Personnel Economics

Lecture 3: Investment in Skills

§ Strategic Organization Design

§ Department of Marketing & Management
§ www.sdu.dk/sod

1Personnel Economics, Lecture 3.

 Today’s Menu

• Patterns about tenure, promotion, and firing:

* The signal and screening (sorting) perspective.
* The human capital perspective.
• Returns on formal education.
• Case: Reduction in SU.
• Where to invest.
• Who should invest – the holdup problem.

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 Newbies, tenured, and their performances:
Empirical patterns…
• Higher turnover among newbies • Tenured more likely promoted
• Promotion mainly from tenured • Promoted newbies advance further
• Newbies more likely demoted

Tenured
have less
extreme
outcomes

3Personnel Economics, Lecture 3.

 Perspective 1

Signaling and Screening

(Sorting)

• Signaling and screening is imperfect.

• Hiring errors (seen from both sides) take time to eliminate.
• After some time of employment, the likelihood of error is small.

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 Signaling, Screening and Education

Employee Selection by Companies

Employees display their formal education history to companies

Successful formal education is costly and cannot be displayed by

anyone. It also signals personal qualities that correlates
positively with future job performance.

5Personnel Economics, Lecture 3.

 Perspective II

Human Capital

• Tenured workers achieve greater specific human capital.

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 Newbies, tenured, and their backgrounds:
More empirical evidence…
• Newbies have longer general education
• Newbies have more (outside, general) work experience

7Personnel Economics, Lecture 3.

 Time in organization à Learning à Productivity

The development of human capital requires

investment

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 The Growing Value of Skill, I

11% per year:The

internal rate of return
on higher education in
US, Asia, and EU.

The relative return on

skill is rising steadily, as
indicated by formal
education data.

9Personnel Economics, Lecture 3.

 The Growing Value of Skill, II

The relative return on

skill is rising steadily, as
indicated by firm data.

NB: Levels correspond

to seniority within the
firm.

Personnel Economics, Lecture 3.

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 Outcomes of Learning (1): General Human Capital
Definition: Human capital of equal economic value
inside or outside a specific firm.

Typical Sources: Schools, universities, society, or as a general rule,

anywhere outside the workplace.

Examples: Mathematics and languages, but also basic social rules.

Prevalence: Most human capital has this character.

IMPORTANT: ‘General’ does NOT mean ‘common’. Some people have

more valuable general knowledge than others.

Personnel Economics, Lecture 3.

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 Outcomes of Learning (2): Firm-Specific Human Capital
Definition: Human capital of less economic value outside a specific
firm.

Typical Sources: Training or experience, within the specific firm.

Examples: Corporate culture, social network position, and

knowledge of idiosyncratic capital.

Prevalence: Much less prevalent than general human capital, but still
very prevalent overall

Personnel Economics, Lecture 3.

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 The Human Capital Spectrum
Portfolios of Skill: People have collections of skills, each subset
being more or less general. The value given to this portfolio by firms,
generally, determines where on the spectrum between firm-specific
and general human capital the entire collection is categorized. Higher
frequencies of firm specific subsets will tend to move the entire
portfolio towards the firm-specific characterization…

More general portfolio:

General Firm-Specific

More specific portfolio:

General Firm-Specific
Personnel Economics, Lecture 3.

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 Returns on Formal Education

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 Modeling returns on formal education.

Where:
K: Financial earnings if education is continued,
H: Financial earnings if education is stopped,
r: Interest rate,
t: Period of time (i.e. we can plot t on the x axis and see a relationship)
T: Last period,
C0: Direct costs of starting education, borne upfront, hence t = 0,
F0: Opportunity costs of education.

Net earnings from continuing education = Kt – Ht

(each period)
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Personnel Economics, Lecture 3.
 Returns on formal education, Model:

K: Increasing, but at a decreasing rate,

H: Increasing, at an increasing rate, Sum of period values
…
(a)
Losing
(b)
K
Value

Before (c)
Profitable discounting
After

H discounting After
direct and
opportunity
costs

Time, t
Personnel Economics, Lecture 3.
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 Returns on formal education, Predictions:

Larger K, caused by:

• Greater innate ability,
• Greater quality of schooling,
• …

Leads to … K´
K
Value

• Longer optimal education

• Perhaps greater inequality (why?)

H
time
Personnel Economics, Lecture 3.
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 Returns on formal education, Predictions:

Smaller T, caused by:

• shorter working life
Due to:
• Pregnancy, T´
• Maternity leave
Leads to …
K
Value

• Shorter than optimal education

In Denmark, 60% of
university students are
woman, but most PhD's
H
are men…
time
Personnel Economics, Lecture 3.
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 Larger r, caused by:
• Greater uncertainty
Leads to …
• Lower optimal level of education, as future earnings are discounted to lower
present values.

NB! Being a long-term investment, education

should not be very responsive to r.

Personnel Economics, Lecture 3.

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 Smaller F, caused by:
• Economic downturn and small labor market opportunities

Leads to …
• Greater present value of education, and higher enrollment rates.

Personnel Economics, Lecture 3.

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 Returns on formal education, Predictions:

Larger C, caused by:

• Greater (up front) tuition fees.
Leads to …
• Lower present value of education,
Causing …
• Lower enrollment rates (as ‘marginal’ students tip towards not studying)
• Lower optimal education length across society.
• Lower specialization (because people tend to specialize if they have more
time to do so),

Personnel Economics, Lecture 3.

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 CASE:
Reduction in SU-subsidies

The Danish government wishes to reduce SU-subsidies to

decrease the average time taken by students to complete
tertiary education. According to our model, will this
succeed? What other effects might this have?

20 min.

Personnel Economics, Lecture 3.

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 Where to Focus and Invest?
Current Other
firm firms

Focus of
training

Weight of
skill in
task

Where to invest depends on the expected productivities obtained after

training, which depends on value created for different firms, and the
likelihood of being at these firms.
Personnel Economics, Lecture 3.
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 Who Should Invest in the
Development of Human Capital?

Personnel Economics, Lecture 3.

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 Who Should Invest? The Case of General Human Capital

RULE: The worker should pay for investments in general human

capital, because this capital increases the employee’s market value, and
creates pressure on the employer to compensate through wages.

Exceptions:
Matching: Some employees may be particularly matched to a firm, and
this specificity creates willingness by the firm to invest.
Recruiting: Offering to reimburse education creates a sorting
mechanism for highly motivated persons.
Arbitrage: Tax benefits for education may give the firms cost
advantages over employees, creating incentives to invest.

Personnel Economics, Lecture 3.

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 Who Should Invest? The Case of Specific Human Capital

V=H–C–F
Situation A: Employee Invests
Before training:
Employer’s costs = 0 Ex ante
Employee’s costs = 5 promise

10 + 5.2 After training:

10 + 4.4 Employer’s gain = (15.2 – 14.4) – 0 = + 0.8
Employee’s gain = (14.4 – 10.0) – 5 = – 0.6

No training
Ex post
offer Firm
Investment cost = 5

Personnel Economics, Lecture 3.

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 Who Should Invest? The Case of Specific Human Capital

V=H–C–F
Situation B: Employer Invests
Before training:
Ex post
Employer’s costs = 5 demand
Employee’s costs = 0 Ex ante
promise

10 + 5.2 After training:

10 + 4.4 Employer’s gain = (15.2 – 15.2) – 5 = – 5.0
Employee’s gain = (15.2 – 10.0) – 0 = + 5.2

No training

Firm
Investment cost = 5

Personnel Economics, Lecture 3.

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 Who Should Invest? The Case of Specific Human Capital

V=H–C–F
Situation C: Joint Investment
Before training:
Employer costs = 2.5
Employee costs = 2.5

10 + 5.2 After training:

10 + 4.4 Employer gain = (15.2 – 14.8) – 2.5= –2.1
Employee gain = (14.8 – 10.0) – 2.5= +2.3
Demanding 15.2 but getting 14.4 elsewh
No training still leaves a surplus for the employee.

NB! Splitting the benefits and costs

Investment cost = 5 reduces, but does not eliminate, the
temptation to renegotiate.

Personnel Economics, Lecture 3.

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 Implications of Firm-Specific Human Capital
Turnover: With shared firm-specific investments, both parties lose if
the worker leaves. Both the employer and the employee therefore
has an incentive to maintain their relationship. This decreases the rate
of turnover.

Labor Market Thickness: Heavy investment in firm-specific human

capital creates a portfolio of skills that is heavily firm specific. This
reduces the options to find alternative jobs with equal pay elsewhere.
This is more or less problematic depending on Firm Size. Large firms
typically have extensive internal labor markets.

Personnel Economics, Lecture 3.

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 DETERMINANTS OF STABILITY

§ Costs and benefits of ending a relationship:

§ (e.g. discount factor for the future)
§ The history of the relationship:
§E.g., given one person using the grim strategy, a
relationship is hard to restore, once it is damaged.
§ Observability of decisions.
§ Hostages in the relation.

Slide 24
offers
offers
 CASE:
Hostages

Using hostages may reduce very costly renegotiations

(hold-up)

What can be used as a hostage (from the

employee/employer) and how would it work?

20 min.
Personnel Economics, Lecture 3.
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