1. CHAPTER 6 – Human Capital
6-1 Education in the Labor Market: Stylized facts
6-2 Present Value
6-3 The Schooling Model
6-4 Education and Earnings
6-5 Estimating Rate of Return to Schooling
6-7 School Quality & Earnings (R)
6-8 Do Workers Maximize Life-time Earnings?
6-9 Schooling as a Signal
6-10 Post School Human Capital Investments
6-11 PA: Evaluating Gov. Training Programs
Give a brief overview of the presentation. Describe the major focus of the presentation and why it is important.
Introduce each of the major topics.
To provide a road map for the audience, you can repeat this Overview slide throughout the presentation, highlighting the particular topic you will discuss next.

2. Variation in wages  Heterog. jobs vs worker attributes
Introduction
Theory of compensating differentials:
Variation in wages  Heterog. jobs vs worker attributes
Workers bring a unique set of abilities and acquired skills, known as human capital, into the labor market.
Focus on:
How to decide on amount of schooling?
Methodology: earnings generated today vs future
Estimate rate of return to schooling
Main assumption:
Individuals optimize
Schooling = Investment (self)
Optimal choice = Maximum PV of lifetime earnings

3. 6-1 Education: Stylized Facts
Education is strongly correlated with:
Labor force participation rates
Unemployment rates
Earnings

4. Education is strongly correlated with: +vely with LFPR and Earnings
Labor Market Indicators by Educational Attainment (Turkish Data - Overall)
Education is strongly correlated with:
+vely with LFPR and Earnings
-vely with Unemployment rates
Gender differences:
Higher % of males are educated.
Women earn less at every level.

5. 6-2 Present Value Calculations
Present value allows comparison of dollar amounts spent and received in different time periods.
Present Value
y is the future value.
r is the per-period discount rate.
t is the number of time periods.
Higher the discount rate, lower the present value of future payment.

6. Potential Earnings Streams Faced by a High School Graduate
A person who quits school after getting her high school diploma can earn wHS from age 18 until retirement.
If she decides to go to college, she foregoes these earnings and incurs a cost of H dollars for 4 years and then earns wCOL until retirement.
Hence, college education can be viewed as an investment that requires an immediate cost outlay of “H” dollars with future payments of “wCOL” dollars upon completion. 18 65 22
Age
wCOL
wHS -H
Dollars
Goes to College
Quits After High School

7. 6-3 The Schooling Model
Assumption: Ignore +ve externalities of education, focus on monetary rewards only. No training in the post-school period, skills don’t depreciate across time
Real earnings (earnings adjusted for inflation).
Age-earnings profile: the wage profile over a worker’s lifespan.
The higher the discount rate (r), the less likely someone will invest in education (present-oriented).
The discount rate depends on:
the market rate of interest.
time preferences: how a person feels about giving up today’s consumption in return for future rewards.

8. 6-3 The Schooling Model Two periods only (simplicity)
Example
Two periods only (simplicity)
Two schooling choices: High School vs College
WHS = $20,000 WCOL=$47,500 with H=$5,000
Assume a discount rate of 5%, i.e. r=5%
Choose the option with highest PV of earnings:
If r=15%, then PVHS ($37,391) > PVCOL($36,304), would have remained as a high school graduate instead!
Since PVCOL> PVHS go to college!

9. The Wage-Schooling Locus
The salaries firms are willing to pay workers depend on the level of schooling.
Properties of the wage-schooling locus.
The wage-schooling locus is upward sloping. (compensate OCEduc)
The slope of the wage-schooling locus indicates the increase in earnings associated with an additional year of education.
The wage-schooling locus is concave, reflecting diminishing returns to schooling. 13 14 18 12
30,000
20,000
23,000
25,000
Years of Schooling
Dollars

10. The Schooling Decision
The MRR schedule gives the marginal rate of return to schooling, or the percentage increase in earnings resulting from an additional year of school.
A worker maximizes the present value of lifetime earnings by going to school until the marginal rate of return to schooling equals the rate of discount.
A worker with discount rate r goes to school for s* years.
Problem: May not be easy to forecast future returns to education (MRR).
Years of Schooling
Rate of Discount s* s r r
MRR

11. In-class exercise:
6-6. Suppose Carl’s wage-schooling locus is given by
Derive the marginal rate of return schedule.
When will Carl quit school if his discount rate is 4 percent?
What if the discount rate is 9 percent?

12. In-class exercise:
6-6. Suppose Carl’s wage-schooling locus is given by
Derive the marginal rate of return schedule.
When will Carl quit school if his discount rate is 4 percent?
What if the discount rate is 9 percent?

13. 6-4 Education and Earnings
Observed data on earnings and schooling does not allow us to estimate returns to schooling, because more able persons tend to get more education.
Ability bias: The extent to which unobserved ability differences exist affects estimates on returns to schooling, since the ability difference may be the true source of the wage differential.

14. Schooling and Earnings When Workers Have Different Rates of Discount
Years of Schooling
Rate of Interest 12 11
rBO
rAL
MRR
Dollars
wDROP
PAL
PBO
wHS

15. Schooling and Earnings When Workers Have Different Abilities
Years of Schooling
Rate of Interest 12 11 r
MRRACE
MRRBOB
Dollars
wHS
wACE
wDROP Z
Bob
Ace B C A
Ace and Bob have the same discount rate (r) but face a different wage-schooling locus.
Ace drops out of high school (11yrs) and Bob gets a high school diploma (12 yrs).
The wage differential between Bob & Ace (wHS - wDROP) arises both because of schooling & ability.
Consequently, this wage differential does not tells us by how much Ace’s earnings would increase if he were to complete high school (wACE - wDROP).

16. 6-5 Estimating the Rate of Return to Schooling
A typical empirical study conducts regression analysis and estimates the following specification:
Log(wi) = b0+b1Schoolingi + b2Xi
“w” is the wage rate of individual “i”
“Schooling” controls for the educational attainment of individual “i”
“X” is the matrix that contains other relevant information about individual “i” such as industry, occupation, experience, tenure, region, etc.
“b1” provides an estimate for the percentage change in wage rate as a result of an additional year of schooling completed (on average, holding other variables constant).
Empirical consensus: 9%
Problems with estimation: Biased estimates due to endogeneity (ability)

17. Evidence: Natural Experiments
In studies of twins, presumably holding ability constant, valid estimates of rate of return to schooling can be estimated.
Estimates range from 3%-15% annual return to a year of education.
Another interesting question:
Given that twins have similar abilities, why do they choose different levels of schooling?
Different discount rates? They are not so similar after all...

18. 6-7 PA: School Quality & Earnings (R)
Prior to 1992, literature had a consensus:
High level of school expenditures had little impact on labor outcomes of students.
Card & Krueger (1992):
Influential study  Public schools in US
Corr(Sch. Quality, Rate of return to schooling) >0
Corr(Student/Teacher, RoR to schooling) < 0 (Small)
Corr(Teacher Salaries, RoR to schooling) > 0 (Fair)
Perspective:
S/T by 10  RoRtS by 1%
Teacher Salaries by 30%  RoRtS by 0.3%

19. School Quality and the Rate of Return to Schooling
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 (
Homework: Experimental Evidence from STAR: Compare & Contrast to Card & Krueger

20. 6-8 Do Workers Maximize Lifetime Earnings?
The schooling model assumes that workers select their level of education to maximize the present value of lifetime earnings.
To test this hypothesis directly, we must observe the age-earnings profile at two points in time.
Unfortunately, once a choice is made, we cannot observe the earnings associated with the non-choice (counterfactual).
Thus, using the observed wage differential to determine if the worker selected the “right” earnings stream yields meaningless results.

21. 6-8 Do Workers Maximize Lifetime Earnings?
Unfortunately, once a choice is made, we cannot observe the earnings associated with the non-choice (counterfactual).
Thus, using the observed wage differential to determine if the worker selected the “right” earnings stream yields meaningless results.
Example:

22. Two people: Billy (B) vs Wendy (W)
Example
Two periods
Two people: Billy (B) vs Wendy (W)
Two jobs: Blue collar (BC) vs White collar (WC)
WC requires one period of schooling with no cost
Assume a discount rate of 10%, i.e. r=10%
Choose the option with highest PV of earnings:
Individuals
Blue-collar Earnings
White-collar Earnings
Billy
$20,000
$40,000
Wendy
$15,000
$41,000

23. Homework:
6-1 Debbie is about to choose a career path. She has narrowed her options to two alternatives:
She can either become a marine biologist or a concert pianist.
Debbie lives two periods. In the first, she gets an education. In the second, she works in the labor 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.

24. Homework:
Suppose Debbie can lend and borrow money at a 5 percent rate of interest between the two periods.
Which career will she pursue?
What if she can lend and borrow money at a 15 percent rate of interest? Will she choose a different option? Why?
(b) 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 interest rate is 5 percent?

25. 6-9 Schooling as a Signal
Assumption: Education reveals a level of attainment which signals a worker’s qualifications or innate ability to potential employers (otherwise unobserved).
In the absence of signal (education), there would be a pooling equilibrium. Not beneficial to firms and high-productivity workers.
Education enables 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.

26. Nuts & Bolts of the Signaling Model
Two types of workers:
Low-productivity (L), Proportion in population  q
MPL =$200,000
High Productivity (H), Proportion in population  (1-q)
MPH =$300,000
If productivity is observed, firms would pay:
WL  $200,000 to a low-productivity (L) worker
WH  $300,000 to a high-productivity (H) worker
If productivity is unobserved, firms cant distinguish worker type when hiring, hence offer the same wage to everyone based on expected productivity (pooling equilibrium):
E(Wages) = q*MPL + (1-q)*MPH
E(W) = q*$200,000 + (1-q)*$300,000 = $300,000 – 100,000q

27. Education as a Signal
Dollars
Dollars
Costs
300,000
300,000
Costs
250,001 y
Slope = 25,000
200,000
200,000
Slope = 20,000
20,000 y y y
Years of Schooling
Years of Schooling
(a) Low-Productivity Workers
(b) High-Productivity Workers
Consider the case where schooling is available to workers.
Schooling is costly (tuition, books, tutoring, etc.).
Cost of schooling is higher for low-productivity workers ($25,000) than it is for high-productivity workers ($20,000)
Firm adopts the following rule: If Schooling is less than ybar, offer WL, and offer WH if schooling is equal to or greater than ybar years (threshold).

28. In-class exercise:
Suppose 40 percent of all potential workers are highly skilled and contribute $50,000 to the firm each year.
The remaining 60 percent of potential workers are less-skilled and contribute only $30,000 to the firm each year.
Schooling costs a highly skilled worker y per year, while it costs a less-skilled worker 2y per year.
When schooling is not used as a signaling device, how much is the firm willing to pay a worker chosen at random?
What range of y will support a signaling equilibrium? 

29. Implications of Schooling as a Signal
For schooling to act as a signal, schooling must be more “costly” for low-ability workers compared to high-ability workers.
Which model’s arguments are empirically sound? Hard to verify since both have identical predictions: Higher wages with more schooling Ferrer & Riddell (2002)
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.
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.

30. 6-11 Post-School Human Capital Investments
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.

31. Age-Earnings Profiles of Women (Full-time)

32. 6-11 On-The-Job Training
Most workers augment their human capital stock through on-the-job training (OJT) after completing education investments.
Two types of OJT:
General: training that is useful at all firms once it is acquired. (ex: computer use, typing, writing, etc.)
Specific: training that is useful only at the firm where it is acquired. (ex. Driving a tank)

33. Implications
Firms only provide general training if they do not pay the costs.
In order for the firm to willingly pay some of the costs of specific training, the firm must share in the returns to specific training.
Engaging in specific training eliminates the possibility of the worker separating from the job in the post-training period.

34. Costs, Benefits, and Financing of Training
Specific training as a shared investment
Employer’s costs
Employee’s benefits
VMP*
VMPt
Employee’s costs Wt
Employer’s benefits W*
Wages
VMP
Wa = VMPa t*
Training
Time

35. 6-13 Policy Application: Evaluating Government Training Programs
Aimed at exposing disadvantaged & low-income workers (poor labor markert outcomes) to training programs. $4 billion of federal spending per year.
Question: How to measure the effectiveness of these government programs?
Before-after comparison:
WageBefore= $300 vs WageAfter= $1500
Δwages = $ $300 = $1200
Not meaningful: Selection bias, counter-factual outcome, Average Treatment on Treated (ATT) vs Average Treatment Effect (ATE)

36. Social Experiments National Supported Worker Demonstration (NSW)
Random assignment of applicants into two groups
Treated (T): Job placement for 9-18 months
Control (C): No placement
Cost of the program: $12,500 ($1998) per worker
Average Treatment on the Treated (ATT):
Δwages = Y1T – Y0T where Y=wages, T: Treatment group
Problem:
Y1T is observed (wages of the worker after receiving treatment)
Y0T is unobserved (what would a worker earn if not treated), substitute it with Y0C since they have similar motivation & prior labor market outcomes

37. Social Experiments National Supported Worker Demonstration (NSW)
Results of the NSW suggest a 10% return to investments in human capital for workers treated under the program.
Return= $1407/$12,500=11.2%
Concern: What about Average Treatment Effect?
Other potential issues: Attrition bias, Substitution via other programs (violation of ceteris paribus)

38. Homework:
Suppose there are two types of persons: high-ability and low-ability.
A particular diploma costs a high-ability person $8,000 and costs a low-ability person $20,000. F
Firms wish to use education as a screening device where they intend to pay $25,000 to workers without a diploma and $K to those with a diploma.
In what range must K be to make this an effective screening device?