1. Human Capital Theory and Benefit-Cost Analysis in Education
Ajou University
The Principles of Economics I
Presentation by D. Kelleher
(Based on a presentation originally delivered by Emmanuel Jimenez and Peter Moock, World Bank)

2. Outline Basic Framework for Analyzing Investments in Human Capital
Relevance for project analysis...not
Issues
Modifying the approach
T.W. Schultz, Becker, Mincer, Psacharopoulos
Estimating the rate of return investment in an additional year of education or an additional level of education (primary as compared with none, secondary as compared with primary)
On average across the society
Often not relevant to what needed to justify a particular project in education
Issues -- will return
Modifying the approach -- say some things and subsequent sessions

3. Human Capital Scale -- Weighing Private Benefits and Costs
Benefits Costs
Economic analysis -- in general, a comparison of benefits and costs
Can consider the costs from private or social point of view
Private -- analyzed in order to understand and predict how individuals will behave
Social may differ
because of subsidies -- costs to society often greater than costs to the individual
because of externalities (market failures) -- benefits to society may be be larger (or smaller) than benefits to individual
Comparison of private and social rates of return often used to justify government interventions (or lack thereof)
Start here by considering private benefits and costs

4. The productivity chain
Education Human capital Productivity
Wages Welfare
Economic theory says that people will chose to get more education (and incur the associated costs) because it increases their well-being
One (but not the only way) education does this is by increasing the individual’s earnings in the future
Why does it do this?
HC theory says, by making the individual more productive

5. The productivity chain
Education Human capital Productivity
Wages Welfare
One critique of HC theory -- the screening theory, HC not make people more productive, simply identifies those who are more productive
From employer’s point of view, not matter which
But from social point of view, very expensive way of sorting people
Education does both, but much research to sort out productivity effects from sorting/screening effects

6. Human Capital and Productivity
Working with Existing Developing
Technology Better New Technology
Acquiring Processing
New Information
Knowledge
How does education make people more productive
Technical advances depend, in part, on HC stock of the population
Quality of research and innovation faster and better in developed economies, where much of the world’s new technology is produced
more educated nations also better at adapting technology developed elsewhere
More of a social benefit of education than private (except to the extent that private individuals and private industry can monopolize the benefits, at least in the short run, by patenting the innovation and/or by being ahead of competitors

7. Education raises wages for both men and women:
Wages strongly correlated with educational attainment everywhere
Returns tend to be higher in less developed economies, where education relatively more scarce
But still high in most developed economies (e.g., U.S.) even as population continues to become more and more educated
In fact, considerable stability in rates of return over time

8. Returns over time Wage ($) S2 D1 S1 D2 W S2 D1 D2 S1 G1 G2
Number of Graduates

9. Education raises wages for both men and women:
In many economies, women still earn less than men
But, if so, then they earn less at every attainment level
Relative returns and rates of return often higher for women

10. Education and productivity
Better educated farmers get a higher return on their investments in agriculture:
In Africa, farmers who have completed 4 years of education (the minimum necessary for literacy) produce, on average about 8-10 percent more than farmers who had not gone to school (Moock, Jamison et al., Jamison & Moock)
Technical and allocative efficiency (Welch, Timmer)
Evidence of productivity effect of education
Some critics of economic theory say wage workers may not be paid their marginal product
Perhaps employers like hiring graduates, even if they no more productive than non-graduates -- consumption value of hiring graduates
More difficult to make this argument in the case of self-employed workers
If a more educated farmer produces more farm output than another, less educated farmer, hard to argue that this has anything to do with the farmer’s preference for education per se
Early study of maize (corn) farmers in Kenya (1973)
Replicated elsewhere, reviews in 1980 (EDCC), updated in 1997 (Internat’l Encl of Educ.)
Allocative eff’y -- Given budget, produce more corn and less wheat, use more fertilizer and less labor
Techical (eng.) eff’y -- Given fert. & labor, produce more output

11. Education and productivity (cont’d)
Production function may matter:
In simple tasks or in settings where technology slow to change, effect of education small
In traditional farming, techniques passed from generation to generation (T.W. Schultz)
In piece-rate work in the Philippines, wage not related to schooling after controlling for gender and physical stature (Foster and Rosenzweig)
With very simple tasks or where technology slow to change, education’s effect small or non-existent
In study of maize farming in Kenya, effect not found for trad’l seed varieties, which farmers been growing for generations
similarly, study of assembly-line, piece-rate work in Philippines

12. Human Capital and Wages
Education Human capital Productivity
Wages Welfare
But productivity on the job also related to education, and much of this benefits the individual directly in the form of increased earnings
This a private benefit, except to the extent that earnings may be taxed

13. Education and productivity (cont’d)
But, if task involves new technology whether there is a premium on learning and information acquisition learning may be very important
For example, large effect of education in Kenya after introduction of new hybrid seed varieties (Moock)
In India, areas with relatively few educated farmers at the onset of the green revolution experienced less growth compared to other, high schooling areas (Foster and Rosenzweig)
But if task technology changing fast or where tasks complex and difficult to learn, education has a large effect
Green Revolution 1970s
In Kenya, effect found for hybrid varieties that had recently been introduced -- different techniques required in order to obtain potentially much higher yields, educated were quick to understand and adopt these new techniques
In India, district-level growth higher in farming areas where aver ed attainment higher

14. Human Capital Scale -- Weighing Private Benefits and Costs
Benefits Costs
Increased market productivity
Private non-market effects
(e.g., better personal
health, household productivity
effects)
Wage (or productivity) effect not the only thing that motivates individuals to invest in education
Some individuals may go to school just because they like it -- entertainment or consumption effect, like going to the movies (probably not a big factor)
Also productivity effects that not marketed and therefore trickier for researchers to measure
What about someone who does not work for pay?
Do we believe there is no productivity effect for that person?
Have been studies that compare efficiency in HH work
Differences found but difficult to assign monetary value
Economist’s assumption is that the increased productivity must be at least as large as the what that individual would be earning if he or she chose to work for pay
Health -- may have an indirect productivity effect, but valuable nevertheless

15. Human Capital Scale -- Weighing Private Benefits and Costs
Benefits Costs
Increased market productivity Direct costs
Private non-market effects Foregone
production or
earnings
But there must be costs as well
Individuals would never stop going to school if there were only benefits
For the individual, two kinds of costs

16. Graph on Rate of Return Estimation for University-level Education
graduates
Post-tax earnings
To measure the private returns to education, in many studies economists look only at the market returns -- because the non-market returns are too hard to quantify
To do this, it is necessary to predict what an individual will earn over his or her entire lifetime
Economists are not fortune-tellers -- they don’t know what people will earn in the future
Especially, not know what any particular individual will earn in the future -- there will always be variation
To estimate what the average person will earn in the future, look at what a sample (the larger the better) of individuals are earning now or have earned in the past
Longitudinal study -- follow a group over time, but to know what they earn at retirement age, must follow over 40 years
Cross-sectional studies more common
Age 22 65

17. Graph on Rate of Return Estimation for University-level Education
graduates
Returns
Secondary
school leavers
Indirect costs (foregone earnings)
But to estimate the returns to investment in one level of education (or one year of education), must also know what the average individual would have earned without having made this investment
Difference are the returns to that investment
While at school, these returns are negative
Negative returns = costs
Opportunity costs or foregone earnings
Age 18 22 65
Time (years)
Cost
years
Benefit
years 43

18. Graph on Rate of Return Estimation for University-level Education
graduates
Returns
Secondary
school leavers
Indirect costs (foregone earnings)
There are also direct costs that the individual incurs
Age
Direct costs (out-of-pocket expenses)

19. Graph on Rate of Return Estimation for University-level Education
graduates
Benefits
Secondary
school leavers + +
+ + + + + -
- - -
Add the direct and indirect costs together during each year of the investment
Although not shown, there may even be foregone earnings after the individual gets out of university, if earnings at that point would have been higher than the starting salary upon graduation
Costs
Age
- - -

20. Human Capital Scale -- Weighing Private Benefits and Costs
Benefits Costs
The individual weighs benefits and costs
If benefits larger, will choose to invest
But wait a minute

21. Graph on Rate of Return Estimation for University-level Education
graduates
Benefits
Secondary
school leavers + +
+ + + + + -
- - -
Some of the returns will not be received for years and years
a $ earned 40 years from now is worth less today than a $ spent today
Costs
Age
- - -
age 18, t = 0
age 22, t = 4
age 65, t = 47

22. Inflation plus real rate of interest
Time Value of Money
Now Later
In part because of inflation -- if I lock up a $1000 diamond ring in my safe deposit box and take it out in 40 years, the ring will not have changed but it will be worth more -- this is inflation
However, if I put $1000 in a savings account, it will be worth more in the future also because it will have been invested in some productive way
As a saver, I insist that the interest rate paid is least as great as much as inflation, otherwise I am better off buying a diamond ring and locking it up
But I hope it will be higher than inflation -- this is the real interest rate
Hence a $ now can be expected to be more than a $ in the future -- how much more <-- how much time and what interest rate
Inflation plus real rate of interest

23. Discounting
Now Later
By the same token, a $ in the future is worth less than a $ today
How much less <-- time and rate

24. Interest Rate (Discount Rate)
FV = PV(1+r)t
PV = FV/(1+r)t

25. Interest Rate (Discount Rate)
Future Value ($ in t years)
Life of investment
FV = PV(1+r)t
Principal ($ invested)
Interest rate
PV = FV/(1+r)t
Present Value of FV paid t years from now
Discount rate

26. Weighing Private Benefits and Costs -- Without Discounting
If not discount future benefits, investment will look better than it really is
The bigger the discount rate, the lighter will be the future benefits

27. Internal Rate of Return
Benefits Costs
There is some discount rate that will make the benefits just equal to the costs
This is the IRR
How is the IRR used to make a decision about an investment?
Choose if IRR > discount rate
What rate should be used to discount?
Discount rate is the opportunity cost of investing in education rather than something else
Hence depends on what rate the investor would get in the best alternative
Often 10% taken to be the long-term discount rate
The discount rate that equates benefits and costs

28. Returns to Investment in Education by Level (%) -- Private Rates of Return
Country/Yr Prim Sec Higher
Bolivia
Brazil
Greece
Israel
Japan
Mexico
Paraguay
Taiwan
Venezuela
Source: Psacharopoulos (1994).
Private (internal) rates of return
Private rates for tertiary sometimes higher and sometimes lower than private rates for primary
This depends partly on supply and demand (above)
But it depends even more on public policy -- how much Government subsidizes the costs of university education

29. Social Benefits Private benefits Additional social benefits
Increased market productivity
Private non-market effects
Plus ...
Additional social benefits
Taxes on higher earnings
Externalities
Spillover effects (my education increases your productivity)
Technical innovation
Community non-market effects (e.g., lower crime)
Now lets turn to social rates of return
Social benefits -- obviously include all private benefits, since the individual is part of society
Public policy is also concerned with how earnings are distributed across members of society
Some govts may decide that it is socially more valuable to increase the income of a poor person than to increase by the same amount the income of a rich person -- ignore for the moment
Social benefits usually thought to be higher than just the private benefits

30. Marginal Gains in Per Capita GDP Growth per 10% Increase in Enrollment Rate, 1960-1985
An aggregated measure of the returns to education provided by Mingat and Tan
Suggests that many low- and middle- income countries overinvested in university education, whereas the returns to univ. investment in high-income countries very positive
Not a popular finding
Bank “anti-higher education”
Suggests that low-income countries may need to focus on quality of HE before continuing to expand access
Source: Mingat and Tan, 1996.

31. Child mortality and education
100 80
Percent 60 40 20
Non-market effects, particularly of women’s education, include lower child mortality and lower fertility rates
1-3 years
4-6 years
7+ years
Mother's educational level

32. Fertility and education7 6 5 4
Total fertility rate (%) 3 2
This may or may not be a private benefit, but in most instances, this is usually a social benefit, at least in the long run
Less pressure on scarce natural resources, less pollution
Of course, in some countries, population growth is still a public policy goal -- for military reasons, or because land still relatively uninhabited
Also, the demographic transition results in an aging populations, which implies a higher dependency ratio, just as fast growing, young populations have high dependency ratios
One study in Pakistan estimated the cost of education 1000 women one additional year to be $40,000 and the value (reduced costs) in terms of lower fertility, lower child and lower maternal mortality to be $140,000 1
No schooling
4-6 years
7+ years
Mother's educational level

33. Human Capital Scale -- Weighing Private Benefits and Costs
Benefits Costs
Increase market productivity Direct costs
Private non-market effects Foregone production or
earnings
Spillover effects Public subsidy
Technical innovation
Community non-market effects
Reduced fertility/child mortality P R I V A T E P R I V A T E
Social costs equal all of the private costs plus public subsidies S O C I A L S O C I A L

34. Measurement Can we measure externalities?
Can we measure monetary value of reduced fertility and reduced mortality?
Can we measure returns to equality?
Very difficult to measure externalities -- e.g., value of technological change attributable to investment in education
Difficult but (as seen) not impossible to measure value of reduced fertility and mortality
To extent that subsidies targeted to benefit the poor results in a more equal distribution of income, can we measure the value of this? No, it is a policy decision as to what the value of this is

35. Full (“Social”) Rates of Return
Benefits Costs
Increased market productivity Out-of-pocket expenses
Private non-market effects Foregone production/
earnings
Taxes on higher earnings Public subsidy P R I V A T E P R I V A T E
Hence, many studies may say that they are measuring “social” rates of return, but this usually a misnomer
Sometimes, instead, called “full” rates of return, meaning only that there is an attempt to measure the full costs
Social benefits inevitably underestimated, but by how much, or whether externalities greater (and hence the underestimation greater) for primary education or for tertiary education -- difficult to say S O C I A L S O C I A L

36. Estimated Full Rates of Return by Level of Education and Country Group (%)
Low-income Middle-income High-income
group group group
Level of education (74 countries) (19 countries) (20 countries)
Primary
Secondary < 0
Higher < <
Meta-analysis (summary of many studies) shows high (full) rates of return to lower levels of education in low-income countries
In high-income (OECD) countries, rates of return to primary education cannot be estimated because nearly everyone gets at least a primary education
High rates for tertiary
Rates often found to be lower for economies in transition
Wages were administered in past, markets not yet functioning well
Usually rates go up later in transition process
Source: Mingat and Tan, 1996.

37. Studies of rates of return to sector investment
Relevant to the economic analysis of projects?
Often not
At least 3 reasons

38. Relevant to economic analysis of projects?
externalities
marginal returns vs. average returns
projects more delimited
(1) Most studies unable to take externalities into account
(2) Studies using information on earnings differences in the past may lead to the wrong investment decision for the future
In dynamic, rapidly changing economy, rate of return to given level of education may be going up or down
(3) Many projects have more limited or otherwise different objective than simply to expand number of students -- e.g., to increase efficiency (reduce unit costs) or raise quality
Requires a modified cost-benefit framework

39. Using economic sector work to diagnose sector issues and design appropriate interventions

40. Cote d’Ivoire: Distribution of Education Subsidies
For example, here is an analysis of the way in which public subsidies distributed in Cote d’Ivoire
Subsidies in primary education quite evenly distributed -- because most children get at least some primary education, and public spending does not (or at least in this study) assumed not to differ very much from one school to the next
In secondary and tertiary, however, much greater share of public subsidies benefit the rich
In the case of tertiary, most goes to the richest 5th of population
Very inequitable -- and typical 2 4
All

41. Ratio of Private to Public Spending
Nicaragua
Primary
Secondary
Kenya
Primary
Secondary
In Nicaragua, in primary education, on average families spend about as much as Govt for primary and 2-1/2 times as much as Govt for secondary
This is equitable, given that secondary students tend to come from wealthier homes
In Kenya, on the other hand, families spend more than twice as much as Govt for primary and only 60% as much for secondary
Very inequitable
Strong argument for Kenya to re-allocate public spending -- more on primary, less on secondary

42. Some of the right questions
What is the full cost of the project?
What are the alternatives to the project?
What are the benefits -- to the project?
More students -- what will be the impact of the project on their future productivity?
More efficient education system -- what are the cost savings?
In terms of the economic analysis of a project -- Annex 4 of the PAD

43. More of the right questions
What is the appropriate role of government?
Try and estimate externalities
How large would externalities have to be?
What are the incentives (and the disincentives) to reform?
Who benefits from the intervention?
Who loses?

44. Human Capital Theory and Benefit-Cost Analysis in Education
Questions from Participants?