CHAPTER 9
Human Capital
Labour Economics
Professor: Dr. Jason Dean
1
HUMAN CAPITAL
• We have talked about the quantity of labour supply but
not the quality.
• Human capital refers to the economic value of the
unique set of abilities and acquired skills of a worker.
– People bring into the labour market a unique set of
abilities and acquired skills known as human capital.
– Workers add to their stock of human capital
throughout their lives, especially through formal
education and on-the-job experience.
Labour Economics
Professor: Dr. Jason Dean
2
HUMAN CAPITAL
• Education: Stylized Facts
– Education is strongly correlated with:
– Labour force participation rates
– Much lower for less educated
– Unemployment rates
– Much higher for less educated
– Earnings
– Strong positive correlation
Educations plays a significant role in
improving one’s labour market outcomes.
Labour Economics
Professor: Dr. Jason Dean
3
HUMAN CAPITAL INVESTMENT: THE BASIC MODEL
• Investments in human capital are made to improve productivity and earnings.
• Is the investment worthwhile?
– Costs incurred with the expectation of future benefits.
– Thus, expected benefits must exceed costs.
Labour Economics
Professor: Dr. Jason Dean
4
OPTIMAL HUMAN CAPITAL INVESTMENT
• The optimal investment in human capital is determined by comparing the:
– Costs and the benefits of an additional year of education, using the following
concepts:
1. Marginal costs and benefits of education
2. Rate of return on investment in education
Labour Economics
Professor: Dr. Jason Dean
5
HUMAN CAPITAL INVESTMENT: THE BASIC MODEL
• EXPECTED RETURNS OR BENEFITS
– To education and training investments (human capital) are in the form of:
1.
Higher future earnings.
2.
Increased job satisfaction
– More responsibility autonomy etc.
3.
A greater appreciation of non-market activities and interests
– Reading, hobbies, internet etc.
Labour Economics
Professor: Dr. Jason Dean
6
HUMAN CAPITAL INVESTMENT: THE BASIC MODEL
• COSTS OF ACQUIRING OR ADDING TO HUMAN CAPITAL
– Fall into three categories:
1.
Out-of-pocket or direct expenses – tuition costs, expenditures on books, and other
supplies.
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2.
Forgone earnings – salaries/income given up (i.e. opportunity cost).
3.
Psychic losses – occur because learning is often difficult and tedious for some people.
Professor: Dr. Jason Dean
7
SIMPLE ILLUSTRATION OF MODEL
Potential Earnings Streams Faced by a High School Graduate
Dollars
•
after getting her high school
Goes to College
w
A person who quits school
COL
diploma can earn wHS from
D
age 18 until retirement.
Quits After
High School
w
HS
•
A
B
If she decides to go to
college, she foregoes these
0
18
22
C
-H
65
Age
earnings and incurs a cost of
H dollars for 4 years and then
earns wCOL until retirement.
If Area D > (B + C) then she should go to college.
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Professor: Dr. Jason Dean
8
Alternative Income Streams
A 16-year old faces 3 choices:
He can drop out of high school at
16 and get income stream A for
the remainder of his working life.
$Earnings
Complete high school and earn
nothing between 16-18, but get
income stream B after graduation.
The opportunity cost of staying in
school is the foregone earnings
(area a), while the benefits are
increased earnings, (area b + e).
University: will incur direct costs,
in addition to foregoing income
stream B, while attending
university. The total cost of
attending university equals the
area b + c + d, while the benefit is
the higher earnings stream
corresponding to area f.
f
e
b
Direct costs
d
16
18
STREAM B
(HIGH SCHOOL)
STREAM A
(NO HIGH
SCHOOL)
Age
c
a
STREAM C
(UNIVERSITY)
22
9
OPTIMAL HUMAN CAPITAL INVESTMENT
• BENCHMARK MODEL
• Which lifetime income stream should the individual choose?
• To address this question we will initially make the following simplifying assumptions:
1. No direct (consumption) utility or disutility from education
2. Hours of work are fixed
3. Income streams associated with education amounts are known
4. Individuals can borrow and lend at the real interest rate (perfect capital markets)
Labour Economics
Professor: Dr. Jason Dean
10
PRESENT VALUE CALCULATIONS
• Present value allows comparison of dollar amounts spent and received in different time periods. (An
idea from finance.)
• Present Value = 𝑷𝑽 =
𝒚
(𝟏 + 𝒓)𝒕
– r is the per-period discount rate which depends on:
– The market rate of interest.
– Time preferences: how a person feels about giving up today’s consumption in return for future
rewards.
– y is the future value.
– t is the number of time periods.
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Professor: Dr. Jason Dean
11
HUMAN CAPITAL INVESTMENT: THE BASIC MODEL
The Concept of Present Value in more detail:
• The FV (= B1) of $100 at 5% interest rate a year from now is:
B1 = B0 + B0(r) = B0(1 + r)
= 100(1.05) = $105
(9.1)
• Solving for B0 (= PV) yields:
B0 
B1
105

 100
(1  r )
1.05
(9.2)
where r = market interest rate, and (1 + r) = discount factor.
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Professor: Dr. Jason Dean
12
HUMAN CAPITAL INVESTMENT: THE BASIC MODEL
•
If the return is two years from now, the FV (= B2) is:
B2 = B1 + B1(r) = B1(1 + r)
(9.3)
Recall: B1 = B0(1 + r)
and substituting equation (9.1) into equation (9.3) yields:
B2 = B0(1+ r) + B0(1+ r)(r) = B0(1+ r)(1+ r) = B0(1+ r)2
(9.4)
Since B2 = B0(1 + r)2, therefore, solving for B0 (= PV) will yield:
•
E.g. If the PV of a human capital investment yields return B1 in the 1st year, B2 in the
2nd year and so forth, and for T years, it is expressed as:
Present Value =
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B3
B1
B2
BT



...

T
1  r 1  r 2 1  r 3
1  r 
Professor: Dr. Jason Dean
(9.6)
13
OPTIMAL HUMAN CAPITAL INVESTMENT
• Formal analysis:
• The costs and benefits can be more formally represented in terms of the present value formula.
• Consider an 18-year-old high school graduate faced with a decision to work or go to college:
• The present value of benefits at age 18 over T – 18 remaining years of work would be:
PV = Y/(1+r)0 + Y/(1+r) 1 + … + Y/(1+r) T-18
T-18
PV = Y + ∑ Y/(1+r) t
t=1
OR
𝒀
𝑷𝑽 ≈ 𝒀 +
𝒓
Where, Y = income (constant over working years, T – 18)
r = market interest rate (discount rate)
T = age
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Professor: Dr. Jason Dean
14
OPTIMAL HUMAN CAPITAL INVESTMENT
• Now let’s consider the marginal cost and marginal benefit of investing in further (post-secondary)
education.
• Marginal Cost (MC)
– As illustrated in Figure 9.1, the cost consists of:
– The direct cost of schooling, D.
– Plus the foregone earnings while attending school, Y.
– Thus, the marginal cost, MC, of investing in a further year of schooling is:
MC = Y + D
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Professor: Dr. Jason Dean
15
OPTIMAL HUMAN CAPITAL INVESTMENT
• Marginal Benefit (MB)
– On the benefits side, assume that a further year of schooling permanently increases the salary of the
student by ΔY.
– Since annual earnings are now Y + ΔY the present value of net income with one further year of
education, PV*, is
𝑷𝑽∗ =
(𝒀 + 𝜟𝒀)
–D
𝒓
– Where, ΔY = increase in annual income due to extra year of schooling (MB)
Labour Economics
Professor: Dr. Jason Dean
16
OPTIMAL HUMAN CAPITAL INVESTMENT
– The net gain from an additional year of school is s given by the difference in the two present values:
(𝑌 + 𝛥𝑌)
𝑌
PV∗ − PV =
–D − 𝑌+
𝑟
𝑟
=
Recall:
PV ≈ Y + Y/r
(𝜟𝒀)
− (Y + D)
𝒓
MB
MC
It is optimal to keep acquiring
education up to the point
where MB = MC
(𝜟𝒀)
= (Y + D)
𝒓
Labour Economics
Professor: Dr. Jason Dean
17
OPTIMAL HUMAN CAPITAL INVESTMENT
MC increase b/c:
Forgone earnings
increase with schooling
and also direct costs.
The net benefit of obtaining education
level E equals the difference between
benefits and costs, and is maximized
by setting marginal benefit
(MB) equal to marginal cost (MC).
MB falls b/c:
Diminishing returns
Labour Economics
Professor: Dr. Jason Dean
18
OPTIMAL HUMAN CAPITAL INVESTMENT
• To maximize the net present value of lifetime earnings:
– Increase education:
– Until the present value of benefits of additional year (MB) equals present
value of additional costs (MC)
OR
– Until the internal rate of return i exceeds the market rate of interest r, the
opportunity cost of financing the investment.
Labour Economics
Professor: Dr. Jason Dean
19
INTERNAL RATE OF RETURN
• Internal Rate of Return
• For any specific amount of education, the IIR can be defined as the implicit rate of return earned
by an individual acquiring that amount of education.
• How large could the discount rate be and still render the investment profitable?
The Internal Rate of
Return is the interest
rate that makes the Net
Present Value zero
Set PV = C and solve for r
The IRR is the rate at which the present value of all future
cash flows is equal to the initial investment or in other words
the rate at which an investment breaks even.
Labour Economics
Professor: Dr. Jason Dean
20
OPTIMAL HUMAN CAPITAL INVESTMENT
• The internal rate of return as a function of
The individual should invest
until the internal rate of return
equals the opportunity cost of
the investment, given by the
interest rate, r.
years of schooling is given by the schedule
i in panel (b).
• The individual should invest until the
internal rate of return equals the
opportunity cost of the investment, given
by the interest rate, r.
• This condition yields the same education
choice E*, when we look at MB=MC.
Labour Economics
Professor: Dr. Jason Dean
21
IMPLICATIONS OF THEORY
• Investment should be made early in one’s life
– When older:
– Period to enjoy benefits is shorter
– Forgone earnings are higher
• Less incentive for individuals experiencing discontinuity in the workforce
• Investment in education and progressive tax system
– Higher taxes means a shift downwards in income streams
– MB=MC will be at a lower level
Labour Economics
Professor: Dr. Jason Dean
22
AGE-EARNINGS PROFILES
• Three important properties of age-earnings profiles:
– Highly educated workers earn more than less educated workers.
– Earnings rise over time at a decreasing rate.
– The age-earnings profiles of different education cohorts diverge over time (they “fan
outward”).
– Earnings increase faster for more educated workers.
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Professor: Dr. Jason Dean
23
AGE-EARNINGS PROFILES
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Professor: Dr. Jason Dean
24
AGE-EARNINGS PROFILES
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Professor: Dr. Jason Dean
25
ACTIVE LEARNING
• Calculate the present value of earnings for a discount rate of 10%, 45 time horizons, and per period
wages w of 10. Assume the person works 5 days a week, 48 weeks a year, and works 8 hours per day.
Annual hours:
Estimate using Y+ Y/r formula
48×5×8=1,920
Annual earnings:
1,920×$10=$19,200
𝑃𝑉 = 𝑌 +
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𝑌
19200
45
𝑡=1 (1+𝑟)𝑡 = 19200 + .10 =$211,200
Professor: Dr. Jason Dean
26
ACTIVE LEARNING
•
Debbie is about to decide which career path to pursue. She has narrowed her options to two alternatives:
– She can become either a marine biologist or a concert pianist.
•
Debbie lives for two periods. In the first, she gets an education. In the second, she works in the labour market. If
Debbie becomes a marine biologist, she will spend $15,000 on education in the first period and earn $472,000 in the
second period. If she becomes a concert pianist, she will spend $40,000 on education in the first period and then earn
$500,000 in the second period.
a) Suppose Debbie can lend and borrow money at a 5 percent annual rate. Which career will she pursue?
b) What if she can lend and borrow money at a 15 percent rate of interest? Will she choose a different option? Why?
c) Suppose musical conservatories raise their tuition so that it now costs Debbie $60,000 to become a concert
pianist. What career will Debbie pursue if the discount rate is 5 percent?
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Professor: Dr. Jason Dean
27
ACTIVE LEARNING - SOLUTION
a) Debbie will compare the present value of income for each career choice and choose the career with the greater present
value. If the interest rate is 5 percent,
PVBiologist = -$15,000 + $472,000/(1.05) = $434,523.81
and
PVPianist = -$40,000 + $500,000/(1.05) = $436,190.48
Therefore, she will become a concert pianist.
b) If the rate of interest is 15 percent, however, the present value calculations become
PVBiologist = -$15,000 + $472,000/(1.15) = $395,434.78
and
PVPianist = -$40,000 + $500,000/(1.15) = $394,782.61
In this case, Debbie becomes a biologist. As the interest rate increases, the worker discounts future earnings more,
lowering the returns from investing in education.
Labour Economics
Professor: Dr. Jason Dean
28
ACTIVE LEARNING - SOLUTION
• C) Debbie will compare the present value of being a biologist from part (a) with the present value of
becoming a pianist. The relevant present values are:
PVBiologist = -$15,000 + $472,000/(1.05) = $434,523.81
and
PVPianist = -$60,000 + $500,000/(1.05) = $416,190.48
In this case Debbie will become a biologist, showing that as the cost of an investment increases, the
chance of pursuing that investment falls.
Labour Economics
Professor: Dr. Jason Dean
29
SCHOOLING AS A SIGNAL
The Signaling Model
• Recall the stylized fact that there is a positive relationship
between education wages.
– We tend to think that education is productivity enhancing.
– In terms of causality: education  wages.
• Here we explore an alternative idea that suggests education may
just be a signal of ability.
• Thus, the positive relationship between higher wages and
education could be due to ability rather than any productivity
enhancing attributes of education.
Labour Economics
Professor: Dr. Jason Dean
30
SCHOOLING AS A SIGNAL
The Signaling Model
•
Apart from observing certain indicators (age, experience, education, and personal characteristics) that are
correlated to productivity, employers cannot determine the actual productivity of any applicant during the
interviewing and hiring process, therefore, they rely on the formal education that workers acquire.
• Some see the educational system as a means of finding out who is productive, not of enhancing worker
productivity.
• Employers can use education as a signaling device, which enables them to sort workers into different
levels or categories of productivity rather than assume that all workers/applicants are “average.”
Filter of
ability
Higher
education
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Higher
wages
So we could observe a
positive relationship between
wages and education even if
the later does not enhance
productivity.
Professor: Dr. Jason Dean
31
SCHOOLING AS A SIGNAL
• Education reveals a level of attainment which signals a
worker’s qualifications or innate ability to potential
employers.
• Information that is used to allocate workers in the labour
market is called a signal.
• There could be a “separating equilibrium.”
– Low-productivity workers choose NOT to obtain X years
of education, voluntarily signaling their low productivity.
– High-productivity workers choose to get at least X years
of schooling and separate themselves from the pack.
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Professor: Dr. Jason Dean
32
AN ILLUSTRATION OF THE SIGNALING MODEL
An Illustration of Signaling
• Employers use education to classify workers with less
than e* years of education as lower-productivity workers
that should be rejected or prevented from any job paying a
wage above 1.
• Those workers with at least e* or more years of education
beyond high school are considered to be the higherproductivity workers who can obtain a wage of 2.
BUT - if education is a signaling device
which yields a wage of 2, all workers would
want to acquire the signal of e* if it were
costless for them to do so.
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Professor: Dr. Jason Dean
33
AN ILLUSTRATION OF THE SIGNALING MODEL
But lets further suppose that the costs of education are lower
for those with high ability compared to those with low
Costs (low ability)
ability.
Think of the psychic costs – perhaps it takes more able
workers less time or that they simply dislike school less.
Crucial assumption: education is more costly for low
Costs (high ability)
ability workers.
Now consider the optimal choice of
education for each type of worker.
Low ability?
High ability?
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Professor: Dr. Jason Dean
34
THE LIFETIME BENEFITS AND COSTS OF EDUCATIONAL SIGNALING
• PVE1 and PVE2 are the sums of the discounted
lifetime earnings of workers who earn wage of 1 and
wage of 2, respectively.
• Each year of education costs C for those with lower
productivity (lower cognitive ability or distaste for
Max e=e*
for low
prod.
learning) and C/2 for those with greater productivity.
• Workers choose the level of schooling at which PVE1
– C and PVE2 – C/2 will be maximized.
• Low productivity workers: the choice would be A0
with zero years of schooling beyond high school
Max e=0
for low
prod.
because acquiring e* yields BD (< A0).
e1
e2
• Higher productivity workers: with cost of C/2
would find it profitable to acquire e* years beyond
high school because BF (>A0) exceeds other
schooling choices.
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Professor: Dr. Jason Dean
35
OFFERED WAGE AND SIGNALING COST SCHEDULES
Wages W(S),
Cost C(S)
Cost of education
• Low-ability workers’ cost of acquiring
CL(S) = S
education is given by CL(s).
• Their return acquiring s* is given by 2 -
W(S)
2
CL(s*) < 1, so they are better off NOT going
to school, and accepting the lower wage.
CH(S) = S/2
1
• High-ability workers’ cost of acquiring
education is given by CH(s).
• Their net benefit of education is given by 2
- CH(s*)>1, so they are better off acquiring
1
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S*
2
Education
the education level s*
Professor: Dr. Jason Dean
36
REQUIRING A GREATER SIGNAL MAY HAVE COSTS WITHOUT BENEFITS
Some Cautions About Signaling
If those with costs along C have higher costs only because of
lower family wealth, and that they may be no less productive on
the job than those along line C/2, then using e* as signaling
would fail.
Even when using e* as a useful way to predict future
productivity, there is an optimum signal beyond which society
would not find desirable to go.
If employers now require e* years of schooling beyond HS for
their entry level jobs paying wage of 2, and if they raised their
hiring standards to e′ years, then those with costs along C would
still find it in their best interests to remain at zero years and
retain A0 since A0 > B′D′.
Those with costs along C/2 would still find it profitable to invest
in the newly required signal of e′ years because B′F′ still exceeds
other schooling choices (since B′F′ > A0).
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Professor: Dr. Jason Dean
37
IMPLICATIONS OF SCHOOLING AS A SIGNAL
• For schooling to act as a signal:
– Schooling must be more “costly” for low-ability workers compared to highability workers.
• Social return to schooling (percentage increase in national income) is likely to be
positive even if a particular worker’s human capital is not increased.
– Due to matching
• Although education may incorporate a signaling aspect, it is well-accepted that
education is more than a signal.
– Education is at least partially an investment in human capital.
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Professor: Dr. Jason Dean
38
EMPIRICAL EVIDENCE: EDUCATION AND EARNINGS
Figure 9.4 Earnings by Age and Education, Canadian Males, 2015
•
This graph shows the average earnings by age
group for different levels of education.
•
For example, the lowest line shows the relationship
between age and earnings for those men who have
not completed their high school education. Their
earnings generally increase with age, as they
accumulate on-the-job experience.
•
The age-earnings profiles are higher on average for
those men with more education, being highest for
university graduates.
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Professor: Dr. Jason Dean
39
EMPIRICAL EVIDENCE: EDUCATION AND EARNINGS
Figure 9.4 Earnings by Age and Education, Canadian Males, 2015
1. Earnings increase with age experience
2. Increase is most rapid to age 40 or 44 for
individuals with the most education
3. Differential is wider between groups at
age 50 than 20–30
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Professor: Dr. Jason Dean
40
In the U.S.
ECON 33: Labour Economics
Professor: Dr. Jason Dean
41
IMPORTANT PROPERTIES OF AGE-EARNINGS PROFILES
• Important properties of age-earnings profiles:
1. Highly educated workers earn more than less educated workers.
2. Earnings rise over time at a decreasing rate.
3. The age-earnings profiles of different education cohorts diverge over time (they “fan
outward”).
– Earnings increase faster for more educated workers.
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Professor: Dr. Jason Dean
42
HUMAN CAPITAL EARNINGS FUNCTION
• Estimates the rate of return to education.
• Controls for other factors that may affect earnings such as ability and experience
Where:
𝐥𝐧 𝒀 = 𝜶 + 𝒓𝑺 + 𝜷𝟏 𝑬𝑿𝑷 + 𝜷𝟐 𝑬𝑿𝑷𝟐 + 𝜺
Y = Earning;
α = Fixed component of wage with no schooling;
r = i = internal rate of return;
S = Years of schooling;
EXP = Age as a proxy for Experience – Potential experience (Age – Schooling – 5)
ε = Random variable (motivation, luck, etc.)
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Professor: Dr. Jason Dean
43
ESTIMATES: HUMAN CAPITAL EARNINGS FUNCTION
•
This scatter plot shows the relationship between
education and earnings for a sample of 35- to 39-
Log Earnings by Years of Schooling, Women aged 35 to 39 Years, 2005
year- old women in 2005.
•
Each point represents a particular woman, with her
level of education and annual earnings.
•
Also shown is the estimated regression line, which
shows the level of predicted earnings for women
with a given number of years of schooling.
•
While most observations lie close to the regression
line, there are obviously some women whose
earnings are higher than predicted, and some whose
earnings are lower er than predicted.
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Professor: Dr. Jason Dean
44
EMPIRICAL EVIDENCE: HUMAN CAPITAL EARNINGS FUNCTION
Table 9.2 Estimated Returns to Schooling and Experience, 2015 (dependent variable: log
annual earnings)
•
Men
Women
Intercept
9.232 (714.15)
8.605 (628.29)
Years of schooling
0.080 (105.31)
0.114 (140.77)
Experience
0.054 (75.96)
0.041 (62.51)
Experience squared
− 0.0009 (60.14)
− 0.0006 (43.85)
R-squared
0.136
0.204
Sample size
121,947
99,398
NOTES: The regressions are estimated over the full samples of full-year (49 or more weeks worked in 2005), mostly fulltime men and
women, respectively.
•
Absolute t-values are indicated in parentheses, with t-values greater than 2 generally regarded as indicating that the relationship is
statistically significant, and unlikely due to chance.
•
SOURCE: Data from Statistics Canada, Individual Public Use Microdata Files, 2006 Census of Population.
© 2021 MCGRAW-HILL EDUCATION LTD.
Labour Economics
Professor: Dr. Jason Dean
9 - 45
EMPIRICAL EVIDENCE: EDUCATION AND EARNINGS
Table 9.1 Estimates of the Private Returns1 to Schooling in Canada, 2000
•
NOTES:
•
Rates of return by level of schooling are
Level of Schooling
Males
Females
Bachelor’s degree2
12
14
Master’s degree
3
5
Ph.D.
nc2
4
Medicine
21
22
Males
Females
Education
9
14
Humanities and fine arts
nc
10
dentistry, optometry, veterinary) and law
Social sciences3
11
14
degrees.
Commerce
9
19
Natural sciences
9
8
Engineering and applied science
9
14
Health sciences
18
18
Bachelor’s Degree by Field of Study
calculated relative to the next-lowest level. For
example, the return to a bachelor’s degree is
relative to completed secondary school, and the
return to a master’s degree is relative to a
bachelor’s degree.
•
•
“nc” indicates “not calculated” because that
estimated returns were not significantly different
from zero, statistically.
•
© 2021 MCGRAW-HILL EDUCATION LTD.
Labour Economics
Bachelor’s degree includes health (medicine,
Social sciences includes law degrees.
Professor: Dr. Jason Dean
9 - 46
SIGNALING, SCREENING, AND ABILITY
• If there are systematic differences between low and
high educated people that affect earnings and
schooling then the estimate is biased.
• Determinants difficult to control
– innate ability, motivation, perseverance, tolerance,
etc.
• Education as Signaling/Screening
– If true than education itself has no effect on
earnings – it is only a screening mechanism for
highly able workers.
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Professor: Dr. Jason Dean
47
SCHOOLING AND EARNINGS WHEN WORKERS HAVE DIFFERENT ABILITIES
Rate of
Interest
Dollars
• Ace and Bob have the same discount rate (r)
Z
Bob
wHS
but each worker faces a different wageschooling locus.
Ace
wACE
wDROP
r
• Ace drops out of high school and Bob gets a
PACE
high school diploma.
IRRBOB
• The wage differential between Bob and Ace
IRRACE
11
12
Years of
Schooling
11
12
Years of
Schooling
• As a result, this wage differential (11 vs. 12 years) does not tells
(wHS - wDROP) arises both because Bob goes
to school for one more year and because Bob
is more able.
us by how much Ace’s earnings would increase if he were to
complete high school (wACE - wDROP).
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Professor: Dr. Jason Dean
48
ADDRESSING ABILITY BIAS
• Optimal situation – random assignment (randomized
controlled trial)
– Not possible
• Natural experiments
– Another approach is to try to mimic an experiment by
finding a mechanism that affects (“assigns”) education
levels to groups of individuals in some way
independent of the individual’s expected returns to
schooling.
– Isolate the influence of education from unobserved
ability factors
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Professor: Dr. Jason Dean
49
ADDRESSING ABILITY BIAS
•
Research on twins
– Princeton University labour economists collected data on a large
sample of identical twins attending the annual “Twins Festival” in
Twinsburg, Ohio.⁵
– Using the conventional approach- the OLS return to education of
about 11 percent, slightly higher than most other datasets.
– Exploiting the twins feature of the data to control for innate ability,
the return to education fell to 7 percent, suggesting considerable
ability bias.
– However, once they accounted for the possibility of measurement
error, the estimated returns rose to 9 percent, which was still lower
than the conventional OLS results.
– Their results confirm that omitted-variables bias is a problem, but not
large one.
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Professor: Dr. Jason Dean
50
ADDRESSING ABILITY BIAS
– Compulsory school attendance laws
– Law requiring students to remain in school until 16th
or 17th birthday
– Because children born in different months start school
at different ages, these laws imply that some children
are required to remain in school longer than others.
– Month of birth is unlikely to be correlated with ability
– Proximity to college findings
– Card (1995) – 7.5%
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Professor: Dr. Jason Dean
51
EMPIRICAL ESTIMATES
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Professor: Dr. Jason Dean
52
TRAINING: WHO PAYS?
GENERAL TRAINING
• Skills used in various firms
SPECIFIC TRAINING
•
provides the training
• Firms will offer higher wages for
this training
•
for these skills
Trainee is unwilling to bear the cost
because there are no higher earnings
• Trainee is willing to bear the cost
since higher wages are offered
Training useful to the firm that
•
Firm does not have to pay higher
wages because other firms are not
competing for such trainees
Labour Economics
Professor: Dr. Jason Dean
53
COSTS, BENEFITS, AND FINANCING OF TRAINING
Value of
worker after
training
Cost and Benefit of Training
(general skills)
Wages
VMP
VMP*
Wage in absence
of training
benefits
Wa = VMPa
costs
If the benefits exceed
the costs than it is
worthwhile to make
the investment.
VMPt
Value of
worker during
training
0
Labour Economics
training
t*
But who should make the
investment?
Worker because the firm has no
incentive. The employee could
leave and still get a wage of
VMP*.
Time
Professor: Dr. Jason Dean
54
COSTS, BENEFITS, AND FINANCING OF TRAINING
Cost and Benefit of Training
(specific skills)
Value of worker after training
(Only valuable to specific
firm)
Wages
VMP
VMP*
Wage during and
after training
benefits
Wa = VMPa
costs
If the benefits exceed
the costs than it is
worthwhile to make
the investment.
VMPt
Value of
worker during
training
0
Labour Economics
training
t*
But who should make the
investment?
The Firm would provide the
training and pay Wa. There is no
market for this skill so the worker
has no incentive to pay. If the
worker leaves still only be able to
getTime
a wage of VMPa.
Professor: Dr. Jason Dean
55
COSTS, BENEFITS, AND FINANCING OF TRAINING
Specific training as a shared investment
VMP*
Wages
VMP
Employer’s benefits
W*
Employee’s benefits
Wa = VMPa
Employee’s costs
Wt
Employer’s costs
VMPt
0
Training
Labour Economics
Given the uncertainly that the
worker could quit – it could make
sense to share the costs of
training.
t*
Time
Professor: Dr. Jason Dean
56
TRAINING: APPROPRIATE ROLE OF GOVERNMENT
• Private markets may not provide socially optimal amounts of training:
– Imperfect information
– Regulatory restrictions
• Training subsidies to disadvantaged could:
– Increase working hours
– Raise wages above the poverty line
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Labour Economics
Professor: Dr. Jason Dean
9 - 57
HOMEWORK QUESTION
• The costs of obtaining a university degree for high-productivity and low-productivity-type workers are
as follows:
• High productivity: CH= $20,000y
• Low productivity: CL= $40,000y
• where y is years in university. In an economy, workers with a university degree are paid a lifetime
income of $600,000, and workers without a university degree are paid a lifetime income of $450,000.
• For low-productivity workers, the net benefit of four years of university is ______, while the net benefit
of not going to university is ______.
• For high-productivity workers, the net benefit of four years of university is ______, while the net benefit
of not going to university is ______.
Labour Economics
Professor: Dr. Jason Dean
58
HOMEWORK QUESTION - SOLUTION
• a) Low-ability
– Uni: 600,000 - 40,000(4) = $440,000
– No Uni: 450,000 – 40,000(0) = $450,000
• b) High-ability
– Uni: 600,000 - 20,000(4) = $520,000
– No Uni: 450,000 – 20,000(0) = $450,000
Labour Economics
Professor: Dr. Jason Dean
59
HOMEWORK QUESTION
• The costs of obtaining a university degree for high-productivity and low-productivity-type workers are
as follows:
• High productivity: CH= $25,000y
• Low productivity: CL= $41,000y
• where y is years in university. In an economy, workers with a university degree are paid a lifetime
income of $600,000, and workers without a university degree are paid a lifetime income of $430,000.
• Will the earnings paid above result in an effective screening device? Why?
• What is the pay range for university graduates that would result in a separating equilibrium?
Labour Economics
Professor: Dr. Jason Dean
60
HOMEWORK QUESTION - SOLUTION
a) Low-ability
Uni: 610,000 - 41,000(4) = $446,000
No Uni: 430,000 – 41,000(0) = $430,000
High-ability
Uni: 610,000 - 25,000(4) = $510,000
No Uni: 430,000 – 25,000(0) = $430,000
There is no separating equilibrium.
b) x-41,000(4) < 430,000 so x < 594,000 for low ability to chose no University.
x-25000(4) > 430,000 so x > 530,000 for high ability to choose University.
530,000 < x < 594,000
Labour Economics
Professor: Dr. Jason Dean
61
END OF LECTURE
• Socrative Quiz
– https://b.socrative.com/login/student/
– Room: DEAN200
• Next Class:
• Chapter 10
– The Wage Structure
Labour Economics
Professor: Dr. Jason Dean
62