Name: Ellie Ngoc Do
Course: Economics of Education
1) Introduction
In recent news, many studies have suggested that there is a causal relationship between the
quality of education and economic well-being. When talking about the quality of education, we
are referring to its return to the economy, which is human capital. At the same time, economic
well-being could be for an individual or society as a whole. This paper will discuss the definition
of human capital and its role in economic well-being. In addition to explaining this term, this
paper will offer the model of capital to shed light on how people make individual investments in
human capital as well as the return on education.
2) What is human capital?
According to Lovenheim and Turner, human capital refers to all the knowledge, skills,
information, and physical capacity of labor that can be used to produce economic values. This
might sound similar to physical capital as they both contribute to the production process and
produce valuable goods and services. However, this does not mean that humans are capital, or
objects ready to be used. Human capital is different from physical capital in the sense that these
skills and knowledge are inseparable from the workers and therefore, cannot act as collateral or
be exchanged.
Even though we tend to take human capital as the equivalent of education because we
normally think that formal education is the way to obtain human capital, these two concepts are
different. Human capital is not bounded to formal education only. Since, by definition, human
capital comprises all knowledge, skills, and physical advantage of labor, formal education, despite
being an efficient means of acquiring skills and knowledge, is not the only indicator for good
human capital ownership. For example, athletes or artists, who do not have educational degrees
but possess outstanding talents and physical capacities, offer a lot of human capital potential
that is economically beneficial. However, we cannot deny the causal relationship between
education and labor efficiency (human capital) as the return for most of the rest of the
population.
Human capital is the driving force for economic development in this era because the physical
capital and stock of resources are not adequate to account for the economic growth in some
nations. There are nations rich in resources, capital, and labor but they cannot utilize all those
elements and therefore, do not have the same level of growth compared to nations with more
limited resources but acquire higher human capital quality, leading to significant returns in the
national economic performance. Thus, human capital would be the most important indicator for
the growth of the economy of a nation.
3) Why should we invest in human capital (individual investment decision)?
The general common reason for a person to invest in something in the present is that they
expect to receive a higher return on their investment in the future, like buying stocks or going to
bed early before the day of exams. Using the same reward-favor behavior of humans, the human
capital model is designed to explain how the individual current education costs or human capital
investment would reward workers with higher future earnings. Students would pursue a certain
level of education in order to obtain their desired level of future earnings. In other words, they
are accepting the current financial costs of schooling in return for the earning benefit in the
future. In essence, this model is a general framework for all individuals to evaluate the costs and
benefits of their education decisions, with the costs suffered now and the rewards enjoyed later.
The costs and benefits of education investment are plugged into the calculation of this model to
project the outcomes of education persuasion. The main benefit of education investment would
be the higher incomes earned over the working life. There are many more immeasurable benefits
that come with education like social connection, social respect, a higher chance of employment,
etc., however, for the simplicity of the model, we will only consider the financial return of
education investment, which is the future earnings.
The costs of education would involve the direct costs like the actual amount of money an
individual spend to finance their learning at an institution, including tuition and textbooks. In
addition, education takes time, which is the time that an individual potentially can join the labor
market and make income if they did not go to school. The potentially lost wages are another cost
of attending school because education requires your full mental and physical participation, which
hinders any full-time employment that can earn a significant income.
The framework of the human capital model is based on the simple intuition of weighing
costs and benefits. If individuals see that their financial spending on education and foregone
earnings are relatively less significant to the skills and knowledge they acquire from their
education resulting in a higher earning over their working life, they will decide to attend school.
However, depending on the skills and level of future income an individual wishes, they also need
to decide which type of school and major to pursue. However, as this kind of information is
difficult to quantify, the easiest way to access how much a person invests in their education is
the number of years attending school and how much they spend on education. The future return
would be measured in the number of years they can enjoy the financial reward and how much of
the reward they can enjoy.
Even though there are many levels of education, the level that makes a significant
difference in future earnings is higher education as these are the levels that provide skills and
knowledge that are useful and applicable to produce economically valuable goods and services.
Therefore, most human capital would measure the years spent on higher education rather than
the comprehensive duration of attending school of an individual.
This given graph Paulsen shows the costs and benefits of investing in higher education for
an average individual who starts college at 18 and pursues a four-year program. The H curve is
displaying the growth of income given that the individual has no investment in higher education.
Not going to college means the individual does not have to put up with any of the costs but at
the same time, they would not have any of the potential rewards and earn a lower level of
income.
On the other hand, the C curve demonstrates the gain in the income of individuals if they
pursue higher education. As we can see for the four years they are in college, they suffer a loss
in income due to the direct costs (tuition and expenses) and the indirect costs (forgone earnings)
of education, however, they can enjoy a much higher return in earnings which can redeem their
education costs.
Therefore, using the human capital model, it is a reasonable decision to pursue education if
the goal is to earn more in the future.
4) Private and Social Return of Education:
As we have discussed the return on education investment is the higher earnings in the
future for individuals, but that is not the only possible return. There are two kinds of returning
education values: private return and social return. This means that the return of education is not
only enjoyed individually but also socially. Individual return refers to the benefits that a person
enjoys after their attendance in education. Social return is the type of benefit that society enjoys
thanks to the school attendance of an individual. In other words, if a person pursues higher
education, not only they be rewarded with high returns, but society would also be better off. For
example, a person went through medical school and became a doctor, who makes hundreds of
thousands of dollars per year. This doctor, when practicing medicine to make his incredibly high
income because of his long years of education, also saves many people. The high salary that this
doctor earns is their individual return and the people that they save are the social return from
their education.
It is a challenging task to clearly separate the two kinds of benefits because they
intertwine, inter influence, and interdepend on each other. Economists have chimed in their
effort to come up with many studies and formulas to capture or even approximate the share of
social and individual returns. For the individual return, some of the prominent methods to
measure the Mincer equation which derives the relationship between wages and schooling by
accounting for the optimal investment in schooling or the twin studies where the differences in
school attainments and earnings between twins were evaluated given that they share the same
genetic characteristics.
For social return, there is a variety of empirical evidence for this benefit, and the most
prominent indicator for this is the national income, or GDP, using the aggregate production
function. This function can capture all the social benefits because it was set up to account for all
economic activities in a country. If we go back to the doctor example, the number of people they
save, after getting treated, will pay their hospital bills, and potentially join the labor force to make
income. All these outcomes have a form of economic activity and make their way into this
function. There are, of course, a lot of non-economic returns of education like becoming a kind
person and a good stay-at-home parent and this function does not give an absolute number on
the social return, only a good approximation of how much the society will enjoy with a high level
of human capital. This function considers three variables of capital (K), labor (L), and technological
advancement (A) in the calculation of national income (Y), which is also the GDP, the Gross
Domestic Product. The GDP counts all the new, domestic goods and services produced each year,
which acts as a comprehensive measure to evaluate the level of production and economic wellbeing of a country. Technology advances are the innovation that humans that increases the
productivity and efficacy of given a fixed amount of labor and capital. The ability to come up with
innovations and changes is the knowledge and skills of humans, which are a part of human
capital. Therefore, the level of technology variable captures the human capital elements. As we
can see in this function, labor and technology advances are considered separately because the
level of human capital does not grow if the number of laborers grows given that the laborers do
not have any skills or developments that have high social and economic returns. Therefore, given
that the over-reproduction of laborers can cause strains on the ability to provide limited
resources to the planet, the most sustainable and productive way to increase the level of
production is to increase the variable of human capital. Even though education is not the only
way to increase human capital and its return, according to the human capital model, it is a reliable
way to surely harvest and earn that high level of return by efficiently improving the level of
human capital.
5) Conclusion:
By using the human capital model, we can see the future return of pursuing higher
education is significantly greater than the one with lower education. It also shows that the longer
time you spend in education, the more human capital you harvest which contributes to your
higher individual return. This demonstrates a clear causal relationship between human capital
and education. Although education like going to college is not the only way to gain more human
capital, it is a reliable way that is proven to have a sure and high return. This return benefits not
only the individual but also the society that they are in. With the aggregate production function,
we can see that human capital is crucial to the sustainable growth of an economy. Therefore, this
paper is a call for countries to invest more in their education and encourage their citizen to pursue
education, which will lead to a higher return for society and the economy.
Reference:
(1) Lovenheim, M, and Turner, S. (2018). Economics of Education, Macmillan Learning.
(2) Paulson, M, & Smart, J (2001), Chap 3, The Economics of Human Capital and Investment in
Higher Education, The Finance of Higher Education: Theory, Policy, and Practice.