Investments in Human Capital: Education and Training Chapter 9 Investments in Human Capital: Education and Training

A decision today about how much education to acquire will be reflected by future changes in earnings.

Human Capital skills of an individual which he or she can rent out to an employer. How can we analyze the decision of whether or not to attend college and get a degree? What's important?

COSTS Tuition and fees, foregone earnings, psychic costs $15,000 a year minimum.

BENEFITS Future earnings in $ terms.

Age-Earnings Profiles College High School 5

Direct Costs 6

Indirect costs Direct Costs 7

Future Benefits Indirect costs Direct Costs 8

Human Capital Models Can Explain Why: earnings typically increase with age but at a decreasing rate. unemployment rates tend to be inversely related to the level of skill. younger workers change jobs more frequently and tend to receive more on the job training than older workers. persons with greater ability receive more education and other kinds of training than others. 10

How can we derive a model that explains all of these? 11

Assume: The increased amount of human capital affects only the wage rate. Each person produces his own human capital by using his own time and goods to attend classes, receive on the job training, etc. 12

If the present value of net benefits is greater than the present value of costs, the individual will invest in human capital 13

Future Benefits Indirect costs Direct Costs 8

Definitions Let Xt = earnings with college degree in time period t Let Yt = earnings with high school degree in time period t Let r = the discount rate (interest rate) Let R = retirement age 15

16

Two methods to use to determine whether or not the investment in college is worth it or not: present value method - specify the discount rate and determine if PV(BENEFITS) > PV(COSTS) internal rate of return method - How large of a discount rate is necessary to make college profitable? 18

Present Value Method 19

PREDICTIONS what happens when X, Y, C, r and R change? 20

As r rises, the present value of the difference falls Present oriented people are less likely to go to college than future oriented (forward looking) people. Being present oriented implies that the discount rate is high. Present oriented individuals discount the future more heavily. 21

College attendance will increase if costs fall. 24

College attendance will increase if the gap between earnings of college and high school graduates increases. Likewise, people with a higher opportunity cost of foregone earnings may be less likely to attend college, other things equal. 25

College High School 5

College High School 5

What happens during a recession? unemployment is less likely for educated workers this implies that Y does not change high school workers are more likely to be unemployed this implies that X may become $0 thus, (Y-X) increases during recession years

Our model predicts an increase in investment in human capital during a recession.

Is education a good investment? Some studies estimate the rate of return to education after adjusting for inflation is 5 to 15 percent This is similar to the return on other investments

These estimates have biases some of which overstate the return on education and some which underestimate the return on education.

Overestimating the return on education: we cannot separate ability from schooling level this is called a selection bias problem if those who are most able are the ones who go to school we could be seeing increased earnings from higher ability and not from increased schooling

Underestimating the return on education: we cannot measure all returns from education such as psychic benefits fringe benefits are often not included, but generally are higher with higher earnings

Education As A Social Investment U.S. spends 7% of GDP on education (if we include foregone earnings for college education this is 10% of GDP) education has social payoffs in some fields (i.e., engineers) but education may act as more as a sorting device in the labor market

The education of workers may make some workers more productive and employers can then use education as a screen.

Signaling Firms often observe certain indicators that they believe are correlated with productivity examples include age, race, sex. experience, education, etc.

An individual has little control over some signals (age, race) but some can be changed: One of the best examples of a signal which can be changed is education This signal can help firms discern which workers have higher productivity

Even if education does not add to productivity, it can act as a signal which distinguishes workers by productivity. How?

What type of individual is most likely to get education? someone for whom the costs are low

What type of individual is likely to face low costs of attending school? someone who learns easily

Thus, individuals who learn easily are more likely to attend college than those who don’t. Education level then works well as a signal to employers of which workers are most easily trained.

The End