ECOS3008
Labour Economics
Coordinator: Dr. Rebecca McKibbin
Module 3: Education & Human Capital
Reading: ES Ch9
Lecture 3: Education and Human Capital
Outline
1. Background and Stylised Facts
2. Human Capital Model
i. Background
ii. Formal Model: Optimal investment in education
iii. Extensions
3. Signalling Model
Reference: ES Chapter 9
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Introduction and Background
Statistics
Introduction
Human Capital and Schooling
• Last 2 weeks: Labour Supply - static and dynamic issues - quantity
dimension
• This week: consider education and schooling - quality dimension
of labour supply: skills individuals bring to the labour market
àoptimal response to market incentives
àtreat like an investment decision
àempirical issue of identifying 'rate of return' to the investment
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Background Statistics
• Percent of Pop with at least Upper Secondary (Year 12), 2011
25-64 25-34 35-44 45-54 55-64
US 89 89 89 89 90
UK 77 84 80 75 67
Australia 74 84 78 69 61
France 72 83 78 68 58
Italy 56 71 60 52 40
OECD Mean 75 82 78 73 64
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Background Statistics
Evidence shows that higher educational attainment strongly correlated
with:
• employment (higher);
• unemployment (lower); and
• earnings (higher).
The Important Questions:
• What determines the level of education selected by an individual?
• How do we choose the particular set of skills that we offer to employers?
• How do our choices affect the evolution of earnings over the working
life?
• Is investment in education a good investment?
Answers are relevant for ‘on-the-Job' training, and age-earnings profile,
earnings distribution
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Human Capital Model
Human Capital Model
2. Human Capital Model
• Main elements of human capital (HC) theory have a long history:
Adam Smith (1776: 101)
• When any expensive machine is erected, the extraordinary work to
be performed by it before it is worn out, it must be expected, will
replace the capital laid out upon it, with at least ordinary profts. A
man educated at the expense of much labour and time to any of
these employments which require extraordinary dexterity and skill,
may be compared to one of those expensive machines. 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
expense of his education, with at least the ordinary profts of an
equally valuable capital.
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Human Capital Model
Historical Background
• Key Insights:
i. higher wage for workers with greater skill compensates the cost
involved in acquiring those skills
ii. costs of education include the opportunity costs of time and other
forgone investment opportunities
iii. the model for the individual's decision problem is analogous to
the investment decision for physical capital
• Smith’s insights are relevant for modern HC models
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Human Capital Model
Modern Developments
• Formal development in the theory of human capital Becker (1964;
1975)
àeducation is a productive investment which produces a stream of
income into the future
àcosts of the investment include direct costs of studying (fees,
textbooks, materials), forgone potential income from time spent
studying, psychological / effort costs of studying
à education produces set of skills or competencies (human capital)
enhancing an individual's productivity which is compensated in the
labour market
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Human Capital Model
Optimal investment in education
What determines the level of education selected by an individual?
Consider investing in 3-year university degree from age 18.
Assumptions:
• Maximizes the present value of lifetime earnings
• Individuals are risk neutral
• No direct consumption / utility from schooling process (focus on
opportunity costs and benefits)
• Education increases skills and productivity
• competitive capital and labour markets
• Individuals have time-consistent preferences
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Human Capital Model
Optimal investment in education
• Choice of cost / benefit streams:
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Human Capital Model
Optimal investment in education
• Decision based on PV of the 2 streams.
• Let duration of schooling be S years, retire in year T.
! =$"#!$ !1 + "
! =$"#!% −"1 + " + $"#%&'$ (1 + "
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Human Capital Model
Optimal investment in education
• Discount rate r is important (rate of return on alternative
investments)
• Decisions rule is:
àChoose the income stream with the higher PV
• Equivalent rule: calculate the 'internal rate of return' i for the
schooling investment, and compare to r
à proceed with investment if >
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What is the discount rate
i such that the PV
benefits =PV Costs?
Human Capital Model
Optimal investment in education
• More general model: choice of number of years of schooling
àPV of earnings associated with each schooling level
àGoal: maximise PV of lifetime earnings by choosing no. of yrs
of schooling
• What matters in optimal schooling decision?
• Potential costs of each level of schooling
• Discount rate (time preference)
• Earnings differential: wage-schooling locus (salary that workers get
at each level of schooling)
• Age, time horizon,...
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Human Capital Model
Wage-Schooling Locus
• Properties of wage-schooling locus:
• Upward sloping (financial gains only)
• Slope = extra earnings if 1 additional yr of schooling = rate of return
• Concave: diminishing returns to HC accumulation
Yrs of
schooling
Salary or
annual
earnings
($)
33,000
32,000
30,000
27,000
13 14 15 16
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Human Capital Model
Optimal investment
In education
• Marginal return to schooling (MRR) = % change in annual earnings
if 1 extra year of schooling
àOptimal stopping rule: choose s* at r = MRR
Yrs of
schooling
Rate of
discount
(or rate of
return)
r ’
r
s’ s*
MRR
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Human Capital Model
Optimal investment in education
• Why do education decisions differ?
i. Differences in discount rate (r)
ii. Differences in ability (MRR) = ability bias
• Differences in discount rate (r)
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Why might people’s discount
rates differ?
Human Capital Model
Differences in ability and choice of S
Yrs of
schooling
Rate of
discount
(or rate
of
return)
SBob SLuke
r
MRRLuke
MRRBob
SBob SLuke
annual
earnin
gs ($) WSLLuke
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Human Capital Model
Suppose we are interested in rate of return to schooling?
• If wage-schooling locus differs across individuals (e.g. due to ability)
earnings differential does not reflect return to schooling.
àobserved correlation earnings-schooling contaminated by ability diffs
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Human Capital Model
Predictions of Human Capital Theory
• Present-Orientedness - Present-oriented individuals less likely to
go to university than forward-looking people (other things equal).
• 'present-oriented' have higher rates of discount (r), impute smaller
benefits to future income gains for uni education
• Age - Most university students will be young
• younger have larger PV of benefits than older workers - longer time
period to reap rewards
• Costs - Uni attendance decreases when costs of education rise
• Earnings Differentials - Uni attendance will increase if the gap
widens between the earnings of university and HS graduates
• The demand for education is positively related to the increases in
expected lifetime earnings that uni education generates
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Human Capital Model
OJT and Experience
• Basic HC model implies constant earnings after education
Observed age-earnings profiles:
• Highly educated workers earn more than less-educated workers
• Earnings rise over time, at a decreasing rate (concave age-earnings
profile)
• Age-earnings profiles of different education groups diverge over time
• Reconcile with HC model?
à on-the-job training (OJT)
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Human Capital Model
• Males,
• Full-year Full-time, 2011
• Age-Earnings Profiles
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Human Capital Model
• Females,
• Full-year Full-time, 2011
• Age-Earnings Profiles
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Human Capital Model
OJT and Experience
• If enter the labour market at age !, earnings of " without training (or
skills depreciation) over the life cycle
• If invest in OJT, earnings potential enhanced - (dashed) curve # in
comparison to actual earnings ($) which lie below #
• For those investing in OJT, $ starts below " and approaches it at age
A* ("overtaking age") at which $ and " are equal, then $ rises
above ".
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Human Capital Model
OJT and Experience
• Investment in HC does not end when finish formal education.
• subsequent training or retraining.
• --- can be formal courses off-the-job; on the job (learning-by-doing or
formal, costly training)
• --- concave Age-Earnings profile
• Concave Age-Earnings profile caused by:
• decline in HC as individuals age (rational l in training investment;
depreciation of existing skills)
• "Mincer Earnings equations" where earnings depend on formal
schooling (S) and years of labour market experience (X ):ln = ! + ' + ) + *) +
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Human Capital Model
Overall see:
• Earnings differences across workers with different educational
backgrounds tend to become more pronounced as they age.
• Investments in human capital more likely when expected earnings
differentials are greater, when people have the ability to learn
more easily / faster
• Human capital theory predicts workers who invested more in
schooling will also invest more in post-schooling job training
• People with the ability to learn quickly tend to select high-paying
jobs where more learning is required, putting their abilities to
greatest advantage
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Signalling Model
Signalling Model
3. Education as a Signalling Device
• Based on Spence (1973) Job Market signalling, QJE
Education has no effect on productivity, but provides information
about underlying ability
• Workers know own ability, employers do not: Information asymmetry
• Workers differ in terms of innate ability / productivity , = {1, 2}
• Assume Pr = 0.5, Pr = 0.5
• Competitive firms offer = = 1.5 (average productivity of
workers)
• H have incentive to provide credible information on their ability
• Competitive firms have an incentive to hire H types (increase
profits)
àfirms desire a signal
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Signalling Model
Workers Supply of Signals
• Suppose firms beliefs are:
• ≥ ∗ = 2, < ∗ = 1
• where e is years of schooling, which is unproductive
• When could e be a credible signal ?
• If firms use ∗ as a hiring standard, will drive up wages
for those with ≥ ∗ to = 2; offer = 1 to < ∗
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Signalling Model
• Benefits to Worker of Educational Signalling
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Signalling Model
Signalling Equilibria
• If is costless, everyone will acquire ∗ and employer beliefs
contradicted ànot sustained
àTo be effective, costs of acquiring signal e need to be
decreasing in
• Let cost of acquiring extra year of schooling for L types = c, for H
types = c/2
• Separating equilibria possible, depending on ∗ and value of c:
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Signalling Model
• Lifetime Costs and Benefits of Educational Signalling
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Y-axis: PV Lifetime
earnings given
previous wage scheme
Choose 0 or e*
years beyond High
School. Why?
Cost = C => 0
Cost = C/2 => e*
Signalling Model
• 'Separating equilibrium' requires it to be optimal for L workers
not to invest in signal, and H workers to invest in signal
• Requires:% − &∗ < ' → 1 < &∗ (L type do not invest) % − ("∗% > ' → &∗ < 2 (H type do not invest)
àbehaviour confirms employer expectations
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Signalling Model
Usefulness of Education as a Signal
• Workers may not appreciate education is unproductive when
investing in the signal
• 'Pooling equilibria' results if e* too high or low relative to c (not
an effective signal)
• There is a minimum value of e* which is just sufficient to induce a
separating equilibrium; e* beyond that just add to H worker costs
• Is the separating equilibrium, with education acting as a signal of
innate ability / productivity socially optimal ?
àNO: education is socially unproductive (does not expand output),
acts to redistribute income, generate inequality
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Think about what is happening
in the vocational training
market.
Signalling Model
Critiques of the Signalling Model
• Less costly ways to signal ability than investing in schooling
• Use of worker bonds ? (e.g. deferred compensation schemes)
• Is education really unproductive ?
àdifficult to distinguish empirically
àthough HC model more widely accepted than signalling model
Realistically, education probably has elements of both, i.e. is
productive and acts as a signal.
Think about move to free online university courses. Why take this
labour economics unit and not the one offered by say Harvard?
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