Chapter 9

Investments in Human Capital:

Education and Training
 A decision today about how
much education to acquire will be
reflected by future changes in
earnings.
 Human Capital
• skills of an individual which he or she can
rent out to an employer.
• How can we analyze the decision of
whether or not to attend college and get a
degree?
• What's important?
 COSTS
• Tuition and fees, foregone earnings, psychic
costs
• $15,000 a year minimum.
 BENEFITS
• Future earnings in $
terms.
 Age-Earnings Profiles
College
$30,000
$25,000
$20,000
High School
$15,000
$10,000
$5,000
$0
($5,000) 18 21 23 26 29 32 35 38 41 44 47 50 53 56 59 62 65
$30,000
$25,000
$20,000
$15,000
$10,000
$5,000
Direct Costs
$0
($5,000) 18 21 23 26 29 32 35 38 41 44 47 50 53 56 59 62 65
$30,000
$25,000
$20,000
$15,000
$10,000 Indirect costs
$5,000
Direct Costs
$0
($5,000) 18 21 23 26 29 32 35 38 41 44 47 50 53 56 59 62 65
$30,000
$25,000
$20,000
$15,000
Future Benefits
$10,000 Indirect costs
$5,000
Direct Costs
$0
($5,000) 18 21 23 26 29 32 35 38 41 44 47 50 53 56 59 62 65
Human Capital Models Can Explain
Why:
• earnings typically increase with age but at a
decreasing rate.
• unemployment rates tend to be inversely related
to the level of skill.
• younger workers change jobs more frequently
and tend to receive more on the job training than
older workers.
• persons with greater ability receive more
education and other kinds of training than
others.
How can we derive a model that
explains all of these?
 Assume:
• The increased amount of human capital
affects only the wage rate.
• Each person produces his own human
capital by using his own time and goods to
attend classes, receive on the job training,
etc.
 If the present value of net
benefits is greater than the
present value of costs, the
individual will invest in human
capital
$30,000
$25,000
$20,000
$15,000
Future Benefits
$10,000 Indirect costs
$5,000
Direct Costs
$0
($5,000) 18 21 23 26 29 32 35 38 41 44 47 50 53 56 59 62 65
 Definitions
• Let Xt = earnings with college degree in time
period t
• Let Yt = earnings with high school degree in
time period t
• Let r = the discount rate (interest rate)
• Let R = retirement age
 R (X  Y )
PV ( Benefits)   t t
t
t  0 (1  r)
 R
Ct
PV (Cost s) =  t
t =0 (1 r )
Two methods to use to determine
whether or not the investment in
college is worth it or not:

• present value method - specify the discount

rate and determine if PV(BENEFITS) >
PV(COSTS)
• internal rate of return method - How large
of a discount rate is necessary to make
college profitable?
 Present Value Method

R
( Xt  Yt ) R
Ct

t  0 (1  r )
t ? 
t  0 (1  r )
t
 PREDICTIONS
• what happens when X, Y, C, r and R
change?
 As r rises, the present value of
the difference falls
• Present oriented people are less likely to go to
college than future oriented (forward looking)
people.
• Being present oriented implies that the
discount rate is high.
• Present oriented individuals discount the future
more heavily.
College attendance will increase
if costs fall.
 College attendance will increase
if the gap between earnings of
college and high school graduates
increases.
• Likewise, people with a higher
opportunity cost of foregone earnings
may be less likely to attend college, other
things equal.
$30,000
College
$25,000
$20,000
$15,000
$10,000 High School

$5,000
$0
($5,000) 18 21 23 26 29 32 35 38 41 44 47 50 53 56 59 62 65
$30,000
College
$25,000
$20,000
$15,000
$10,000 High School

$5,000
$0
($5,000) 18 21 23 26 29 32 35 38 41 44 47 50 53 56 59 62 65
What happens during a recession?

• unemployment is less likely for educated

workers
• this implies that Y does not change
• high school workers are more likely to be
unemployed
• this implies that X may become $0
• thus, (Y-X) increases during recession years
Our model predicts an increase in
investment in human capital
during a recession.
 Is education a good investment?
• Some studies estimate the rate of return to
education after adjusting for inflation is 5 to
15 percent
• This is similar to the return on other
investments
These estimates have biases some
of which overstate the return on
education and some which
underestimate the return on
education.
 Overestimating the return on
education:
• we cannot separate ability from schooling
level
• this is called a selection bias problem
• if those who are most able are the ones who
go to school we could be seeing increased
earnings from higher ability and not from
increased schooling
 Underestimating the return on
education:
• we cannot measure all returns from
education such as psychic benefits
• fringe benefits are often not included, but
generally are higher with higher earnings
Education As A Social Investment

• U.S. spends 7% of GDP on education (if we

include foregone earnings for college
education this is 10% of GDP)
• education has social payoffs in some fields
(i.e., engineers)
• but education may act as more as a sorting
device in the labor market
The education of workers may
make some workers more
productive and employers can
then use education as a screen.
 Signaling
• Firms often observe certain indicators that
they believe are correlated with productivity
• examples include age, race, sex. experience,
education, etc.
An individual has little control
over some signals (age, race) but
some can be changed:
• One of the best examples of a signal which
can be changed is education
• This signal can help firms discern which
workers have higher productivity
Even if education does not add to
productivity, it can act as a signal
which distinguishes workers by
productivity.
How?
 What type of individual is most
likely to get education?

• someone for whom the costs are low

What type of individual is likely
to face low costs of attending
school?

• someone who learns easily

 Thus, individuals who learn
easily are more likely to attend
college than those who don’t.
Education level then works well as a
signal to employers of which workers
are most easily trained.
The End