1. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-1 Chapter Nine Human Capital Theory: Applications to Education and Training Created by: Erica Morrill, M.Ed Fanshawe College

2. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-2 Chapter Focus  Factors that determine the market rate of return to education  Is education economically worthwhile?  Is education a predictor of greater productivity?  Market signaling and screening  Government-funded training programs

3. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-3 Human Capital Theory  Investments are made to improve productivity and earnings  Costs incurred with the expectation of future benefits  Benefits must exceed costs by a significant amount

4. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-4 Costs  Direct costs  books, tuition  Opportunity cost  income forgone  Private Costs/Social Costs  Real Costs/Pecuniary or transfer costs

5. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-5 Figure 9.1 Alternative Income Streams Earnings 161822 d Direct costs a Stream A b e Stream B c f Stream C

6. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-6 Age-Earnings Profiles  Increase with age but at a decreasing rate  Higher for those with more education

7. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-7 Choosing an Income Stream  Simplifying assumptions  no direct utility or disutility from education  hours of work are fixed  income streams associated with education amounts are known  individuals can borrow and lend at the real interest rates

8. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-8 Human Capital Investment Decision  Quantity of education  maximizes the net present value of lifetime earnings  Human capital wealth  can be distributed by borrowing and lending  Increase education until…  present value of benefits of additional year equals present value of additional costs

9. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-9 Implications of Theory  Investment should be made early in one’s life  Little incentive for individuals experiencing discontinuity in workforce

10. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-10 Factors Influencing Education  Income tax  increase in progressivity of taxes reduce demand for education  Student loans  alter marginal cost of education and levels of educational attainment

11. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-11 Optimal Human Capital Investment Expressed in terms of….  Costs and benefits  Marginal costs and benefits  Rate of return on investment

12. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-12 Education and Market Equilibrium  Interaction between  individuals’ preferences  employers’ preferences  Human capital positively affects productivity of workers

13. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-13 Figure 9.3 Education and Market Equilibrium Years of Education Wage II II UBUB EBEB UAUA EAEA

14. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-14 Education as a Filter  Education acts as a signal of the productivity of employees  Higher wages are offered if employers believe that education increases productivity

15. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-15 Figure 9.4 Offered Wage and Signaling Cost Schedules Wages W(y) Education C L (y) W(y) C H (y) 1 2 y* 1 2 Cost of education C(y)

16. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-16 Empirical Evidence Education and Earnings  Earnings increase with age experience  Increase is most rapid to age 45 or 55 for individuals with the most education  Differential is wider between groups at ages 45-50 than 20-30

17. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-17 Human Capital Earnings Function  Estimates the rate of return to education  Least-squares regression of earnings on education  Controls for other factors that may affect earnings

18. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-18 Signaling, Screening and Ability  Determinants difficult to control  innate ability  Signaling/screening  Private return on education  Social return on education

19. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-19 Addressing Ability Bias  Natural experiments  isolate the influence of education from unobserved ability factors  research on twins  compulsory school attendance laws  proximity to college findings

20. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-20 Increased Returns to Education and Inequality  Variation of returns to schooling over time  Increased returns have coincided with increases in income inequality

21. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-21 Training General Training  Skills used in various firms  Firms will offer higher wage for this training  Trainee willing to bear the cost since higher wages offered for these skills Specific Training  Training useful to the firm that provides the training  Trainee is unwilling to bear the cost because no higher earnings  Firm does not have to pay higher wages because other firms are not competing for such trainees

22. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-22 Figure 9.7 a Costs, Benefits and Financing of Training W a =VMP a Time Wages VMP Costs and Benefits of Training costs benefits 0 VMP* VMP t t* training

23. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-23 Figure 9.7 b Costs, Benefits and Financing of Training W a =VMP a Time Wages VMP Specific training as a shared investment 0 t* training Employer’s costs Employee’s benefits VMP* VMP t Employee’s costs WtWt Employer’s benefits W*

24. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-24 Figure 9.7 c Costs, Benefits and Financing of Training W a =VMP a Time Wages VMP Earnings growth with gradual training 0 VMP* VMP 0 Employer’s costs Employer’s benefits Employee’s benefits Employee’s costs WtWt W*

25. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-25 Appropriate Role of Government  Private markets may not provide socially optimal amounts of training  imperfect information  regulatory restrictions  contract problems  Training subsidies to disadvantaged could  increase working hours  raise wages above the poverty line

26. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-26 Evaluation of Government Training Programs  Difficulties in evaluation  no opportunity to observe earnings in the absence of training  no control group  many variables

27. © 2002 McGraw-Hill Ryerson Ltd.Chapter 9-27 End of Chapter Nine