CHAPTER 4

HUMAN CAPITAL THEORY

Topic to be focused:

❖ Definition of human capital investment.

❖ Age earning profile.
❖ Human capital investment model.
❖ Cost benefits of human capital investment.
❖ Factors affecting human capital investment.
❖ On-the-job training.
HUMAN CAPITAL INVESTMENT

Definition – any activity that increases the

quality(productivity) of labor.

HCI includes expenditures not only on formal education and on-the job training
Generalizations
but also on health, migration, job search and the preschool nurturing of children.

Workers become more productive by improving their physical or mental

health and also by moving from locations and jobs.

Investment should be made by comparing costs and benefits of college

(further education)
HUMAN CAPITAL MODEL

Investments are made to improve productivity and

earnings
Costs incurred with the expectation of future benefits

Benefits must exceed costs by a significant amount

Monetary Costs / Benefits
2 types of Monetary Costs incurred in the purchase of a college education:

1. Direct costs (spending for tuition)

books, tuition fees, special fees,
books and stationaries
2. Indirect cost / Opportunity cost
earning that you have to give
up by not entering the labour
market

Benefits

The economic benefits from the investment in college education is an

enlarged future flow of earnings.
 Age earning profile
Age-earnings profile is a graph showing the earnings of workers at different ages
who obtain different levels of education.

In general, earnings rise as workers become older, though this is not always the
case.

The graph shows that the earnings obtained by more educated workers rise more
rapidly than those of less educated workers.
Curve HS (yellow) represent the earning profile when
a worker decided to enter the labour market after
complete the high school, at age 18.

Curve CC (blue) is the earning profile if a worker enter

a 4 year degree program before entering the labour
market.
Area 1 – direct cost incurred attending college
- monetary cost (eg; tuition fees, special fees, books and supplies)

Area 2 – indirect cost

- the earnings a worker forgo while attending college (eg; income)

Area 3 – the difference of incremental earnings obtained between high

school worker and degree worker

Conclusion for age-earning profile:

Increase with age but at a decreasing rate

Higher for those with more education
Age-earnings profiles are concave (the rate of increase in earnings decreases
as individuals age).

This is caused by:

a decline in human capital investment as individuals age, and
sometimes partly due to declines in physical strength as individuals become
older.
Gender and age-earnings profiles
Historically, women have had shorter
expected work lives.

lower incentives for investment in education.

increases in female educational attainment

are caused by (and are a cause of) increased
expected work lives for women.
Factors influencing human capital investment

✔ interest rates,

✔ the age of the individual,

✔ the costs of education, and

✔ the wage differential between high school

and college graduates.
 Discounting and net present value

Discounting converts the value of future dollars into today’s dollars

through the interest rate.

The present value (Vp) of a payment received one year from now is:
Vp = payment 1 year from now
1 + interest rate

Eg : Vp = 110 = 100
1.10
 Present value

The present value of a future stream of incremental earnings or costs (E) :

Vp = E1 + E2 + E3 ……..+ E4
(1 + i)1 (1 + i)2 (1 + i)3 (1+ i)n

Costs are represented as negative values of E.

A person should attend college if the net present value (Vp) is greater than
0.
The internal rate of return, r, is the rate of return at which Vp = 0:

Vp = 0 = E0 + E1 + E2 + E3……..+ E4
(1 + i)1 (1 + i)2 (1 + i)3 (1+ i)n

A person should attend college if the rate of return (r) exceeds the
market interest rate (i).

examples

Aaron who is an electrical engineer earns RM36,000 per year decided to quit his job
to enroll 2 years study at masters level in local university. After his masters
completed, he expect to receive incremental earnings RM 42,000 for the first year,
RM47,000 in second year and RM50,000 in the third year. He plans to work for 3
years only before he pursue his PhD. Given the interest rate at 15% and below costs.
Information given:

calculate the NPV and decide whether it is economically rational for Aaron
to enroll his masters?
 Generalizations of Net Present
Value
Length of income stream

The longer the stream of positive incremental earnings, the more likely the
net present value will be positive.

As a result, younger people are more likely to attend attend college

Costs of attending college

The lower the cost of attending college, the more likely the net present value
is positive.
Older people have a higher opportunity cost of attending college, less likely to
attend.

Earnings differential

The larger is the college-high school earnings differential, the more likely the
net present value is greater.

College attendance rose in the 1980s as the college-high school premium

increased.
 Private vs. Social Perspective

Education yields substantial external or social benefits that society

gains.

More educated workers have lower unemployment rates.

Education raises the amount and quality of participation in the

political process.

Children grow up in a better home-environment if the parents are

more educated.

The research discoveries of more educated persons yield benefits to

society.
 Private vs. Social Perspective

The social rate of return is higher (lower) than the private rate of return,
resources will be under allocated (over allocated) to human capital
investments.

The private and social rate of return are quite similar.

Diminishing Rate of Return
The marginal rate of return to
education declines as additional
schooling is acquired.

Investment in education is subject

to the law of diminishing returns.
The increases in knowledge decline
with each additional year of
schooling.

The return also falls because the

explicit cost and opportunity cost of
education rises with additional
schooling.
Demand for Human Capital
Ability Differences
Discrimination
Cost of Funds
 On-the-Job Training

Firms will invest in on-the-job training if the present

value of the benefits of the training exceeds the
present value of the costs.

The costs to the firm include:

▪ Direct costs such as classroom instruction and

greater worker supervision.
▪ Indirect costs such as reduced worker output during
training.

The benefit is greater worker productivity.

 General and Specific Training

General training is training that is usable at all firms

and industries.

▪ Eg; Word processing skills or accounting skills.

Specific training is training that is usable at only at the

firm that provides the training.

▪ Eg; Assembly procedure unique to a firm’s product.

Most training is a mixture of general and specific training.

General
Training
Specific Training
 Criticisms of Human Capital Theory

Investment or Consumption?

Not all education expenditures are an investment

because some part is a consumption expenditure.

Courses such as music appreciation yield consumption

benefits rather than investment benefits.

By ignoring the consumption benefits of education,

researchers overstate the investment costs of education
and understate the rate of return.
 Criticisms of Human Capital Theory

Non-Wage Benefits

Studies that only examine the earnings of high school

and college graduates understate the rate of return
for two reasons.

• College graduates have greater fringe benefits as

a percent of pay than high school graduates.

• College graduates tend to work in more pleasant

surroundings and have more interesting jobs than
high school graduates.
 Criticisms of Human Capital Theory
Ability Problem

Those with more ability (i.e., intelligence, motivation, and

self-discipline) are more likely to go to college.

Even without a college degree, they would have earned

more than those who decided not to go to college.

To the extent that the higher earnings of college graduates

reflects their greater ability rather than schooling, the rate
of return is overstated.

Omission of ability biases the rate of return estimates by a

small amount.
 Criticisms of Human Capital Theory

Screening Hypothesis

The screening hypothesis argues that schooling

increases earnings not by increasing productivity but
providing a way to identify high quality workers.

It means that an employer use the level of education

to determine the high quality of workers.