Human Capital : Theory and Application

1. Human Capital : Theoryand Application Sung Jun Jo 11.05.2005

2. Who Are Workers? (Human Resources) • Cost? • Assets? • Business partner?

3. Agenda • Introduction • Schooling and Signaling • On the Job Training • Application-Executive Pay Issue • Discussion

4. Introduction • Human capital refers to the knowledge and acquired skills a person has that increase his or her ability to conduct activities with economic value • Workers add to their stock of human capital throughout their lives, especially via education and job experience • Combination of …. (Fitz-enz, 2000) • traits brought into job • ability to learn • motivation to share

5. A Model of Human Capital Theory Individual Input (Investment) Education Outcomes Productivity Earnings Social Input (Investment) Citizenship Social Efficacy *Source : Swanson & Holton III, 2001, p.110

6. Evolution of Human Capital Theory • Foundations A. Smith, J. S. Mill, A. Marshall • J. Mincer (1958) : Yrs of work forgone to pursue education were rationally compensated with high wage • S. Fabricant (1959) : Intangible assets • G. Becker (1960) : ROR of difference in education • T. Schultz (1961) : US income has been increased in higher rate than combined amount of land, working hours and capital used to produce • Nobel Prize Winners T. Schultz, G. Becker, M. Friedman, S. Kuznets, R. Solow

7. The Schooling Model • A person’s decision maximizes the present value of lifetime earnings • The rate of discount (r) plays a crucial role in determining whether a person chooses to go to school • Wage-Schooling Locus : salary for each level of schooling • Marginal Rate of Return to Schooling : How much earnings increase if a person stays in school 1 more year • Stopping rule : when it is optimal to quit school and enter job market (MRR=r)

8. Potential Earnings Streams

9. Schooling Decision MRR r’ r

10. Factors That Lead Different Level of Schooling • Differences in the Rate of Discount Different schooling decisions simply place them at different points of the common locus • Differences in Ability Higher ability levels shift the MRR to the right, so, earnings gain resulting from an additional year of schooling outweighs the increase in forgone earning

11. Signaling • Education does(needs) not increase productivity at all, but signal a worker’s qualifications to potential employers who do not have private information • Education increases earnings not because it increases productivity but because it certifies that the worker is cut out for smart worker • Self selection constraints 1. Level of education of signaling must be such that non-smart workers are unwilling or unable to attain it. 2. Achieving given level of education must be cheaper for the high smart workers than for non-smart worker

12. Self-Selection NSW’s edu cost curve $ SW’s edu cost curve W T1 T2

13. On the Job Training • Training increases a worker’s productivity (HC stock)after training • Training is an investment with initial costs and expected future returns • The returns are lost in the event of a separation • Should the firm invest? Not if the skills are easily portable (worker can leave) • Should the worker invest? Not if the skills are firm-specific (firm can layoff)

14. Who Bears Costs of Firm Specific Training? • Since there is no commitment to stay on the part of the worker after training occurred firms will not want to bear the costs of training when skills are general • Since there is no certainty that the job will remain profitable in the future, the employee will not want to bear the costs of training for skills that can be valued only by the current employer (specific)

15. Transferable Human Capital The employee will want to bear the full cost by accepting lower wage during training VMP=W2 w1 Time training

16. Firm-Specific Human Capital The employer will want to bear the full cost by paying above the market value to reduce turnover VMP w2 w1 Time training

17. Predictions of Human Capital When skills are transferable… • Employees should be bearing the cost • Wages of trainees (compared to non trainees) should be lower during training • Employer can offer what the market pays for the new skills acquired after training • Given that training increases skills • Wages of trainees (compared to non trainees) should be greater after training at a given employer

18. Predictions of the Human Capital (Cont.) • To reduce transaction costs after firm-specific training • Workers should be paid above the market value of their transferable skills. • Paying above market should minimize transaction(search) cost. • But—if contracts can be renegotiated, the firm does not have to raise wages until faced with a potential quit (Beaudry and DiNardo ).

19. Mincer Equation (1994) • The Mincer equation captures the important empirical regularities 1) increase in earnings with schooling 2) concavity of log earnings in experience 3) parallelism in log earnings experiences profiles for different education groups log w = rs + β1t – β2t2 + other variables *See the attached file for the further discussion

20. Executive Pay (Murphy & Zabojnik, 2004) • Base salary and bonuses of Forbes 800 CEOs increased from $700,000 in 1970 to 2.2 million in 2000 • In 1980, CEOs received about 42 times the average of workers. By 2000, they were paid 475 times the average workers (Milkovich & Newman,2002)

21. 20 Top-Paid CEOs in 2003

22. Possible Explanations on CEO Compensation • Social Comparison : relationship to others • Economic Approach : reward to success, depends on company size • Agency Theory : self-motivated behavior • Fat-Cat Theory : rent seeking • Human Capital Theory : increasing investment on human capital, type of required skill

23. Hiring Sources-Internal or External *Source : Murphy & Zabojnik, 2004

24. Hiring from Outside • Hiring from outside • foregoes valuable specific skills available only through internal promotions • able to hire from a larger opportunity set of managers • allows better matching of managers and firms • Demougin & Siow (1994) • Outside hires involve hiring and replacement costs which are assumed to be higher than the costs of training and promoting from within • Internal labor market with high value for firm-specific skills

25. Executives as Human Capital • As firm-specific capital becomes relatively less important, the benefit of better matching becomes large relative to the cost of (lost) specific capital • prevalence of outside hires will increase • higher wages for outside hires as the general component of skills becomes relatively more important than the firm-specific part of skills • Potential reason for increasing pay + increasing outside hire is the change in the composition of managerial skills toward more general (market valued) skills • CEOs skills are transferable across firms and industries • Greater breadth of knowledge helps management of any company • Any firm-specific information is more easily accessible than before (computerization)

26. Discussions Is education really improving productivity or just signaling? How can we measure the value of human capital? What are the implications of human capital theories for HRD specialists?