Human Capital Theory

History
Schultz, 1961
As economic growth occurs economies tend to use less traditional capital Income has risen faster than the combined growth in land, labor and physical capital

All these can be explained if we add human capital to our explanations

History (cont.)
Becker, 1962
Unemployment rate negatively related to skill levels Younger workers change jobs more frequently than older workers Abler persons receive more training and education than older workers

Forms of Capital
Financial Capital Human Capital Social Capital Intellectual Capital Knowledge Capital

The Theory of Human Capital

When does it pay to invest in higher education? When does it pay to train a worker? How can the training costs and rewards be structured so as to make both the shareholders and workers better off? Does a firm have to pay its trained workers more?

The Theory of Human Capital

What kind of training should be given? Should it be as general as possible, or should it be idiosyncratic to the current firm? What can be done about retention of trained workers? How can they be tied to the firm?

 What kinds of workers are the best candidates for the training program? Who should be laid off if downsizing is necessary?

The Theory of Human Capital

 Theodore Schultz and Gary Becker were awarded the Nobel Prize in Economic in 1979 and 1992. Both scholars were pioneers in human capital analysis. Human capital theory applies to the acquisition of skills.

HUMAN CAPITAL: SOME BASIC THEORY

Skills can be acquired in a number of ways:

Formal education The primary way to acquire human capital. On-the-job training (OJT) The most important kind of human capital in its impact on business practice. Other human capital investment Exercise, personal beautification expenditures, enrichment courses, and health careetc.

Formal Schooling
What made you decide to go to college? Career considerations. In the theory of investment in physical capital, a manager decides to buy a machine if the present value of the flow of additional revenues generated by the machine exceeds the operating and purchasing cost of the machine. Similarly, the individual must bear a cost now to pay for schooling or other training in hopes that it will bring higher earnings in the future.

The Cost of Going to School

Direct Costs
tuition, books, living expenses

Opportunity cost
Forgone salary

Choosing Whether to Stay in School K : salary of those with a high school diploma will
t

earn in year t. Dt: salary of those who drop out after 11th grade. r: interest rate C0: direct cost of schooling. The individual will invest in the final year of school if the following condition holds: T t t 0 0 t t =1

K D C +D < (1 + r )

Choosing Whether to Stay in School

Direct cost of schooling Forgone salary

K t Dt C0 + D0 < t t =1 (1 + r )
T
The discount factor: to bring the earning differentials back to present value.

Year to retirement

The earning differentials between a high school graduates and a high school dropout.

Why get an Master degree?

Kt: Your monthly salary, assuming starting salary K1=40,000 Dt:Monthly salary of those with a college degree, assuming starting salary D1=35,000 r: interest rate, assuming r=.06 C0: Direct cost of schooling. Suppose that 2 year expenses at RSOM is Rs 150,000 . more than a college graduate. Suppose your salary increase by 5% every year, A college graduates annual increase = 3%

Direct cost (Rs 150,000) + forgone salary (approximately Rs 85,000) = Rs 235,000,.

Suppose that after taking this course, your IQ level improved substantially, say, from 90 to 140.

As a result, your annual salary increase in the next 20 years will be 10% rather than 5%!

 Two reasons: First, there is much to be learned when an individual knows very little.

For early years of schooling, the returns to schooling exceed the costs.

A little bit of school can affect productivity dramatically.

Second, the costs of going to school are very low during the early years of schooling.
With public subsidies to education, direct costs are virtually zero up through high school. The forgone earnings are low during the early years.

The above discussions implies that...

It pays for everyone to invest in some formal education, and there is also an optimal stopping date for each individual as well. The stopping date is the year when the inequality in the equation switches

Are you making a wrong investment?

The above example assumes a constant rate of return, but that is usually not the case. The rate of return for an MHRM is better characterized by an exponential function.

Non-pecuniary benefits of schooling

People attend school for other reasons as well. For example, learning may be regarded as a form of intrinsic reward in itself Additional schooling may put you in a position for a more rewarding job. The rewards can take the form of higher status, more flexibility, more interesting assignmentsetc. We need only to think of K as the value of improvement in well-being at work that result from additional schooling...

 Increases in tuition rates decrease school enrollment.

Effects of Costs and Benefits of Education on the Optimal Amount of Schooling

K t Dt C0 + D0 < t t =1 (1 + r )
T

Individuals who already have high-paying jobs will be reluctant to go back to school to acquire an MBA.

Effects of Costs and Benefits of Education on the Optimal Amount of Schooling

Increases in the interest rate mean less schooling.

K t Dt C0 + D0 < t t =1 (1 + r )
T

The higher the interest rate, the lower is the value of future earning. The higher is the interest rate, the better it is to work and put your money in the bank. Schooling is a better investment when the alternative investment are poor choices.

Effects of Costs and Benefits of Education on the Optimal Amount of Schooling

High interest rate increases cost of borrowing. Banks are generally reluctant to lend to students whose only collateral is their future earning power. This means that children whose parents are poor might face much higher borrowing costs and consequently , would drop out of school to work at an earlier age. Financial aid programs that target the poor could offset this tendency.

Effects of Costs and Benefits of Education on the Optimal Amount of Schooling

The longer the work life, the more investment in schooling.

K t Dt C0 + D0 < t t =1 (1 + r )
T

Effects of Costs and Benefits of Education on the Optimal Amount of Schooling

Will women obtain less schooling than men? Yes. ==> The average woman spends less time in the labor market than the average man. No. ==> Even if women are less likely to spend time in the labor market, their training may be valuable in increasing their productivity at home. Future housewives may take more humanities and education courses, which have more general applicability. More educated people may be better at raising children?

Effects of Costs and Benefits of Education on the Optimal Amount of Schooling

When the difference in earnings between educated and less educated worker (K - D) increases, school attendance should rise.

K t Dt C0 + D0 < t t =1 (1 + r )
T

(K - D) is likely to reflect differences in productivity. Improvement in school quality would be expected to have a positive effect on K, and therefore would be expected to increase education. Education is complementary with a technologically advanced society.

On-the-Job Training
General on-the-job training: an investment in human capital that is effective in raising productivity at the firm providing the training and at some other firms by an identical amount. Firm-specific on-the-job training: It makes a worker more productive at the current firm, but has no effect on productivity elsewhere.
Example: Database programmer at Formosa Plastics. An account manager who knew a great deal about the idiosyncrasies of the companys major clients.

General On-the-Job Training

Suppose that the firm has the opportunity to provide a 25-year-old worker with one year of on-the-job training. The training costs Rs 2500 during the first year, raises the workers productivity by Rs 50,000 per year thereafter. What wage should the firm pay the worker?

General On-the-Job Training

If the firm leave the workers wages unaltered, rival firms can easily pick off the worker by giving the worker a raise up to the full Rs 50,000 of increased productivity. To keep the worker, the original firm will be forced to raise wages up to the new level of worker productivity. But why would a firm bear a Rs 25000 cost to make the worker more productive when it can capture none of the gain to that productivity?

General On-the-Job Training

Although the firm will be unwilling to pay for the investment, the worker will be happy to do so. By paying Rs25000 at the outset, he buys himself a raise of Rs 50000, which persists for each year that he works hereafter. Thus the worker should offer to pay the firm for the on-the-job training and the firm should be happy to oblige.

 Workers do pay for their training by accepting lower wages than they would otherwise receive. Example: Apprenticeships in the early days. Young cooks work in established restaurants at low wages. Assistant professors are often willing to take lower salary in major universities.

Do workers actually pay firms for training?

 When on-the-job training is general, workers must pay for it themselves through reduced wages. This means that any worker who would like to undertake the training program should be given the opportunity to do so. The workers most likely to select jobs that offer training at the cost of low initial wages are young workers and others who plan to remain in the labor market for a long period of time.

Summary

 Workers firm-specific OJT cannot be pirated by other firms. Since the skills are firm specific, the firm can offer higher wage than outside firm. This suggests that the firm should be willing to pay for firm-specific OJT. But such is not the case.

Firm-specific On-the-job Training

Firms bear the full cost of training

Suppose that the firm agreed to finance all the training, in return for which the firm would expect to receive the entire difference between productivity and outside wage. The worker can ask for a higher wage. The worker knows that if he quits, the firm loses its investment. Further, the worker is indifferent between working here and working elsewhere because the wage is the same.

Workers bear the full cost of training Since the worker has borne the full cost of

Since the worker has borne the full cost of investment, he expects to get the full return. But this will make the firm indifferent between hiring the skilled, but highly paid worker and hiring the unskilled, less well-paid worker. Now the worker is at a disadvantage. The firm can threaten to fire the worker unless the worker takes a lower wage.

Solution
The solution is to split the costs and benefits. Since the firm needs to give up some of the profit from investing the worker, it can ask the worker to bear some of the costs. Since the worker knows that the firm will be able to force him to accept a wage less than his productivity when he is skilled, he can ask the firm to bear some of the cost.

 The shared benefits mean that both worker and firm have incentives to remain together. The worker is worth more to this firm than to any other. The worker earns more at the current firm than he does at any other firm. The scheme that shares the costs and benefits makes separation much less likely to occur.

Mutual beneficial Arrangement The shared benefits mean that both worker and

Summary
Since workers may not always have the best information about their departure probabilities and since firms bear costs when workers with firm specific human capital leave, a firm takes a more active role in selecting workers to offer firm-specific OJT than it does for general OJT. The workers that the firm wants to train are those with low turnover probabilities whose productivity will be greatly enhanced by the training.

Experience--total time in the labor market Tenure--experience in a particular firm If there is no systematic difference in wages between those who stays with the firm and those who leaves, then it can be inferred that the human capital obtained at the first firm must be general. If wages are lower for those who leaves the firm than for those who stays, it can be inferred that some of the human capital was probably firm specific.

Determining specificity of human capital

 The extent to which skills are general or specific may not be know in advance. A firm may be trying to decide whether it will lose much by hiring from the outside rather than training its own workers. The company can also compare the productivity of workers with 10 years of tenure at the firm to that of workers with 10 years of total experience, but who has less than 10 years of tenure in the firm.

Determining specificity of human capital