine the market rate
of return to education
 Is education economically worthwhile?
 Is education a predictor of greater
productivity?
 Market signaling and screening
 Government-funded training programs
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-2
Human Capital Theory
 Investments
are made to improve
productivity and earnings
 Costs incurred with the expectation of
future benefits
 Benefits must exceed costs by a
significant amount
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-3
Costs
 Direct
costs
 books,
tuition
 Opportunity

cost
income forgone
 Private
Costs/Social Costs
 Real Costs/Pecuniary or transfer costs
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-4
Figure 9.1
Alternative Income Streams
Earnings
Stream C
f
Stream B
e
b
Stream A
c
a
Direct costs
d
16
18
22
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-5
Age-Earnings Profiles
 Increase
with age but at a decreasing
rate
 Higher for those with more education
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-6
Choosing an Income Stream
 Simplifying
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 9-7
Human Capital Investment
Decision

Quantity of education


Human capital wealth


maximizes the net present value of lifetime
earnings
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 9-8
Implications of Theory
 Investment
should be made early in
one’s life
 Little incentive for individuals
experiencing discontinuity in workforce
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-9
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 9-10
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 9-11
Education and Market
Equilibrium
 Interaction
between
 individuals’
preferences
 employers’ preferences
 Human
capital positively affects
productivity of workers
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-12
Figure 9.3
Education and Market
Equilibrium
UA
Wage
EA
UB
I
EB
I
Years of Education
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-13
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
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-14
Figure 9.4
Offered Wage and Signaling
Cost Schedules
Cost of education C(y)
CL(y)
Wages
W(y)
2
W(y)
CH(y)
1
1
y*
2
Education
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-15
Empirical Evidence Education
and Earnings
 Earnings
increase with age experience
 Increase is most rapid to age 45 or 55
for individuals with the most education
 Differential is wider between groups at
ages 45-50 than 20-30
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-16
Human Capital Earnings
Function
 Estimates
the rate of return to education
 Least-squares regression of earnings
on education
 Controls for other factors that may affect
earnings
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-17
Signaling, Screening and Ability
 Determinants
 innate
difficult to control
ability
 Signaling/screening
 Private
return on education
 Social return on education
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-18
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
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-19
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 9-20
Training
Specific Training
General Training
 Skills used in various firms  Training useful to the firm
that provides the training
 Firms will offer higher wage
 Trainee is unwilling to bear
for this training
the cost because no higher
 Trainee willing to bear the
earnings
cost since higher wages
 Firm does not have to pay
offered for these skills
higher wages because other
firms are not competing for
such trainees
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-21
Costs, Benefits and
Financing of Training
Figure 9.7 a
Costs and Benefits of Training
Wages
VMP
VMP*
benefits
costs
Wa=VMPa
VMPt
0
training t*
Time
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-22
Costs, Benefits and
Financing of Training
Figure 9.7 b
Specific training as a shared investment
VMP*
Wages
VMP
Employer’s benefits
Employee’s benefits
W*
Wa=VMPa
Employee’s costs
Wt
Employer’s costs
VMPt
0
training
t*
Time
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-23
Costs, Benefits and
Financing of Training
Figure 9.7 c
Earnings growth with gradual training
Wages
VMP
VMP*
Employee’s costs
Employer’s benefits
Employee’s benefits
Wt
W*
Wa=VMPa
Employer’s costs
VMP0
0
Time
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-24
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 9-25
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 9-26
End of Chapter Nine
© 2002 McGraw-Hill Ryerson Ltd.
Chapter 9-27