Labor Economics
5. Human Capital
Martin Halla
University of Innsbruck
Department of Public Finance
Last update: June 10, 2015
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Human Capital
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Theory of compensating differentials suggests that wages will
vary among workers because jobs are different
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Wages also will vary because workers are different
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Why do some workers obtain a lot of schooling, and other
workers drop out at an early age?
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Trade-off between lower earnings today and higher earnings later;
financial and institutional constraints
Is the money spent on education is a good investment?
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Workers bring into the labor market a unique set of abilities and
acquired skills, called human capital
Most of our human capital is acquired in school and in formal and
informal on-the-job training programs
Rate of return to schooling compare vs. other investments
We will assume: workers choose human capital to maximize the
present value of lifetime earnings
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women, but that there are substantial differences among racial and ethnic groups. By 2010,
about
8 percent Market:
of white personsSome
did not have
a high schoolFacts
diploma, (I)
as opposed
Education inonly
the
Labor
Stylized
to 13 percent of African Americans and 34 percent of Hispanics. In contrast, more than
38 percent of whites had at least a college diploma, as compared to only 20 percent of African
Americans and 14 percent of Hispanics.1
TABLE 6-1
Educational Attainment of U.S. Population, 2010 (Persons Aged 25 and Over)
Source: U.S. Bureau of Labor Statistics, Annual Demographic Supplement of the Current Population Surveys, March 2010.
Highest Grade Completed (Percentage of Population in Education Category)
Less Than
High School
Group
All Persons
Gender:
Male
Female
Race/ethnicity:
White
Black
Hispanic
1
High School
Graduates
Some
College
11.6%
32.5%
16.8%
11.3
12.0
31.7
33.3
17.1
16.5
8.1
13.4
34.3
32.5
37.3
12.5
17.5
20.0
12.9
Associate
Degree
9.1%
Bachelor’s
Degree
Advanced
Degree
19.4%
10.5%
10.2
8.0
18.4
10.4
10.2
10.9
9.7
9.4
6.3
26.4
13.3
10.1
11.9
6.6
3.8
A careful study of the differences in educational attainment among race/ethnic groups is given by
I Little divergence
Stephen V.across
Cameron
and James
J. Heckman,
“The across
Dynamicsethnicities
of Educational Attainment for Black,
sexes,
large
differences
Hispanic, and White Males,” Journal of Political Economy 109 (June 2001): 455–499.
I Patterns are highly correlated with labor force participation rates, unemployment
rates, and earnings (see next slide)
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Education in the Labor Market: Some Stylized Facts (II)
Human Capital 237
TABLE 6-2 Labor Market Characteristics, by Education Group, 2010 (Persons Aged 25–64)
Source: U.S. Bureau of Labor Statistics, Annual Demographic Supplement of the Current Population Surveys, March 2010.
Less Than
High School
High School
Graduates
Some
College
Labor force participation rate
Unemployment rate
Annual earnings (in $1000)
61.9
16.9
22.1
76.0
12.2
33.1
79.9
8.7
40.5
85.8
4.7
69.8
Labor force participation rate
Unemployment rate
Annual earnings (in $1000)
74.0
17.8
25.8
83.1
13.9
38.1
85.6
10.0
48.9
91.6
5.1
85.6
Labor force participation rate
Unemployment rate
Annual earnings (in $1000)
48.2
15.4
17.2
68.2
9.9
26.5
75.0
7.5
32.6
80.4
4.3
53.8
Labor force participation rate
Unemployment rate
Annual earnings (in $1000)
56.3
17.8
24.7
76.4
11.2
35.3
80.4
7.9
42.6
86.1
4.1
71.9
Black
Labor force participation rate
Unemployment rate
Annual earnings (in $1000)
49.5
23.3
19.5
70.9
17.7
29.0
77.8
12.6
33.5
87.2
7.9
56.1
Hispanic
Labor force participation rate
Unemployment rate
Annual earnings (in $1000)
69.6
15.3
21.1
79.0
12.3
28.2
80.9
9.7
36.3
84.8
5.6
57.9
All workers:
Gender:
Men
Women
Race/ethnicity:
White
College
Graduates
differences in educational attainment among workers are significant because, as
I Education playsThe
a crucial
role in improving labor market out- comes for both men
Table 6-2 shows, education is strongly correlated with labor force participation rates,
and women and
for workers
in all
racial
groupsrate of persons who lack
unemployment
rates, and
earnings.
Theand
labor ethnic
force participation
a high school diploma is only 62 percent, as compared to 86 percent for college graduates.
Similarly, the unemployment rate of high school dropouts in the midst of a deep recession
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Present Value
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Any study of any investment decision must contrast
expenditures and receipts incurred at different time periods
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The notion of present value (P V ) allows us to compare dollar
amounts spent and received in different time periods.
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Assuming an discount rate of r, the P V of a payment y dollars
next year is given by
y
PV =
1+r
P V tells us how much needs to be invested today in order to
have y dollars next year
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P V of y dollars received t years from now equals
PV =
Martin Halla (U Innsbruck)
y
(1 + r)t
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The Schooling Model
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First analyzed by Jacob Mincer (JPE, 1958)
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Workers acquire the education level that maximizes the PV of
lifetime earnings
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Ignore other pos. effects of education (e.g., marriage market)
Going to school involves two different types of costs
1. Opportunity cost: A year spent in school is a year spent out of the
labor force (i.e., forgo some earnings)
2. Direct cost: tuition, books, and fees
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Since school has no intrinsic value to the student, employers will
have to offer higher wages
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Compensating wage differential for schooling costs
See age-earnings profile (that is, the wage path over the life
cycle) on next slide
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Potential Earnings Streams
I A high school graduate can
earn wHS from age 18 until
the age of retirement
I If s/he decides to go to
college, s/he forgoes these
earnings and incurs a cost of
H dollars for four years and
then earns wCOL until
retirement age
I wCOL > wHS
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Present Value of Age-Earnings Profiles
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P V of the earnings stream for high school (HS) graduate
P VHS = wHS +
I
wHS
wHS
wHS
+ ... +
+
(1 + r)
(1 + r)2
(1 + r)46
(1)
P V of the earnings stream for college (COL) graduate
H
H
H
P VCOL = −H −
−
−
(1 + r)
(1 + r)2
(1 + r)3
|
{z
}
Direct cost
wCOL
wCOL
wCOL
+
+
+ ... +
(1 + r)4
(1 + r)5
(1 + r)46
|
{z
}
(2)
Post-college Earnings Stream
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College attendance if: P VCOL > P VHS
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Discount rate plays a crucial role
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The higher the rate of discount (less value is attached to future
earnings), the less likely a worker will invest in education
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The Wage-Schooling Locus
I Wage-schooling locus gives
the salary that a particular
worker would earn if he
completed a particular level
of schooling
I If the worker graduates from
high school, he earns
$20,000 annually.
I If he goes to college for one
year, he earns $23,000.
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The Wage-Schooling Locus Is
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Market determined: salary for each level of schooling is
determined by the intersection of the supply demand for those
particular workers
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Upward sloping: To attract educated workers, employers must
compensate those workers for the costs incurred in acquiring an
education
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Slope: provides the rate of return to schooling (increase in wage
due to an additional year of schooling)
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Is concave: Law of diminishing returns applies to human capital
accumulation. Each extra year of schooling generates less
incremental knowledge and lower additional earnings than
previous years.
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The Schooling Decision
I MRR schedule gives the
marginal rate of return to
schooling (i.e, % increase in
earnings resulting from an
additional year of school:
∆w/∆s)
I Maximization of P V of lifetime
earnings: go to school until the
marginal rate of return to
schooling equals the rate of
discount
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Optimal stopping rule
I A worker with discount rate r
goes to school for s∗ years
I A worker with discount rate r
0
goes to school for s years
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The Schooling Decision: Further Aspects
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Other benefits of education
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Idisyncratic-factors: chance encounters with influential teachers
or ‘significant others’
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Uncertainty in the rewards to particular types of education
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We assumed that students the shape of the wage-schooling locus
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Economic and social conditions change in unpredictable ways
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Education and Earnings
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Schooling and Earnings: Different Rates of Discount
Figure :
Al has a higher rate of discount (rAL ) than Bo (rBO ), so that Bo graduates from high
school but Al drops out. Al chooses point PAL on the wage-schooling locus and Bo chooses point PBO .
The observed data on wages and schooling in the labor market trace out the common wage-schooling
locus of the workers. As long as workers differ only in their discount rates, therefore, we can calculate the
marginal rate of return to schooling from the wage differential between two workers who differ in their
educational attainment.
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Schooling and Earnings: Different Abilities
Figure :
Ace and Bob have the same discount rate (r), but each worker faces a different
wage-schooling locus. Ace drops out of high school and Bob gets a high school diploma. The wage
differential between Bob and Ace (or wHS − wDROP ) arises both because Bob goes to school for one
more year and because Bob is more able. As a result, this wage differential does not tell us by how much
Ace’s earnings would increase if he were to complete high school (or wACE − wDROP ).
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Estimating the Rate of Return to Schooling
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Policy Application: School Construction in Indonesia
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Policy Application: School Quality and Earnings
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School Quality and the Rate of Return to Schooling
Figure :
Source: David Card and Alan B. Krueger, "Does School Quality Matter? Returns to
Education and the Characteristics of Public Schools in the United States," Journal of Political Economy
100 (February 1992), Tables 1 and 2. The data in the graphs refer to the rate of return to school and the
school quality variables for the cohort of persons born in 1920-1929.
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Do Workers Maximize Lifetime Earnings?
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Schooling as a Signal
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Education as a Signal
Figure :
Workers get paid $200,000 if they get less than ȳ years of college, and $300,000 if they get at
least ȳ years. Low-productivity workers find it expensive to invest in college, and will not get ȳ years.
High-productivity workers do obtain ȳ years. As a result, the worker’s education signals if he is a
low-productivity or a high-productivity worker
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Postschool Human Capital Investments
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Age-Earnings Profiles of Full-Time Workers, 2010
Figure :
Source: U.S. Bureau of Labor Statistics, Annual Demographic Supplement of the Current
Population Surveys, 2010.
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On-the-Job Training
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On-the-Job Training and the Age-Earnings Profile
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The Acquisition of Human Capital over the Life Cycle
Figure :
The marginal revenue of an efficiency unit of human capital declines as the worker ages (so
that M R2 0, the marginal revenue of a unit acquired at age 20, lies above M R3 0 ). At each age, the
worker equates the marginal revenue with the marginal cost, so that more units are acquired when the
worker is younger.
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The Age-Earnings Profile Implied by Human Capital Theory
Figure :
The age-earnings profile is upward-sloping and concave. Older workers earn more because
they invest less in human capital and because they are collecting the returns from earlier investments. The
rate of growth of earnings slows down over time because workers accumulate less human capital as they
get older.
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Policy Application: Evaluating Government Training
Programs
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