Human capital Borjas chapter 6 (6.7 not included)

1. Human capitalBorjas chapter 6(6.7 not included)

2. ”Human capital Smith: Costs of acquiring skills should be compensated through wages. Contemporary economics uses ”Human capital theory” to analyse The decision whether to acquire skills The wage* effects of acquiring skills Human capital – all the skills, abilities and knowledge that a person has acquired and which affect their productivity. Footnote: *Wage = hourly wages (usually) or full-time full-year wage (less often). NOT annual earnings

3. Oxford English Dictionary human capital n. a labour force, or the skills it possesses, regarded as a resource or asset. Nationalencyklopedin: humankapital,human resources, HR, människors kunskaper, färdigheter och andra till produktionsförmågan bidragande fysiska och psykiska egenskaper som förvärvats genom bl.a. utbildning.

4. Education levels by age 2009

5. Education by gender, 2006

6. Labour market statusby education and gender

7. Monthly wages by education and gender 2006 Source: Statistics Sweden

8. US data (Borjas pp 245) Within each gender/ethnic group wages increase with education. College graduates earn about twice as much as high school graduates. Women and ethnic minorities receive higher wages if they acquire more education but the race and gender ratios within education groups are not smaller for the highly educated.

9. Education – who and why? There is a positive correlation between level/length of education and wages. Why do some people choose a longer and some a shorter education? As with labour supply there are many reasons, economic and non-economic.

10. Non-economic factors Content of work: Enjoyable? Stimulating? Creative? Socially useful? Work conditions & work environment Status Self-esteem Social norms and expectations (given gender, ethnicity, social class, age, place) And various others… We study the economic reasons assuming the others to be constant

11. Economic reasons: Economic costs of education Economic gains from education. Significant economic factors: Earnings foregone during the period of study (opportunity cost of time) Direct costs of studying (tuition, books, travel etc.) Grants, loans and stipends given to students The probability of getting a job. Higher wages if one has more education The pension system Time preference (rate of discount) Liquidity constraints Risk aversion

12. ”A larger wage difference between those with and without university education will make people choose to got to university” means that out of so many thousands there will be some more individuals who choose to go to university”. ALL ELSE EQUAL lower costs of education and higher gains from education  more people will get more education

13. Choice of education and maximisation of life-time income. Assume: An individual chooses between starting to work after secondary school or going on to university. He/she has a time discount rate of r, 0<r<1 and maximises the present value of life-time income. Choosing university means abstaining from potential earnings during n years but getting a higher wage afterwards.

14. Age-income profiles with secondary and tertiary education for a given individual n

15. Net gains from education Model: Assume that there are 47 years between leaving secondary school and retirement. Potential earnings with secondary education the first year after leaving school (t=1) = yst, with univ. education = yut Assume that university takes 4 years. Income minus costs for year i of studies yei. The rate of discount of this person is r For simplicity, we disregard pensions in this model.

16. The PV of life earnings without university education is The PV of life earnings with university education is

17. Under these conditions, an income-maximising individual will choose to go to university if the NET GAIN

18. A numerical example (7-2) Peter lives for three periods. He is currently considering three alternative education-work options. 1. He can start working immediately and earn $100,000 in period 1 $110,000 in period 2 $90,000 in period 3 2. He can attend college and Pay$ 50 000 in period 1 Earn $ 180 000 in period 2 Earn $ 180 000 in period 3 3. He can get a doctorate in economics and Pay the $ 50 000 in period 1 Have neither costs nor earnings in period 2 Become a professor and earn $400 000 in period 3 Peter’s discount rate is 20 percent per period. What education path maximizes Peter’s net present value of his lifetime earnings?

19. Solution: The present discounted values of Peter’s earnings associated with each of the alternatives are High school PV = College PV = PhD PV= The best option is only high-school. Calculate PV from the three alternatives with r=10% (274000, 264000 and 281000).

20. We have assumed that individuals maximise the PV of life-time earnings. The only subjective element is discount rate (time preference) The model could be modified to make people maximise PV of life time utility – but that is harder to operationalise

21. So why doesn’t everybody take a PhD – or nobody? Time preferences are different Costs of education are different (ability and funding possibilities) Potential earnings are different (ability, social capital, discrimination). Both absolute and comparative advantages in jobs requiring different levels of education can be different.

22. Different time preferences Exc. ´6-2: Different choices with r=.20 and r=0.10 Education means less income in first years, more income in later years – a higher discount rate makes education less economically attractive.

23. Example of the impact of discount rates A person chooses between starting work after school and studying for another 4 years. The red curves in the diagram show the experience-earnings profile she can expect with longer education, the blue curves if she starts work after school. The dashed curves show the earnings if they are discounted.

24. Life-time earnings with different levels of education, with and without discounting

25. Rate of return to schooling: • Textbook: concave wage-schooling function  decreasing returns to a year of schooling. • Empirically measured difference: Some studies find increasing returns to schooling if we compare different individuals. • But • The cost may be increasing. We cannot measure the effort required. • A cross-section sample does not take into time-discounting into account. • A cross section analysis assumes that all individuals have the same wage-schooling function.

26. Differences in ability Assume that Peter and Paul have the same discount rate (for simplicity, say r=0) and that they would earn the same (200 000) if they start to work directly after secondary school. If they go to university they will loose 4 years of earnings but increase their wages. Peter would earn 225 000 but Paul only 218 000.* They have a time horizon of 44 years from school-leaving age. * We have to assume these small differences because there is no time discounting!

28. Peter Paul Opportunity cost 800 800 of university Gain from univ. 40*25= 40*18= 1000 720 Returns to education 25 = 12.5 % 18=9% Per year of education 3.125% 2.25% If we estimate returns to education from data about Peter and Paul we will observe a difference of 12.5% BUT this is not what Paul would get so it is not the MR of education. Part of the observed Δwage is due to education and part to difference in ability. We overestimate returns to education also if Peter earns more if neither goes to university too. In 1000s SEK

29. The ”Willie and Wendy example, Borjas pp. 260-261 where workers have advantages in jobs with different education levels PV of life-time earnings If each maximises earnings, Willie will earn more with less education than Wendy will with more. Does that  that there negative returns to schooling?

30. Two individiduals (Red and Blue) with comparative advantages in jobs requring different kinds of education Full lines – wage with higer education Dashed lines –wage with lower education

31. Ability bias If those with greater ability to earn at any level of education are more likely to acquire education, then observed wage differentials between workers with different education will overestimate the real returns to education. The estimates have an (upward) ability bias. We cannot know the true return to education because we cannot observe “counter-factual earnings”.

32. Attempts to get around the ability bias problem: Compare the wages of identical (monozygotic) twins with different education. But if they have different education, other things may be different too. Look at “natural experiments” when the length of compulsory schooling is changed for a “random” part of the population. Compare applicants to a university who did/did not start or where a lottery decided between equally qualified candidates. Control for various measures of “innate ability” in the estimates (IQ, other test results, school-grades). Panel data. Selection bias corrections – fine in principle but very hard to do correctly in practise.

33. Signalling DOES schooling increase productivity? Some economists advance an alternative theory, SCHOOLING AS A SIGNAL which says: Schooling doesn’t change productivity but more productive individuals acquire education to show potential employers that they are very productive.

34. Assume that there are two types of workers. A-workers add 300 000/year to production, B-workers 200 000. The employer has to pay an A-worker 300 000. The employer does not want to pay a B-worker 300 000. Both A- and B-workers will claim that they are A-workers when they are interviewed. What should the employer do to “get the right worker in the right job”? (Avoid mismatches.) Education can work as a signal that a person is a high-productivity worker because the theory assumes that the cost of acquiring education is lower for a high-productivity worker than for a low-productivity worker.

35. Assume that there is a correlation between productivity in studies and productivity at work. As an example, assume that the PV of life-time difference in productivity at work between A- and B-workers is 1.5 million SEK. Assume that the marginal (opportunity) cost of acquiring one HP (point) at university is 8 000 for B-workers and 7 000 for A-workers. If the employer requires 180 HP: A-workers: 180*7=1260<1500 B-workers: 180*8=1440<1500 If the employer requires 210 HP: A-workers: 210*7=1470<1500 B-workers: 210*8=1680>1500

36. Requiring 150 HP for a high-wage job does not separate A- workers from B-workers but requiring 210 HP does. With this threshold there will be no mismatches. Is this the right threshold? The threshold must not be more than 1.5 m/7000214, otherwise A-workers will not acquire the required schooling. The threshold must be at least 1.5 m/8000188, otherwise B-workers will acquire the signal for high-productivity jobs too. Will any threshold in this range do? If the firm chooses a level above 188, say 210 could other firms offer similar jobs and wages with a requirement of only 190?

37. Generally: Type 1 workers have a PV of life productivity of PV1 and a cost of acquiring one year of education of C1 Type 2 workers have a PV of life prodictivity of PV2 and a cost of acquiring one year of education of C2 To get only type 1 workers to apply for ”Type 1”-jobs the employer should require a length of schooling of y years where

38. Human capital or signalling – which is it? And does it really matter? Is it “She’s got a degree from Harvard, she must have learnt a lot of useful stuff – hire her” or is it “She’s got a degree from Harvard, she must be really clever – hire her”. Answer: We can’t know which is it, but probably a bit of both. And for the individual it doesn’t make much difference. According to both theories, the wage will increase with education. For the allocative function of wages it doesn’t make much difference. BUT for assessing the effect of public investment in education it matters very much!

39. Social return to schooling The social return to schooling = the effect on GNP of schooling ≠ the private effect of schooling. A cost-benefit analysis of investment in schooling can also take broader effects into account on culture, health, life-expectancy, participation in democratic processes and on economic growth. Human capital theory: There is a direct, positive effect. Signalling theory: There is no direct effect but signalling improves the efficiency of worker/job matching.

40. For each level of schooling, wages increase with experience, but at a decreasing rate ln w S3 S2 S1 Experience

41. Given the length of work experience, wages increase with years of schooling ln w Exp. = 30 yrs Exp. = 15 yrs Exp. = 0 yrs Years of schooling

42. The Mincer equation Both these two relations (schooling-wage and experience-wage) are captured in the Mincer earnings equation (or function). ln W = α + rS + 1E + 2E2 + ε If r>0 and 1 >0 and 2 < 0, the mathematical form implies that the wage increase by the same percentages for each additional year of schooling but with a decreasing percentage for each year of experience. The ε implies that there are other determinants of earnings too and often in empirical estimates some of them are included in the wage function too. An alternative form is ln W = α + r1S1 + r2S2 + … + rnSn + 1E + 2E2 + ε where each Si is a dummy variable for the highest completed level of education. (If S3 represents three years of secondary school it takes the value one if the person has completed three years of secondary school but not any higher education. If he/she has only primary school or only two years of secondary or any completed post-secondary education, S3 = 0).

43. Over-, Under- and Required education • There can be ”mismatch” between the workers education and job requirements. • Can be measured in different ways • Job assessment (workers’ or experts’) • Relative to average in occupation • When job assessment is used: • Women are more often overeducated than men • Men are more often undereducated than women.

44. Standard results from the ORU-literature: • An overeducated person earns more than a person doing the same job who has only the required education. • An overeducated person earns less than a person with the same education whose job requires this education • An undereducated person earns less than a person doing the same job who has the required education. • An undereducated person earns more than a person who has the same education but whose job doesn’t require more.

46. Why do wages increase with experience? Post-school human capital investments alias on-the-job training Not only formal schooling increases productivity – worker skills increase through Training courses provided by the employer Mentoring by more experienced workers Learning by doing

47. General and specific training Human capital can be (more or less) general or (more or less) (firm) specific. Depends on how transferable it is to another employer. Therefore on-the-job training (OJT) can be general or specific too.

48. OJT for general human capital The worker bears the cost. The area H represents the cost of OJT. If the employer pays w0 during the training, the wage exceeds productivity. The employer would be compensated if the wage after training was below the new higher productivity. But if the OJT is general the worker can leave and obtain a higher wage = VMP somewhere else. Produc-tivity Work which increases skills w0 Work which does not increase skills H

49. Specific OJT Specific OJT increases the workers’ productivity – but only if they stay in the firm. If the employment relation is broken, whoever paid for the OJT looses. Since workers can both be fired and quit, both sides are reluctant to bear the cost although both benefits. A negotiated compromise tends to be a sharing of the cost. It is profitable for the employer to pay the trained worker less than VMP – it is possible because he/she has no better outside option. But if the wage is no better than the alternative wage the employee may quit. Both parties have an interest in long employment – and empirical studies confirm that the longer a worker has been with a firm, the smaller the likelihood of separation.