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 2 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 4 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 5 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 6 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. 8 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 9 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 10 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 11 Human Capital Model Optimal investment in education Choice of cost / benefit streams: 12 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 + ” 13 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 > 14 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,… 15 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 ($) 33,000 32,000 30,000 27,000 13 14 15 16 16 Human Capital Model Optimal investment In education Marginal return to schooling (MRR) = % change in annual earnings if 1 extra year of schooling àOptimal stopping rule: choose s* at r = MRR Yrs of schooling Rate of discount (or rate of return) r ’ r s’ s* MRR 17 Human Capital Model Optimal investment in education Why do education decisions differ i. Differences in discount rate (r) ii. Differences in ability (MRR) = ability bias Differences in discount rate (r) 18 Why might people’s discount rates differ Human Capital Model Differences in ability and choice of S Yrs of schooling Rate of discount (or rate of return) SBob SLuke r MRRLuke MRRBob SBob SLuke annual earnin gs ($) WSLLuke 19 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 20 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 21 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) 22 Human Capital Model Males, Full-year Full-time, 2011 Age-Earnings Profiles 23 Human Capital Model Females, Full-year Full-time, 2011 Age-Earnings Profiles 24 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 “. 25 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 = ! + ‘ + ) + *) + 26 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 27 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 29 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 < 30 Signalling Model Benefits to Worker of Educational Signalling 31 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: 32 Signalling Model Lifetime Costs and Benefits of Educational Signalling 33 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 34 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 35 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 36
