Chapter 2 Human Capital Saumen May 2011

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The Human Capital Approach to Education
Chapter · October 2012

DOI: 10.1093/acprof:oso/9780198082255.003.0002
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2
The Human Capital Approach to Education
The subject of education is amenable to economic analysis since the delivery of education,
both formal and informal, entails use of resources in terms of time and effort, and more
importantly, monetary resources. In view of the resource constraint faced by an individual as
well as by an economy at the macro level, the pertinent question is one of determining how
much resources should be allocated optimally towards education at the two levels, individual
and societal. Supply of and demand for education involves economic decision making in the
sense that economic factors play a crucial role in shaping the decisions of the providers, the
institutions and the purchasers, i.e., students and the parents. The institutions invest resources
to set up infrastructural facilities and employ teachers to deliver education. Similarly, the
individuals invest in themselves in various ways like acquisition of skill and health which
entails a sacrifice of current consumption with the purpose of an income gain in future. This
is not to deny that there are factors other than economic which influence both supply and
demand. As long as delivery of education entails economic costs and benefits to the
individuals and the institutions and to the society as a whole, delivery of education could be
subject to an economic analysis. Further, the developments in the two domains of education,
the institutions (or the societal) and the individuals and benefits arising out of education
accrue to the society drive home the point that valuation of the costs and benefits in economic
terms both at the individual and the societal levels are critical in the determination of
resources to be dedicated to the delivery of education.
For the economy as a whole, fostering human resource development has remained an
important agenda for all the nations for long. The state has to make budgetary provision for
the delivery of education and skill development to supplement and encourage individual
effort. It is therefore an imperative that we subject education to an economic analysis both at
the micro as well as at the macro level for the study of the education sector in general.
In economic theory, it is argued that there is no free lunch. Having more of one thing
requires giving up of something else. Scarcity of resources means that trade-off becomes a
basic fact of life. The objective is to understand the trade-offs involved in the process of
delivery of education and guide decision making for resource allocation both at the individual
level as well as at the national level.
It is argued in the realm of economic theory that decision makers respond to
incentives, mostly in pecuniary terms. For understanding the process of choice making, the
underlying incentive structure has to be understood. Economic theory would help in
analyzing the functioning of an educational institution and decision making of an individual,
the students and the parents. In fact, incentivisation remains a key to the reform of the
education system world over. The other key aspect of economic theory is exchange of goods
and services. Exchange in a market place is crucial to an understanding how resources are
allocated, what is produced, and how is it produced. Exchange is an outcome of decision
making by the two sets of agents, the providers and the buyers. Exchange takes place at a
mutually agreed price which reflects opportunity cost of supply to the supplier whereas
marginal benefit to the purchaser. Delivery of formal education is envisaged as an exchange
in a market place in the main-line economics. Information or its absence plays a key role in
determining the nature of markets and the ability of private markets to ensure that the
economy‟s scarce resources are used efficiently. The students need information to make
informed decisions. Markets determine how the goods and services are produced in an
economy, and how resources are allocated by the government institutions, the private and the
philanthropic ones for imparting education to the members of the society. However, for
education, whether the role of market is desirable and if so to what extent will be taken up for
discussion in Chapter 7.
Economics of education can be said to have originated from the contributions of
Schultz (1961), Becker (1964), Mincer (196), Denison (1962) and in the development of the
concept of human capital. This chapter focuses on the human capital approach to the study of
education. In Section 2.1, we begin with the concept of human capital. In Section 2.2, we
discuss the important concepts of rate of return and its usefulness in decision making. In
Section 2.3, we discuss a model developed by Becker which gives a comprehensive account
of two different aspects of human capital formation, the supply and the demand side to help
explain income distribution. The primary aim of the model is to understand the underlying
factors behind income differentials among the individuals.
DEVELOPMENTS IN THE THEORY OF HUMAN CAPITAL
The fact that individuals invest in themselves to acquire skills and knowledge failed to draw
enough attention from the economists notwithstanding the fact that human beings are at the
centre of any developmental agenda. Individual demand for education was studied mainly
from the perspective of education as a consumption good as price of education (fees), income
of the household and „tastes‟ among other factors were considered to be the determinants of
demand for education (Blaug 1976). As Schultz (1961) says that,
“Our values and beliefs inhibit us from looking upon human beings as capital goods,
except in slavery, and this we abhor. ......hence to treat human beings as wealth that can be
augmented by investment runs counter to deeply held values.”
One way of looking at the economic theory as per the neoclassical approach is all
about choice, rational decision making which entails trade-offs involving scarce resources
and arriving at an optimum decision by taking decision at the margin based on marginal cost
and marginal benefit or to put it simply, constrained optimisation.
Chapter 2: Economics and Education 14
Mincer (1958) was interested in finding out the factors behind income distribution or
differential earnings. But, what could be the possible reasons? Is it human capital, or ability
and opportunities, and intelligence quotient (IQ) and/or, emotional quotient (EQ)? How do
the life-time earnings behave over time? Those with high skill witness higher growth in
income or at least slower retardation in income growth than those with low skill employees. It
was found that “the higher the occupational rank, the higher the level of earnings, the steeper
the life-path earnings”. Intra-occupational differences result from experience. But bona fide
conceptualizations could be traced centuries ago to Smith (1776), John Stuart Mill (…) and
Alfred Marshall (1890). However, the idea of investment in man could be traced to the
mercantilists who emphasized on the importance of „art and ingenuity‟ or skilled manpower
(Bowman 1966: 103). However, Adam Smith (1776) was the first to characterize expenditure
on education as investment expenditure by drawing analogies between men and machines
which would contribute to the enhancement of skill and productivity of individuals and hence
for the economy as a whole1. Marshall referred to socio-economics of „talent wastage‟ but not
explicitly to investment in man and Keynes‟s General Theory made labour passive rather
than an active agent (ibid: 108)2. As an illustration of an early awareness, we can see in
Adam Smith (1776/1876, 118),
“A man educated at the expense of much labour and time to any of those
employments which require extraordinary dexterity and skill, may be compared to [an]
expensive machin[e]. The work which he learns to perform, it must be expected, over and
above the usual wages of common labour, will replace to him the whole expence of his
education, with at least the ordinary profits of an equally valuable capital.”
Alfred Marshall in his Principles of Economics (1890/1922: 564) echoes similar
understanding of education as,
„The most valuable of all capital is that invested in human beings‟.
The enrichment of the theory of human capital has been made possible because of the
contributions made from labour economics, public sector economics, welfare economics,
growth theory and development economics. Possibly because the theory concerns with people
and people are at the centre stage of any economic theory and developmental agenda,
education deserves more attention in both academic and policy discourse today than what it
has received as a sub-discipline of economics. Human capital research programme witnessed
a very rapid growth in the 1960s and 1970s. Blaug (1966) bibliographically organized 792
journal articles, books and research studies. Less than four years later, this number had grown
to 1350. In 1976, it exceeded 2000 with an astonishing 1200 articles per year. The growth in
research publications was not sustained and economic of education as a sub-discipline of
Economics withered or at least, it can be argued, it did not flourish despite having many
linkages with various branches of Economics. However in the recent years, there has been a
surge in the publications in the area of economics of education. As Dearden et al (2011)
argued that the papers related to education in mainstream economics journals was only 2.5
during the 1980s which went up to 5.2 and 9.7 during the 1990s and 2000s respectively.
There are edited books on economics of schooling and economics of education by Hanushek

(2003) and Belfield edited on Modern Classics in the Economics of Education (2006) and
Handbook of Economics of Education by Jones and Jones and Encyclopaedias by Dominic
and McEwan (2010).
THE HUMAN CAPITAL APPROACH
The emergence of economics of education as a sub-discipline of neo-classical economics and

its relevance even today in policy making can be attributed to the concept of human capital.
The recognition to the area also came in the form of two Nobel prizes to those who
contributed to the advancement of the concept of human capital and its salience in the
economy as mentioned earlier. The connectivity between human capital theory and the Nobel
prize for Economics is perhaps more impressive (Sweetland, 1996). Theodore Schultz (1961,
1979), and Gary Becker (1964) are the two most prominent scholars who contributed to the
development of the human capital theory3. Arguably, there were notable contributions from
Friedman and Kuznets (1945) as well. The growth models developed in the 1980s helped to
identify relatedness of education to the aggregate production function (through endogenous
growth theory) and growth. Even, Sen (2000), the Nobel Laureate in Economics assigned
special role to education in his capability approach to the study of „development as freedom‟.
Becker (1966) applied neo-classical economic theory of optimisation to understand
various aspects of household decisions and the most prominent of those remain that of
investing resources for education. Education expenditure is considered to be investment
expenditure as it involves sacrifice of resources for presumably no present benefits but with
an expectation of future gains in the form of higher remunerations accruing to the individual
than what would have been otherwise with a lower level of education 4. At the national level,
education and in particular human capital formation gained more importance to spur growth
with the knowledge assuming dominance in policy discourse. Empirical studies were
undertaken to ascertain the contribution of human capital in growth which will be discussed
in Chapter 3.
DEFINING HUMAN CAPITAL
The rationale behind introducing the concept of human capital and its definition comes out
clearly but only in few words in Schultz (1960) as follows:
“I propose to treat education as an investment in man and to treat its consequences as
a form of capital. Since education becomes a part of the person receiving it, I shall refer to as
Human Capital…it is a form of capital if it renders productive service value to the
economy..”

Human capital is an outcome of learning which remains embodied in an individual
and manifests in the form of augmentation of productivity of the individual. Schultz (ibid.)
argued why acquiring skills and knowledge constitute a form of capital, a part of deliberate
investment which was found to be rising at a much faster rate than physical capital. During
1900-56, while assessing the contribution of the factors production to the growth in national
income, the estimated stock of education as embodied in the workforce was estimated to have
grown at nearly twice the rate of reproducible capital.
The human capital theory suggests that individuals and society gain substantial
economic benefits from investments in people. The hard core of the theory as Blaug (1976)
would argue that the individuals spend on themselves with the purpose of future gains,
pecuniary and non-pecuniary and not for the sake of present enjoyments. Educated
population is a productive, creative and innovative resource for not only growth but to
achieve a broad based growth. This means that human capital formation, both formal and
informal education, on-the-job training, „learning by doing‟ as all of these contribute to the
enhancement of economic capabilities of people. To be precise, Schultz (ibid.) listed 5 major
categories of investment which would lead to improved human capabilities.
First, health facilities and services including stamina, vigour and vitality; (ii) on-the-
job training including old style apprenticeship; (iii) formally organized education at the three
levels, primary, secondary and higher education; (iv) study programmes for adults (extension
programmes including agriculture), (v) migration of individuals and families to adjust to
changing job opportunities. In addition, individuals spend time in searching for jobs or spend
to gather information about job opportunities (Blaug 1976: 829).
Education could be treated both as a consumer good as well as a capital good. As a
consumer good, it yields satisfaction to, say, a student as she goes through the process of
learning in the sense of socialisation in the school campus, participation in extra-curricular
activities and even, simply enjoying the exposure to the new vistas of knowledge and class
room experiences. But more importantly as per the human capital theory, education is an
input to the production of goods and services through the agency of labour. Not only working
with the machines requires skill and dexterity acquired in the process of schooling and
training but the very production of physical capital today with higher and higher
productivities is largely an outcome of new ideas, innovative thinking and research. So in the
sense of production function, both capital and labour undergo transformation through
education and training and the consequent skill development. Further, it can bring about both
economic and social transformation. It is in fact a pre-requisite for not only narrowly defined
economic growth but also for broad based notion of development. Benefits may accrue in
terms of health and nutrition, a control on population growth, improvement in the overall
quality of life, enlightened citizenry to participate in democratic and legal processes, rational
decision making at the level of community as a concerned member of the society, pursue
values such as equality, fraternity, and liberty at both private and social levels, and lower
levels of corruption. Human resources constitute the ultimate basis of wealth of nations and
educated citizenry are the active agents.

Becker‟s (1964) contribution to the theory of human capital (HC) has been a path
breaking one. He provided a theoretical and empirical analysis of human capital formation
with special reference to education by invoking calculational rationality of the human agents.
Humans are programmed to compete in order to maximise their opportunities in a rational
choice model and it emerged from the neo-classical theory. The basic argument relating to
human capital and growth in earnings can be put in the form of a sequence.
Human Capital: 1. that education and training increase individuals‟ cognitive
capacity; 2. which, in turn, increases its productivity; and 3. productivity tends to increase the
earnings of an educated and skilled individual; 4. which, becomes a measure of human
capital. In short, education becomes a measure of human capital as follows,
Education > cognitive capacity > higher productivity > earnings > a measure of HC.
The major arguments of the human capital approach to education can be put in the
form of three propositions as succinctly put forward by Majumdar (1983).
• A. Concept of human capital, a counterpart to the notion of physical capital formation
• B. Spending resources on education is an act of investment.
• (i) investment decision makers in education are analogous to investors in the capital
market, (ii) alternative opportunities in education are at par with alternative
investment channels, (iii) „choice rule‟ is similar to returns maximisation as in the
normal capital market.
C. Education or learning process is similar to production carried out by a firm: Input-
output analysis.
While A and B are taken up for discussion in this chapter, Chapter 4 will be devoted
to C only, arguably the second paradigm in economics of education. Chapter 3 seeks to add to
the discussion of A as well.
HUMAN CAPITAL AND THE RATE OF RETURN
If expenditure on education is treated as an investment and the students are rational in the
sense of assessing the costs and benefits of education before they decide whether to pursue
studies, students‟ (and/or the parents) decision to spend on education is an act of investment,
and hence, it is an act of investment similar to an act of investment in the capital market.
Therefore, it is a natural corollary that rate of return from investment in education would be a
guiding factor for decision making. Not only so, it is a guiding factor for investment decision
at the macro or national level or a new social investment criterion (Blaug 1976). We present
below the rate of return approach as widely used in the empirical studies and a substantial
critique of it will follow in chapter 5.

Estimating the Rate of Return
Rate of return on a project is a summary statistic describing the relationship between costs
and benefits associated with the project. This equates net discounted benefits to zero.
Let us take the example of assessing the rate of return from doing higher studies
beyond the masters level, say, joining the M. Phil./Ph.D programme. Say the research scholar
after completion of her MPhil/PhD programme intends to find out based on her estimation of
cost and expected pay packages what the rate of return from investing in her PhD programme
would be. Assume she is of 22 years of age and would enter the job market after 5 years to
remain employed for 38 years or so to retire at the age of 65 years. She would incur an
explicit cost (out of pocket expenses), of, say, CP, costs of doing PhD, for 5 years. She would
also incur an implicit cost in the form of opportunity cost as she could join the job market and
earn WM, wage with a Masters degree for the period. Looking forward to the future, she
expects her remuneration to be WP, wage with a PhD degree. Her marginal benefit for
pursuing PhD is the extra pay she expects to earn when she joins the job market. She being at
the juncture of entering the job market, her future pay differences are to be discounted to the
present time. Similarly, costs to be incurred in the next five years are to be valued at the
present time. Equating costs and benefits, rate of return r which is called internal rate of
return, could be calculated at the point of entry to the job market as follows.
∑ t = 1 to 5 (CP + WM) (1+r) -t = ∑ t = 6 to 38 (WP – WM)(1+r)-t 2.1
In general, if Ch is the resource cost of schooling incurred to achieve a higher level h
from a lower level l, Wl,t captures the foregone earnings of the student while the student is
engaged in studying, and (Wh-Wl) is the difference in earning attributable to the two different
levels of education, high and low, „s‟ is the years of schooling and let be R is the retirement
age, and the estimation of costs and benefits being carried out at entry point to the high level
of schooling, then
𝑠 𝑅
𝑡=1(𝐶ℎ + 𝑊𝑙,𝑡 )(1 + 𝑟)−𝑡 = 𝑡=𝑠+1 𝑊ℎ,𝑡 − 𝑊𝑙,𝑡 (1 + 𝑟)−𝑡 2.2
The internal rate of return rule entails its estimation by equating present value (PV) of
benefits with the PV of costs. Investment decision can be argued to be justified or rational if
the internal rate of return is greater than the chosen rate of interest or rate of discount which
should reflect the opportunity cost of the investment expenditure. And the second investment
criterion is to rank alternatives according to their internal rates of return (Vaizey et al 1972).
𝑠 𝑊 𝑙,𝑡 𝑅 𝑊 𝑙,𝑡 𝑊 ℎ ,𝑡
𝑡=1 𝑊 ′ (1 + 𝑟)−𝑡 = 𝑡=𝑠+1 𝑊 ′ − 1 (1 + 𝑟)−𝑡 2.3
𝑙 𝑙 𝑊 𝑙,𝑡
Let us assume that eqn. 2.4

𝑊𝑙′ = 𝑅
𝑡=𝑠+1 𝑊𝑙,𝑡 2.4

W'u is the sum of non discounted life time earnings of a worker with a lower skill or
unskilled labourer. Wl,t/W'u = pt, is the proportion of unskilled labourer‟s life-time earnings
earned in year t. The set of p‟s where pi = 1,..,R gives the shape of the life time age-earning
profile for the unskilled labourer in the form of a distribution function. From the first order
conditions for cost minimisation, marginal productivities of factors be equal to factor prices
under the assumptions of a perfectly competitive market. Cost minimisation requires that
(Wh,t/Wl,t) equals MRSt of low skilled for skilled labourer in period t.
If we substitute p and MRS we obtain the following (2.5),
𝑠 𝑅
𝑡=1 𝑝𝑡 (1 + 𝑟)−𝑡 = 𝑡=𝑠+1 𝑝𝑡 𝑀𝑅𝑆𝑡 − 1 (1 + 𝑟)−𝑡 2.5
The internal rate of schooling can be regarded as a function of three categories of
variables, 1. Marginal rate of substitution through time between labourers with different
skills, 2., the shape of age-income profile, and 3. the state of the arts in production of skill,
𝑠
𝑟 = 𝑟 𝑀𝑅𝑆 𝑡 , 𝑝 𝑡 , 𝑅 2.6
The other way of doing it is to find out whether net discounted value of present
benefit (NDPV) is greater than zero with a pre-determined rate of discount.
Annual net benefits rule: (PV of Benefits – PV of cost) = 0 2.7
The investment criteria would be (i) it makes sense to invest as long as NDPV is
positive, and (ii) rank alternatives according to NDPV. The choice of the appropriate discount
rate would be informed by the rate of interest, „i‟, the discount rate.
A Comparison of the Criteria
Vaizey et al (1972) argue that if the two methods yield different estimates, NDPV is
„conceptually the correct one‟. Below, NDPV is plotted against the different discount rates.
There are two NDPVs with the same cost.
NDPV
A
D1 D2

The lines intersect as the time profiles of the returns from the two investments differ. At
higher rates of discount B has higher NDPV and vice versa. If we go by the maximisation of
the internal rate of return, B would be chosen as D2 is the highest which is achievable.
However, at D1, A would be the right choice. Since at higher rates of discount, B has the
higher NDPV, B yields greater returns in the near future. As Vaizey et al (ibid.) argue, A
must be the right choice because it adds more to the resources of the investor.
Besides these conceptual clarifications, it needs to be remembered that certain
adjustments are required to get closer to the reality. The following adjustments are suggested
in the literature as follows.
Adjustments in the Estimation of Rate of Return
Earnings standardisation: earnings differentials are not entirely dependent on education.

Ability, social class, gender, motivation, parental education, region, schooling, medium of
instruction, etc., are all pertinent. In the human capital approach, the causal link between
education and earnings is established through an enhancement in cognitive capacity and its
impact on productivity. There are two ways of addressing this important issue.
Generally an adjustment factor to education, α “alpha coefficient” suggested by Blaug
(1976) can be used to account for factors like innate ability other than education. This means,
that αΔW will have to be used in the regression exercise rather than ΔW. For example, if
alpha = 0.4, 60% of the change in wage reflects the importance of factors other than
education and skill embodied in the individual. It was argued that to the extent of two-third of
the differences in earnings could be explained by education and training.
Regression method can be used by including the possible variables which could have
an impact on the earnings in the regression to apportion the variability in the wage in terms of
education and all other factors in order to assess the relative contributions of the explanatory
variables. The following regression equation can be estimated,
Wage = f (education/skill, gender, ability, motivation, etc.) 2.8
Unemployment: The benefit profile needs downward adjustment because of the
perennial problem of uncertainty in the job market and a mismatch between demand and
supply resulting in underemployment and unemployment. The wage has to be adjusted by the
probability of unemployment as follows: UstWst where 0 < Ust <1. The other way to look at it
would be to consider labour force participation: if labour force participation rate is Pma,
expected earnings are equal to Pma*Wma which is typical of women‟s education.
Probability of survival: the probability that the worker will survive is greater than zero
but less than one. Hence, the wage profile is adjusted by multiplying the wage by the survival
rate, i.e., St*Wt where St is the survival rate which depends on the mortality and morbidity
rates for a person of age t. This is similar to what Becker (19 , 71-72) said about the possible
length of the period of the activity the individual is willing to invest because it raises the rate

of return. Even if we ignore that the young people have a comparative advantage in learning,
unencumbered by responsibilities and tensions, the incentive to invest would rise simply
because of the fact that they would reap the benefits from their investment over a longer
period of time.
Productivity growth: In the rate of return calculation, we assumed that the wage
profile to remain constant for the rest of the working life as the difference in wage remained
the same for the entire working period. This needs to be modified as wage would generally
grow because of the rising productivity of the worker owing to experience and other intrinsic
factors or even independent of it. We need to multiply the given wage profile with (1+g)t
where t would vary from . Else, we can add „g‟ to the expected rate of return.
Consumption benefits arising out of education is crucial for determining the rate of
return. As discussed earlier, the process of learning can be an enjoyable experience yielding
thereby consumption benefits not only for the period of study but for the entire life time in
terms of appreciation of life, culture, arts and literature resulting in higher and more
satisfactory standard of living. We need to add another stream to income to capture the
additional benefits or a percentage of cost laid aside. For the economy as a whole, the non-
economic benefits are generally defined to be externalities or external benefits which are not
valued in the realm of the market. For estimation of wide social rate of return, the sources of
positive externalities are to be identified, quantified and incorporated (Psacharopoulos and
Patrinos 2004).
Risk and uncertainty: since future is always uncertain, estimation of future benefits in
terms of expected wages is always fraught with uncertainty. A comparison of standard
deviations of incomes received by age-education survey with the mean, would give an idea of
the extent of uncertainty faced by the student while taking the decision. A rational investor
would make sure before investing that the expected rate of return were greater than the sum
of rate of return from the risk less assets plus a term to account for liquidity and risk
premiums associated with the investment. In comparison to physical capital, human capital is
not saleable or to put it differently, human capital is an illiquid asset. The uncertainty in the
rate of return arises from their ability, and unpredictable events. The prevailing situation
would form the basis of knowledge about the emerging macro situation.
It is often argued that imperfections in the capital market to invest in education may
be one good reason to explain underinvestment in education and training. This arises as
explained because of an absence of collateral due to the unique character of human capital.
Becker provides deep insights to the funding aspects of education from loans as
compared to the own sources of funds. Young persons on the verge of entering higher studies
would underestimate their abilities and the investment opportunities available. Investment in
education unlike physical capital is difficult to postpone for the reason earlier the better to
reap the maximum benefits from acquired knowledge and hence the investment would be
made with less knowledge more often without a proper assessment of alternative investment
opportunities (Becker 1975: 80).

Private versus Social Rate of Return
Assessing of costs and benefits can be done at two different levels, at the individual level
(micro) and at the societal level (macro). The rate of return estimated above can therefore be
calculated from the point of view of an individual and the society. When resources are used
up, it has implications for allocation of resources for the society as a whole. Benefits
generated do not accrue to an individual only in the form of pecuniary benefits but to the
society as a whole in the form of non-pecuniary returns. Similarly, from the investment in
school education, the society gains in term of lower crime rate, better functioning of the
democratic institutions, spreading of health awareness and responsible citizenship. Costs and
benefits pertaining to investment in education therefore have important social implications. In
view of this, both costs and benefits need to be reassessed. In view of subsidisation of
education, social costs should include the extent of subsidisation as this reflects resources
dedicated to the provision of education by the government on behalf of the society in addition
to the costs incurred by the individuals. Similarly, benefits arising out of education accrue not
only to the individuals engaged in higher education but to the entire society in the form of
various externalities as mentioned above. When social costs and social benefits are taken into
consideration, we obtain social rate of return.
Private rate of return is estimated when costs of education is what is incurred by the
individuals pursuing higher education and the benefits of education as realised by the same
individual as obtained above.
Social costs would have to be redefined as C′PhD = CPhD + SUniv
SUniv = amount of resources devoted to a student by the university or per capita
subsidy. If the benefit calculation remains the same as that of an individual, i.e., only in the
form of higher stream of earnings, rate of return thus obtained is defined as narrow social rate
of return (Psacharopoulos and Patrinos, 2004). If the calculation of benefits includes
externalities, benefits are to be redefined as follows,
W′MA = WMA + TMA and W′PhD = WPhD + TPhD
Where TMA = externalities accruing to the society emanating from an individual with
a Masters degree whereas TPhD refers to the positive externalities accruing to the society
arising out of an individual who obtained her PhD degree.
The rate of return thus calculated after incorporating the externalities is called wide
social rate of return. Social rate of return (narrow) would be less than the private rate of
return because it includes the cost of subsidisation whereas the estimation of benefits remains
the same in the form of higher remunerations accruing to the individual due to higher level of
education. However, for wide social rate of return, the estimation of benefits is revised
upward by the extent of externalities. It is possible therefore, that depending on the amount of
externalities that education generates, it is possible that the wide social rate of return would

be greater than the private rate of return despite inflation of costs due to subsidisation of
education. It is unfair to ignore social benefits arising out of education also in view of
endogenous growth theoretic literature which supports spill-over effects or externalities
(Lucas 1988: to be discussed in Chapter 3). The nature and estimation of social benefits
would depend on the levels of education, its quality and composition.
It follows therefore,
Social rate of return narrow < private rate of return < Social rate of return wide5
We need to distinguish between marginal rate of return and average rate of return.
What we have calculated is a marginal rate of return for the Ph.D cycle (or from lower level
to higher level). Whereas, average rate of return pertains to the entire period, say of rate of
return of schooling. There can also be a distinction between ex-post rate of return and ex-ante
rate of return. The ex-post rate of return is in the historical sense as it has been recorded in the
past or estimated based on real life data from the past, near and far. Ex-ante rate of return on
the other hand is good for behavioural analysis and relevant for making decisions both by an
individual and by the institutions, public and private. In practice, rate of returns are neither
ex-ante nor ex post. Based on today‟s cross sectional data, rate of return estimates are either
extrapolated backward or forward (reference).
Becker (..) undertook an empirical study involving the college graduates essentially
with the objective of finding out whether national expenditure on higher education was
adequate. He compared incomes of college graduates with those of high school graduates to
assess rate of return to see whether there was an under-investment in college education in
comparison (if rorgrad> rorhs) to other streams. If so, more investment was needed in college
education or otherwise. However, he argued that indirect returns should also be taken into
account.
POLICY IMPLICATIONS OF RATE OF RETURN APPROACH TO EDUCATION
As Blaug (1976) argued that the rate of return calculation has an important implication for
guiding resource allocation at the macro level because one could come up with new social
investment criterion. Resources are to be allocated to the different levels of education and to
the different years of schooling to ensure that marginal social rate of returns across the
various avenues are equalized (Blaug 1976: 830). Rate of return estimated for education is
treated at par with rate of return for any other sector in policy making when it is argued that
the equalized rate of return from investment in education should not be lower than the yield
on alternative investment opportunities. Though there is indeed a huge literature on the
estimation of rate of return for understanding career choices and evaluation of decision
making both at an individual as well as at an institutional level, implications for policy
making are often very tenuous. The basic question is whether rate of return should be used at
all for guiding decision making? What is the use of private rate of return calculation for

schooling? Education can be argued to be so fundamental to a dignified existence, treating it
at par with other sectors is tantamount to saying education is no different from power and
irrigation, for example. Power and irrigation are no doubt important and so are education and
health for the government to invest. Within education level, can we use estimates of rate of
return to determine level of investment in the three levels, primary, secondary and tertiary?
Take for example, can we compare rate of return of college education with that of school
education, or compare rate of return for higher education with other sectors such as power,
irrigation and transport. Education creates externalities, quantification of which would always
remain problematic. It does not really matter how large or small the rate of return are.
Therefore, both intra-sectoral as well inter-sectoral allocations are not meaningful if they are
based on rate of return estimation. Since estimation of externalities and non-pecuniary
benefits remains a formidable challenge, the estimates vary and so with it, the optimal
strategy for investment (Blaug 1976: 831).
As discussed earlier, a part of the education expenditure could be treated as
consumption expenditure also. The issue is how to apportion the expenditure into investment
and consumption? How to separate out the impact of ability on rate of return estimates as the
higher wages would be not only caused by human capital but many other factors (ref from
Blaug ).
At the macro level,
Certain criteria for economic evaluation of educational investment projects:
i. Direct economic returns balancing opportunity cost of resources and expected
future benefits.
ii. Indirect economic returns, in terms of external benefits affecting members of
society.
iii. The private demand for education and other factors determining individual
demand for education,
iv. The geographical and social distribution of educational opportunities; and
v. The distribution of financial benefits and burdens of education.
vi. And, the need of the under privileged and certain social categories like, SCs, STs,
OBCs. Gender may also be an important consideration.
The pertinent issue is whether the policy makers should be guided by the estimates of
rate of return from investment at different levels and different sectors. How much to spend on
education or how much resources are to be devoted in aggregate for education as a whole?
How to mitigate the mismatch between demand for skill and supply of skill? How does
quality matter and by how much? How to subsidise education and how much would be the
extent of subsidisation?
Without specifying how does the government expand education facilities, it is
difficult to estimate the demand for schooling function as supply function is also involved in

the process. There lies the possibility that both the supply and demand function would be
estimated in the process.
THE GENERAL EARNINGS FUNCTION: BECKER AND MINCER
Investment on education or human capital could be one of the major factors to explain
differences in income over time and also among persons and families, both within a region,
or across different regions. The talent required for gaining economic success should
encompass some particular kinds of personality, persistence and intelligence. Since ability
and differences in education would affect income, the difficulty lies in separating out the
effect of ability from that of education. Becker (ibid: 84) suggests one way of capturing the
impact of ability on earnings when all other possible variables are held constant. As shown,
gross earnings would include returns on human capital (r) as well as amount invested (C) plus
that of earnings which is independent of education (X).
Y = X + r.C 2.9
The distribution in Y would be determined by distribution in r and C given that X
remains more or less unchanged for all. Ability would be measured by only the average rate
of return (r) on human capital when C is held constant if we ignore distribution of X because
the same level of C would generate different levels of Y ceteris paribus. Hence differences in
r thus estimated will capture differences in abilities intrinsic to the individuals‟
characteristics. But the new dimension Becker adds is the interdependence between r and C.
individuals would have a greater tendency to invest more on education compared to others if
they perceive a higher marginal rate of return keeping all other personal sources of variations
being held constant. We can resolve this apparent confusion since as in (See eqn. 2.9 above)
ability is measured by the average rate of return, but decisions are taken at the margin by
invoking the positive correlation between the marginal and the average.
Becker began his analysis with a simplified version of his human capital model. Net
earnings of a person in period t (Et) can be looked at as the sum of earnings she could have
earned with no contribution from education or broadly speaking human capital (Xt). Since the
person invested in education, she earns a return. The total returns to him at time period t on
investments made on education in him earlier (kt) minus the cost to him of investments at t
(Ct) need to be added with Xt.
Et = Xt + kt - Ct 2.10
Total returns would be the sum of the products of the amount invested in each period
and their corresponding rates of return adjusted for the finiteness of the labour force period.
So,
Et = Xt + ∑j =1 to n rt-j ft-j Ct-j - Ct 2.11

Where rt-j is the rate of return on investment made in period t-j and ft-j is the finite life
adjustment. Becker assumes that Xt is small because of a variety of investments made which
contribute towards income earned by an individual. Income earned independent of investment
made in skill formation would therefore be highly limited and hence it can be neglected.
Further, human capital is assumed to be homogenous in the sense all are perfect substitutes
and add to the same amount to the earnings. Quality training and skills do matter but they do
not count much in the final analysis.
Eti = Xti + ∑j =1 to n rt-j Ct-j - Ct 2.12
The general implications of equations 2.10 is that the distribution of earnings would
depend on distribution on investment costs Ctj and distribution of the rates of return ri and the
correlation between the r and C.
It is also generally observed that earning distribution of the skilled and the older
people would be more skewed than the younger people. In the last equation, the investment
cost was ignored. But at an younger age, the cost of investment would be higher. Net
earnings would be given by,
𝑗 −1
𝑌𝑗 = 𝑋0 + 𝑖=0 𝑟𝑖 𝐶𝑖 + (−𝐶𝑗 ) 2.13
Let Yj refer to the net earnings and Cj to the investment cost at an younger age j. Let
Ci measure investment cost at the age of i and ri the rate of return on Ci. As it is seen, the
distribution of (-Cj) would impact the distribution in Yj as Cj tends to be larger at earlier
stages of individuals engaged in studies. So the skewness would rise as the negative impact of
C wanes and impact of X tends to dominate. In addition, the negative correlation between (-
Cj) and ΣriCi would negate the positive correlation between r and C. Becker (ibid.) adds a
new dimension to the debate on income distribution with the incorporation of the argument
that investment in human capital can shed light on (inequity in) income distribution purely in
terms of economic factors.
THE MINCERIAN APPROACH TO THE DETERMINATION OF WAGE AND RATE OF

RETURN
Mincer (1958, 1974) identified education as one key determinant of income or wage in his
empirical investigation of factors responsible for earnings differentials. He took years of
schooling in the earnings function to estimate rate of return on education for a cross section
of workers. He showed that if opportunity cost of student‟s time as the only cost of an
additional year of schooling and further if we assume that proportional increase in earnings
attributable to education remains the same over the years. It was shown that the logarithm
(log in brief) of earnings would be linearly related to individuals‟ years of schooling. The
regression coefficient could be interpreted as the rate of return on investment in schooling.
The model was augmented to include a quadratic term in work experience to allow for returns

for on-the-job training. Assume that the total cost C to an individual investing into a year of
schooling is the opportunity cost of not joining the job market, or, annual earnings foregone
to pursue education in that year. Let Wt be the annual earning after t years of schooling is
equal to the annual earnings with t-1 years of schooling plus the cost of education (Ct=Wt-1)
times the rate of return on investment in education.
𝑊𝑡 = 𝑊𝑡−1 + 𝑟𝑊𝑡−1 (2.14)
Following the rule of mathematical induction, it follows that earnings after „s‟ years
of schooling are given by:
𝑠
𝑊𝑡 = 𝑊0 𝑡=1(1 + 𝑟𝑡 ) (2.15)
If we take natural logarithms and apply the approximations that for small values of r,
ln(1 + r) ≈ r, yields,
𝑠
𝑙𝑛 𝑊𝑡 = 𝑙𝑛 𝑊0 + 𝑡=1 𝑟𝑡 (2.16)
For r = rt being constant across the levels of schooling, this is equal to
ln 𝑊𝑠 = 𝑙𝑛 𝑊0 + 𝑟𝑠 (2.17)
Or equation 2.17 could also be written as
𝑊𝑡 = 𝑊0 (1 + 𝑟)𝑠 (2.18)
Equation 2.17 is also the logarithmic version of equation (2.18). The relationship
between earnings and investment in education measured in monetary units is converted to the
relation as in 2.14 where natural logarithms of earnings and investment in education
measured are in time units. Logarithm of earnings is a linear function of years of schooling.
The interpretation that each additional year of schooling raises earnings by r percent is made
possible by the log linear formulation of the wage function.
Mincer (ibid.) estimated the rate of return for across the section of countries by
controlling for work experience of the individuals. It spawned many empirical studies only to
reconfirm faith reposed on the Mincerian wage equation. Since Ct equals Wt-1, there is no
scope for direct costs such as tuition, school fees, books and other stationeries. As indicated
earlier, the age earnings profile (Wӧβmann 2003) are assumed to be constant for different
levels of education otherwise the regression coefficient would be a biased estimate of the rate
of return on investment in education.
However, there are problems associated with the treatment of average years of
schooling as the proxy of human capital other than the date related problem including
problem with recording average years of schooling. There could be two major criticisms
(Wӧβmann 2003: 249/265). An increase in the year of schooling by one year would not
necessarily lead to an augmentation of the stock of human capital irrespective of the level of
schooling. What „t‟ means, is different years of schooling contributes to the enhancement on
the human capital stock by different degrees. And secondly, quality of education matters.
Merely by saying that the average years of schooling has gone up by one year means very
little, unless the education imparted was of good quality. This is a typical problem with

education that focusing on the number of years would not be able to capture what education
essentially is and what it does to an individual. To refer to the first criticism, assigning same
weight to any year of schooling to quantify the human capital by average years of schooling
implies productivity differentials among the workers which are assumed to be proportional to
their years of schooling. But empirical studies of micro-econometric in nature show that that
there are decreasing returns to schooling (Psacharapoulos 1994). Ideally that a year of
schooling should be weighted depending on the how many years of schooling the individual
has acquired.
The familiar Mincerian wage equation can be written as
𝑙𝑛𝑊𝑖 = 𝛽0 + 𝛽1 𝑆𝑖 + 𝛽2 𝑒𝑥𝑝𝑖 + 𝛽3 𝑒𝑥𝑝𝑡2 + 𝜖𝑖 2.19
Where lnWi is the natural logarithm of individual earning i, Si is the number of years
of schooling, „exp‟ is the experience and exp2 is the squared of experience and ε is the error
term. The coefficient of schooling is the rate of return obtained as the discount rate obtained
by equating two present values of earnings of cost and benefits. The estimate of β 1 ranges
from 0.05 to 0.15. The usefulness of the Mincerian equation is that the semi-log formulation
captures the relevant data in countries with sharp differences in socio-economic conditions
(Krueger and Lindahl 2001: 1104/1108). Wage is assumed to rise with the gain in experience
but with a decreasing rate.
The issue is whether the coefficient reflects unobserved ability and other variables
which are correlated with education or the “true reward that the labour market places on
education?” (Krueger and Lindahl 2001: 1104). There can be two ways to interpret. Either, it
is a signal for ability (Spence 1973) or it is a measure of increases in productive capabilities
(Becker 1964) and in all probability, it is a blend of two. Further, would all the individuals
gain equally in their earnings or would it vary systematically with individual characteristics.
The evidence suggests that education is more than being a proxy for the unobserved ability.
EARNINGS DISTRIBUTION
The persons who consider themselves to be „able‟, would also invest in migration to pursue
their higher studies. The separation of “nature from nurture” or ability from education and
other environmental factors is difficult because of the possible correlation between ability and
better education. As one moves from one level of education to another say from Bachelor to
Masters degree, the earnings differential would not merely capture the additional level of
education but ability as well as the persons who moved onto the higher level would have
earned more even if they did not pursue Masters level as those are more able than those who
opted out of higher studies.
The challenge lies in reconciling skewness in the distribution of earnings with that
nearly normal or symmetrical distribution in abilities. Distribution in earnings would match
distribution in abilities if everyone had invested the same amount. Similarly the distribution

in earnings would also match the distribution of C if all were equally able. However, Becker
began his analysis with a simplified version of his human capital model. Net earnings of a
person in period t (Et) can be looked at as the sum of earnings she could have earned with no
contribution from education or broadly speaking human capital (Xt). Since the person
invested in education, she earns a return. The total returns to him at time period t on
investments made on education in him earlier (kt) minus the cost to him of investments at t
(Ct) need to be added with Xt.
Et = Xt + kt - Ct 2.20
Total returns would be the sum of the products of the amount invested in each period
and their corresponding rates of return adjusted for the finiteness of the labour force period.
So,
Et = Xt + ∑j =1 to n rt-j ft-j Ct-j - Ct 2.21
Where rt-j is the rate of return on investment made in period t-j and ft-j is the finite life
adjustment. Becker assumes that Xt is small because of a variety of investments made which
contribute towards income earned by an individual. Income earned independent of investment
made in skill formation would therefore be highly limited and hence it can be neglected.
Further, human capital is assumed to be homogenous in the sense all are perfect substitutes
and add to the same amount to the earnings. Quality training and skills do matter but they do
not count much in the final analysis.
Eti = Xti + ∑j =1 to n rt-j Ct-j - Ct 2.21
The general implications of equations 2.21 is that the distribution of earnings would
depend on distribution on investment costs Ctj and distribution of the rates of return ri and the
correlation between the r and C if incentive to invest depends positive. Perceived ability (or r)
skewness in earnings would arise even if both ability and C were independently and
symmetrically distributed. Higher the magnitude of this correlation, greater would be the
skewness in earnings as the product of two symmetrical distributions in r and C.
From 2.17, it follows,
𝜎 2 𝑙𝑛𝑊𝑡 = 𝑟 2 𝜎 2 𝑠 + 𝑠 2 𝜎 2 𝑟 + 𝜎 2 𝑠 𝜎 2 (𝑟) 2.22
The inequality in earnings is large when σ(r) and the average level of schooling s, are
large other than the contributory factors r and σ(s).
BECKER‟S APPROACH TO HUMAN CAPITAL AND INCOME DISTRIBUTION
Becker (1975: 94) proposed a model which essentially captures the centrality of human
capital in determining income distribution, but in a somewhat broader framework
incorporating various other non-economic aspects, individual cognitive capabilities and
family environment other than the economic factors such as financing of education. As

Becker (ibid.) made his intention very clear in the beginning that the objective was to
advance a comprehensive explanation of the factors behind personal income distribution
particularly focusing on why individuals make different amounts of investment in education
with the analysis focusing on a representative individual within a framework traditionally
used to deal with investment in physical capital. Becker sought to explain actual income
differences across regions, countries and time periods with the help of a comprehensive
economic theory. The key to understand personal income distribution was to address the
basic question, why rates of return and investments vary substantially among the persons.
Rate of return is viewed as the outcome of two forces, demand and supply which
have though different connotations in the present context. The demand curve shows marginal
benefit or rate of return (ror) for different levels of investment whereas the SS curve shows
the marginal cost of financing to her or simply the rate of interest. So both the demand and
the supply curves pertain to the same individual who mobilises her finances to invest on
education with the purpose of gaining in the form of marginal rate of return akin to marginal
benefit obtainable from the consumption of a good. In the diagram below, we depict human
capital along the X axis measured in Rupees and marginal rate of return or cost along the Y
axis. The equilibrium entails the intersection between the demand and the supply curve which
occurs at the equality of ror and rate of interest for financing education, where income is at its
peak. Given the differences in the underlying factors generating the demand curves and the
supply curves, it is an imperative that we deliberate on the factors responsible behind the two
curves.
The demand curve slopes downward but in the present context the reasons behind this
are different. One particular aspect of the distinctions between the human capital and physical
capital is crucial here. In case of human capital, capital is embedded in the person investing.
Since memory capacity, physical size, etc., are limited, as the person keeps on investing,
eventually diminishing returns would set in. Indispensability of time and the universal time
constraint faced by an individual contributes further to the negativity of the curve. As Becker
argued that the factors contributing to the formation of human capital is not a single entity but
it constitutes indispensable elements like which is fixed for all individuals, like time. In case
of upward sloping supply curve, marginal cost rises for producing a rupee of returns as cost
of financing goes up. A large part of human capital is the own time of the person investing
which is equal to foregone earnings. Since time is costly and important, optimal combinations
require capital accumulation forced by the importance of own time can reduce but not
eliminate the decline in marginal benefit (MB) as human capital is accumulated. The value of
own time increases and time is spread out but essentially time remains an important
ingredient as without the importance of all other factors cease to matter. In the long run, there
exists an optimal combination of such inputs to human capital formation which would
maximise the PV of future stream of earnings.

SS
DD
Source: Becker 1975.
So, the later investments become less and less profitable because of high mortality,
and a decline in the present value (PV) as it is similar to a postponement of investment
decision. Capital accumulated becomes increasingly valuable and so does his time associated
with increasing risk aversion at the margin. The supply curve reflects marginal cost of
financing which is equal to the rate of interest of borrowing funds or the opportunity cost if
own funds constitute the source of funds.
This can also be explained as the annual repayment on an additional rupee borrowed
for funding investment in education. In reality, the capital market for funding education is
segmented. The local subsidies, borrowing, transaction costs, imperfections in education
loans market, rationing of funds which may all lead to a rise in cost of financing education. In
fact, higher the segmentation, higher is the cost as one‟s intention to invest rises. Subsidy is

in effect zero cost to the borrower in the form of cheap loans, subsidized loans, commercial
loans, etc. But accumulation of time matters. Longer the time period, costlier is the loans.
At equilibrium, rational decision entails choice of a path that maximizes the present
value (PV) of profits. As per convention, the question is how do we ensure uniqueness and
independence of the DD and the SS curves. Becker assumes that own time and hired inputs
are used in fixed proportion. Time has a fixed cost and has got a maximum limit. At
equilibrium, MB = MC.
The model implies that the total amount invested differs because of differences in
either demand or supply conditions. Therefore, the model provides an explanation why
different individuals invest different amount in themselves thereby causing the incomes to
vary as rate of return varies. Higher demand curve in the form of a rightward movement of
the DD curve and lower supply curves in the sense of a rightward movement lead to greater
investment than others. Given the supply curves, one can find out that higher the demand
curves, higher are the returns. If the underlying conditions determining the cost of education
remain the same, some individuals would invest more and some would invest less depending
on their rates of return. Similarly, given the demand curves, as the supply curves shift right
ward, the return from investment falls. This happens because with rightward movement of the
supply curves, as formation of human capital takes place, rate of returns falls along the
downward sloping DD curve. As we can see both the demand and the supply conditions are
possible factors to explain the differences in earnings. We need to make an attempt to focus
on one aspect at a time.
Egalitarian Approach
Becker (ibid.) distinguishes between the two approaches based on the demand and the supply
curves to explain the rate of return based on the DD and SS curves. In the egalitarian
approach, as Becker (pp.106) defines, “Demand conditions are the same for everybody and
that only cause of inequality is differences in supply conditions”. Same demand conditions
imply that everyone has the same capacity to benefit from investment in human capital but
opportunities differ amongst all to invest in human capital and so there would be different
supply curves for different financing conditions. To effect equality in the distribution of
incomes, the policy should target to eliminate the differences mostly in terms of availability
of funds. Given the segmentation in the capital market, cost of financing is likely to go up.
Availability of subsidies may also differ for different individuals and with respect to different
state policies6.
The investor may be from wealthy families which enable people with favourable
conditions to invest large amounts and SS curve is lower implying cheaper sources of
financing. So the underlying the differences in the supply conditions explain why the supply
curves vary amongst the individuals. As shown earlier, one can write
E = ravg*C (2.23)
If the demand curve for funds is completely elastic, r, average rate of return is
constant for everybody, the differences in E would arise from differences in C. If cost of
borrowing is the same, and people gain equally from human capital, rate of return is the same
for everybody. Inequity in distribution of earnings would reflect inequity in supply or cost
conditions. If demand curve were negatively sloped, the impact on E due to a change in C
will get muted resulting in a fall in the average rate of return (ravg). Higher the elasticity of the
demand curve, greater would the proclivity to invest if supply of finance were favourable and
for a higher rate of return, greater would be the extent of inequity in earnings and skewness.
“Elite” Approach
The other approach also portrays the analysis to be an extreme one for the purpose of
contrast. As defined by Becker (ibid: 109-110 ), “Supply conditions are identical and the
demand conditions alone vary among the individuals”. The underlying assumption is that the
earnings differ primarily because of differences in the capacity to benefit from investment in
human capital in different individuals: some persons are more able and would form an elite
group as reflected. To reiterate, the opportunities are measured by the SS curves and
capacities are by the DD curves. The DD curves can be higher only if more units of capital
are produced for a given expenditure which implies that the human capital formed has more
capacity and ability to gain from a given investment as reflected in higher rates of return.
Ability is measured by earnings received when the investment in human capital is held
constant as discussed earlier.
There can be two definitions of ability: (i) in terms of IQ, personality and motivation,
without regard to the earnings (attention to form and not to results), and, (ii) in terms of
earnings without regard to opportunities (confounding in the process „nature‟ and „nurture‟).
Becker‟s approach emphasizes on the relationship between ability and results with
recognition to the impact of environment on results as SS is given.
As evident from the diagram, if cost rises, rate of return rises as we move up the
common supply curve and along the higher demand curves. With the same cost, rate of return
(ror) rises as DD shifts up. If we combine these two, earnings would tend to be more
unequally distributed and skewed than investments as rate of return rises with a rise in
investment along the positively sloped supply curve.
In the egalitarian approach, marginal rate of return is lower, the larger is the amount
invested in human capital as the DD curve is negatively sloped. Whereas in the elite
approach, marginal rate of return is higher, greater is the investment in human capital as the
SS curve is upward rising.
The inequality in earnings tends to be less than that in supply conditions and greater
than that in demand conditions because the former implies a negative and the latter a positive
correlation between rate of return and investment. In the egalitarian approach, the inequality
in earnings is more serious because it indicates a larger extent of underlying inequities. This
has relevance for the present debate in India. Therefore, a skewed distribution of income with
a presumed symmetrical distribution of abilities can now be explained.
A More General Approach to Rate of Return
Investment in education and return earned there from constitutes the core of the model which
seeks to explain income differential among the individuals. In line with the neoclassical
approach to resource allocation in terms of demand and supply, Becker in an ingenuous way
provided a sound rationale for looking at the rate of return determination in a supply-demand
framework by focusing on the same individual but from two different perspectives, funding
education by linking interest cost and the amount borrowed for investment and return from
investment in education. How to explain the variability in earnings among the people who
invested the same amount in human capital? Neither the special case, nor variations in DD
nor SS alone are sufficient to provide an explanation. There is a new parameter other than
distribution of cost and earnings, elasticity of DD and SS curves.
A Comparison between the Egalitarian Approach and Elite Approach
In the egalitarian approach, as the SS curves move rightward, marginal rate of return falls
with the increase in investments, whereas, in the elite approach, higher the investments,
greater is the marginal rate of return as the DD curve shifts rightward. In the former
approach, the variations in earnings would be less than that of inequities in the supply
conditions because the negative correlation between the rate of return and investment made in
education. In the elite approach, because of the positive correlation between r and C, the
inequities in capabilities get exacerbated in earnings. This model can help explain why a
symmetrical distribution of capabilities would result in a positively skewed distribution of
income under constant elasticity of supply and constant and identical elasticities of demand
curves. It is easier to explain the income inequities in the elite approach which is based on the
differences in capacities than in the egalitarian approach. This is interesting because the
supply curve is amenable to funding policy of the government. The government through
subsidisation and cheaper education loans, „scholarships to the needy‟, can bring about
equality in the SS side but variation in the demand conditions are intrinsic and person
specific, differences in intelligence and other factors not amenable to direct policy
interventions. Focusing on the supply conditions would also effect better allocation of
resources to human capital. So the inequities would remain if the supply curves are made
almost horizontal by policy interventions.
Unlike the conventional DD and SS conditions, there exists a correlation between the
DD and SS curves. As argued, that the supply conditions do not vary independently of

demand conditions. This is in sharp contrast with the conventional demand-supply approach.
This peculiar situation would arise because the model focuses on two different aspects of the
same individual. (i) Abler persons are more likely to receive scholarship or grants from the
public and private schools, shifting the SS rightward, (ii) children from higher income
families on an average are more intelligent and receive greater psychic benefits from human
capital, (iii) government measures to tackle poverty lowering the SS curves. If the first two
dominate, we would get a positive correlation between the SS and the DD curves. It increases
the skewness by increasing earnings and investment of persons who would have high
earnings and investment anyway.
Becker uses the same framework to discuss the important issue of efficiency-equity
trade off. Equalisation of marginal social rate of return across all the persons would ensure
efficient allocation of the total investment in human capital if attitudes towards risk are
ignored. If we assume that marginal social to private ror are equal, the equality of the social
ror would also ensure equality among the private rate of return.
Nature versus Nurture Debate
Though in the human capital theory, it is the levels of education which determine earning,
what is the role of ability is clearly brought out in the demand and supply framework as
discussed above. However the relative impact of ability on return is not really apportionable
in the empirical literature. Even conceptually the how to distinguish the relative contribution
of attributes and schooling is also difficult. We again have to engage ourselves in this debate
in Chapter 5 after we conclude our discussion on the theory of screening.
Generally it is believed that the human capital approach undermines the impact of
pre-school factors on lifetime earnings whether it is in the form of native ability or time spent
by family or family background. The impact of these factors like native ability, family
background and schooling cannot be added to gauge their total impact as in that case we
would ignore the interaction effect. The combined effect would greater than the sum of the
impact of the individual factors. Strictly speaking, as argued by Blaug (1976: 843) the human
capital theory does not deny the interaction but emphasises more on the additive effect. It is
of course a matter of concern that it is difficult to get reliable data on pre-school factors and
family background. The unconvincing empirical results can emanate from three factors: one
the identification problem, the problem related to proxy variables and data related problem.
Since earnings depend on wage which is market determined, an earning function
could be considered as a reduced form equation in which the estimated coefficients are biased
as the simultaneous equation model is not specified and therefore estimated7.
The impact of home environment can be in the form of parental education, income,
parental occupation, both before school or during schooling or post school influences or may
be because of attitudinal changes or aspirations and encouragement. For measuring native
ability, the use of IQ is often contested. Instead achievement motivation may be a better
proxy. It can be argued that schooling does exercise a strong impact and in a way it mediates
the family background and pre-school cognitive ability, which on their own would not mean
much to an individual in the skilled segment of the job market. Not only it is schooling, but
quality schooling which transforms family background and cognitive ability into marketable
assets. It follows therefore that schooling by itself would not suffice to equalize income
without adequate attention given to family support and pre-school development. Otherwise
school would be stratifier instead of an equalising force8.
VALUATION OF HUMAN CAPITAL
If valuation of physical capital remains problematic, valuation of human capital has been a
formidable challenge. However, the economists have not shied away from its valuation either
because it is a first step towards conceptualising human capital and subject it to the rate of
return analysis. All the criticisms levelled against even valuation of physical capital remain
valid for human capital to a large extent. The measurement of human capital is highly
sensitive to the rate of discount applied. As argued by Wӧβmann (2003) argued that the adult
literacy rates, school enrolment ratios, average years of schooling of the working age
population are all poor proxies for human capital. The concept of obsolescence is not
important as it is for physical capital, but mortality rates need to be considered. Further, the
relation between earnings and productivity is central to the measurement of net human
capital. There are two problems associated with it. One, the entire rise in earnings cannot be
attributed to the contribution from human capital as innate ability, race, sex and other socio-
economic factors count. Two, investment in human capital is constrained by various socio-
economic factors. It remains debatable whether quantification of human capital would tilt
more towards earnings based approach or cost based approach. Further, the consumption-
investment apportionment of expenditure on education adds complication to the process. The
delineation of the future profile of earnings and cost is based on the assumption that steady
state or steady growth equilibrium persists in the long run (Vaizey et al 1972) which is,
realistically speaking, untenable.
EVOLUTION IN HUMAN CAPITAL THEORY
Over time, the human capital theory has evolved. There have been changes in methodological
issues, focus and their subsequent impact on the practice of policy making. Marginson (1997:
221-22) has traced the evolution of the human capital theory in three phases. This Chapter
dealt basically with the first phase (during the 1960s) with focus on education augmenting
productivity and therefore income. For policy making, the emphasis was on ensuring equal
access to education with social rate of return being regarded as a measure of investment on
economic growth in a broader sense. In the second phase during the 1980s, the linkage

between education and growth was re-envisaged with technological change being considered
as the mediating factor. Focus was on how education could be an enabling factor in the
development and generation and dissemination of knowledge as embodied in technology to
spur income growth (to be discussed in the next Chapter). Shrinkage in the size of the
governments against the backdrop of the structural adjustment policies underpinned the
approach to education reform. With the coming of the third wave by the early 1990s, termed
as the „market liberal human capital theory‟ (ibid.), the economic logic of free market gained
importance which became a compelling reason to undertake reform in education. For a
change in the focus, the importance of social rate of return waned even though private rate of
return emerged as a guiding factor for individualised investment in education. The role of the
government was to facilitate private investment with the aggregate leading to the optimum
level of social investment. However, all three waves share one core element, expenditure on
education is investment in human capital but they differed in terms of their methodological
approaches and in different ways they informed policy practices in education.
CONCLUDING REMARKS
This chapter dealt with the concept of human capital and rate of return approach to
investment in education. The development of human capital constitutes the core of economics
of education and it is a critical concept in the theory of growth and broad based participatory
development. The theory has had influence over government policies with regard to skill
development in the West. Expenditure for the purpose of acquisition of skill and knowledge
is argued to be no different from investment in physical capital. The choice of making
investment in education would be guided by the same principle applied in case of investment
in physical capital. Concept of rate of return was developed in case of education and how this
idea could be broadened to include other relevant factors determining earnings. At the micro
level, the Mincerian equation posits a relationship between wage and a set of independent
variables including education and work experience. The human capital approach can be
argued to be lying within the mainline economics of “methodological individualism”. So the
criticisms levelled against this approach question the very foundation of this theory which is
based on the methodology of neo-classical economics. As Fitzsimons and Peters (1994/1999)
quote Fred Block (1990) to point out two fundamental building blocks of neoclassical
economics as, one, the economy is analytically separate from society. But, an economy is
indeed influenced by politics, society and culture. Two, individuals act rationally to maximise
their utilities. However, individuals do behave differently but in order to lay bare the
dynamics of the core of the economy, other behaviours are relegated from the analysis.
Fitzsimons and Peters say that “These assumptions are cast in universal and ahistorical
terms”. The neoclassical perspective simplifies the entire gamut of social events that are
significant in education and quantifies all qualitatively different aspects of social, cultural and
historical phenomena. Though this is indeed the approach of this dominant paradigm, the
human capital theory has been very well supported by empirical studies. Sometimes, in order
to unravel the core, a lot many aspects, even though they are important have to be relegated
otherwise it would become almost unmanageable. We have seen in Becker‟s model how
other socio-psychological factors were recognised and made part of the demand-supply
model to determine rate of return.
In order to unravel the relationship between education and earnings, the model
developed by Becker is introduced which seeks to explain the income differences in terms of
demand and supply factors.
Blaug (1976: 828) in his review of the human capital approach raised a fundamental
question which has remained valid even today. He says, “Has it progressed, in the sense of
grappling ever more deeply and profoundly with the problems to which it was addressed, or
are there signs of stagnation and malaise?” Though the human capital approach has led to the
emergence of many new areas of research in many branches of economics, but in terms of
empirical support, Blaug argues that the theory „…is not very well corroborated.‟(ibid.: 833).
While concluding , Blaug quotes Oulton (1974) to make a point which questions the very root
of the demand and supply approach. Accumulated human capital in the earnings function is
supposed to be determined by two exogenously determined distributions, the „abilities‟ and
„opportunities‟. But these two are mere reflections of early cognitive ability and family
background. These two are actually,
“..endogenously determined variables in any intergenerational view of the process of
human-capital formation. Thus, at best, the schooling model is incomplete and, at worst, it is
misleading” (Blaug 1976: 845).
Linking up education with income earnings requires a study of the role of education in
the process of selection in the job market which remains outside the ambit of the human
capital approach. Education may act as a signalling device for the employers to segregate the
job applicants as potentially more productive than with low potential opens up a new channel
to explain the positive correlation between education and productivity and earnings
positively.
The importance of education has to be beyond its mere role in enhancing income.
Education by itself is intrinsically important to a person irrespective of its positive impact on
income earning capacities. This aspect of education that it empowers an individual to
participate in the larger socio-political context and overcome constraints to live life with
more freedom and dignity have been stressed by Sen (2000) in his capability approach.
From a Marxian perspective, the human capital approach scores points but falls short
of giving a fuller analysis. It extends the notion held by the Classical economists like Ricardo
and Marx that labour is a produced means of production scores points as distinct from labour
being treated as a mere commodity. Labour is heterogeneous and differentiated as labour
embodies different levels of skill. An analysis of the process of production of education
requires both the social institutions, schooling and family to be put together rather than
relegating family in the background of analysis. But the notion of schooling needs to be

deconstructed along with the attempt to unravel the implications of education imparted within
a social context in a typical capitalist order.
The focus on individuals as decision making agents in education ignores the other
domain of decision making ignoring thereby their interactions. Choice making from society‟s
perspective is often insightful and meaningful as argued by Majumdar (1983). What it
appears is an overall critique of the human capital approach which needs a much broader
canvass to appreciate how economic theory has dealt with education over the years from
various viewpoints. We would take up some of these points for the purpose of detailed
investigation in Chapter 5 where we revisit the contributions of human capital theory from
four different perspectives, education is a screening device, Sen‟s approach to education in
his approach to development, Majumdar‟s critique of the human capital approach from the
social choice perspective and the Marxian critique.

NOTES
1
Because of Adam Smith‟s emphasis on division of labour, economic progress would reduce rather
than raising supplies and demand for human skills. Malthus like Smith treated education for
betterment of man and not for the creation of human resources (Bowen 1968: 104).
2
Sustained investment in physical capital was necessary to sustain the demand for labour as aggregate
demand determines output and hence employment.
3
Specifically, Schultz was awarded in 1979 and Becker was awarded in 1992.
4
To the extent, acquisition of skill and knowledge and being a part of the institution gives satisfaction
to the individual in the form of socialization and realization of one‟s potential, expenditure on
education would constitute consumption good.
5
It is assumed that the valuation of externalities would be large enough to outweigh
6
If scholarships are given on the basis of merit or income, only those fulfill the defined criteria
become eligible for the scholarships. The supply curve will also vary from individual to individual
depending on the family‟s income and wealth condition.
7
This issue will appear in the discussion in the context of a critique advanced by Majumdar (1983) in
chapter 5. He argues that the human capital approach focuses only on the one domain of investment,
the individual domain and there may arise difference between micro and macro estimates. Both these
put together show that supply responses in the education sector matters for realization of returns as
wages are essentially market determined.
8
Blaug (1976: 844-45) quotes Fägerlind (1975) to drive home the point that schooling after all does
matter.
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The Human Capital Approach to Education

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The Human Capital Approach to Education

DEVELOPMENTS IN THE THEORY OF HUMAN CAPITAL

Chapter 2: Economics and Education 15

THE HUMAN CAPITAL APPROACH

The emergence of economics of education as a sub-discipline of neo-classical economics and

DEFINING HUMAN CAPITAL

Chapter 2: Economics and Education 16

Chapter 2: Economics and Education 17

HUMAN CAPITAL AND THE RATE OF RETURN

Chapter 2: Economics and Education 18

Let us assume that eqn. 2.4

Chapter 2: Economics and Education 19

A Comparison of the Criteria

Chapter 2: Economics and Education 20

Adjustments in the Estimation of Rate of Return

Earnings standardisation: earnings differentials are not entirely dependent on education.

Chapter 2: Economics and Education 21

Chapter 2: Economics and Education 22

Chapter 2: Economics and Education 23

POLICY IMPLICATIONS OF RATE OF RETURN APPROACH TO EDUCATION

Chapter 2: Economics and Education 24

Chapter 2: Economics and Education 25

THE GENERAL EARNINGS FUNCTION: BECKER AND MINCER

Chapter 2: Economics and Education 26

THE MINCERIAN APPROACH TO THE DETERMINATION OF WAGE AND RATE OF

Chapter 2: Economics and Education 27

Chapter 2: Economics and Education 28

Chapter 2: Economics and Education 29

BECKER‟S APPROACH TO HUMAN CAPITAL AND INCOME DISTRIBUTION

Chapter 2: Economics and Education 30

Chapter 2: Economics and Education 31

Source: Becker 1975.

Chapter 2: Economics and Education 32

A More General Approach to Rate of Return

A Comparison between the Egalitarian Approach and Elite Approach

Chapter 2: Economics and Education 35

Nature versus Nurture Debate

VALUATION OF HUMAN CAPITAL

EVOLUTION IN HUMAN CAPITAL THEORY

Chapter 2: Economics and Education 37

Chapter 2: Economics and Education 39

Chapter 2: Economics and Education 40

Chapter 2: Economics and Education 41

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