HRER816:

Lesson 04 - Human Capital: Investments in Education and Training

Previous lessons provided analysis of the labor supply decisions of individuals as part of households. Before we leave the supply side of the labor market, Lesson 04 examines one other critical decision made by individuals: investment in their education and training. Why is this important and how does it influence the labor supply and hours decisions? Why do firms provide some types of training to workers for free and does not subsidize other types of training and education at all? In addition to providing analysis of these questions, the discussion of human capital and education has important implications in the discussion of wages and inequality coming up in future lessons.

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Topics Covered

• What is human capital?
• Investment in human capital, individuals
• Investment in human capital, employers

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What is Human Capital?

Human capital theory grew out of attempts to explain differences in income among individuals. Human capital is the accumulation of prior investments in education, on-the-job training, health and other factors that increase productivity (McConnell, et al. 2013, p. 588) Human capital deals with the qualitative aspects of labor. The basic idea is that the more human capital a person has, the more productive they are, and the more they contribute at the margin. Markets for investment in human capital differ from markets for physical capital (machines) in that human capital is rented, not sold. Human capital belongs to each individual human being and you sell your labor services, but not yourself. This is the reason that most investment in schooling is usually made by the individual or their families and not businesses. Loans or investments in human capital (school loans) are often considered risky because there is no physical collateral and no financial collateral.

The rising college wage premium has raised the importance of attaining higher education for future earning power, which, because of rising tuition and "capital market imperfections" (restricting access of families with modest means to credit and loans, offset only somewhat by grants and scholarships), has ratcheted up the demand on the part of citizens for relief and subsidization. Think how much more inequality would be growing without the public sector picking up more of the tab.

One vital form of human capital investment is in higher education which both provides general knowledge and creates general skills, some of which you may not even be consciously aware. Examples of such general skills include self-direction, punctuality, meeting deadlines, time management, research methods, report-writing, public speaking, note-taking, typing, Internet searching, juggling demands, and "people-skills" such as teamwork, leadership, and last but not least, asynchronous communication. These skills can be applied at almost any job, occupation, industry, or workplace that you enter. In addition, higher education may help you develop new skills that are specific to a given occupation, such as accounting, counseling, computer programming, teaching, market analysis, lab work, nursing, to name a few.

Whether or not it is their initial goal, individuals enter or stay in school, including college, or trade programs, because it is hoped that it will increase their future earning power. Indeed, studies of the impact of education on individuals' earnings find that on average, each additional year of education bestows on individuals an identifiable, future monetary gain. Just attending college, without having completed a degree, produces a payoff in the form of a higher stream of lifetime earnings.

Investment in Human Capital: Individuals

Education, higher education in particular, indeed, may be considered an investment, but is it not also, at least in part, a "consumption" good? Probably, in the sense that it is acquired to enhance one's current, not just future, utility, and thus well-being. Some people just seem to delight in learning, engaging or developing their mind, being around knowledge, knowledgeable people, ideas, or academic institutions. Because there may be some "psychic" payoff, many such "consumers" are willing to pay the expense (in terms of both money and time).

If we treat the investment in human capital as a decision similar to investing in physical capital, then we can subject it to net present value analysis. Since the payoff accumulates only gradually, it may take many years for the initial investment to pay "dividends."

In order for an investment in education or training to be rational, the net payoff must be positive over the life of the investment, which, in this case is the expected duration of your working life (until retirement). To project the net present (life-time, discounted) value of the initial investment, one need only be given the total costs of the investment, added earnings per year, discount rate and number of years expected to be in the labor force. At some year in the future, the additional stream of income each year breaks even with and then surpasses the (substantial) initial cost, after which you will realize it was worthwhile and rational.

In the case of higher education, studies find that the private rate of return to a college education is in the range of 10 percent, give or take a few percentage points. Indeed, every additional year of higher education, on its own, contributes a positive return, at least on the average.

Thoughts to Ponder

Do you think this increasing premium is encouraging or discouraging high school students to attend college? To what extent does the answer depend on opportunities in the labor market without a college degree? To what extent does it depend on the number of individuals who go to and/or complete college, and increase the supply of college educated workers hunting for jobs at the same time?

Reference: Campbell McConnell, Stanley Brue, David Macpherson, Contemporary Labor Economics, 10th edition, McGraw-Hill, 2013

The Benefits of Education

Productivity

There is controversy regarding whether schooling directly enhances productivity on the job, or merely transmits signals to employers regarding the potential ability, trainability, adaptability, of an employee. In addition, such information may be imperfect and sometimes even inaccurate or misleading (is your current or undergraduate GPA truly your potential? Must it be your destiny?). It is also not clear whether the advantage of schooling is due to just the quantity (as measured in years) or to the improving quality (as measured by improving faculty and technology resources, for example) of higher education. Finally, attending college has become such a huge expense that access to funds and credit is crucial to realize one's intended human capital investment. Many families cannot incur the direct, let alone the larger indirect, cost of college. Paying-as-you-go requires a huge time and energy commitment to work for pay, which in turn may hurt students' performance and skill-acquisition during college so much as to undermine the future return on the initial investment. Even without a college degree (complete program of courses as opposed to an incomplete, perhaps varied selection of courses), there are people who earn more than those who decided not to go to college at all.

Externality Benefits of Education

Education has properties of a public good, which means it yields spillover benefits (an externality) to those who have not directly invested in education. This means the "social" return to expenditures on education exceeds the simple private return realized just by the individuals receiving it. This justifies at least some public expenditures on education, even at the cost of raising tax revenues, and explains why so many parties—workers, non-employed, corporate employers and government officials—tend to agree on the importance of subsidizing education. (Higher levels of education indirectly benefit all because education has been linked to lower unemployment rates, healthier behaviors, greater amount and quality of civic participation (voting, for example). Within a household or among parents, greater education leads to further child development and likelihood of the next generation to seek higher education. Finally, in more subtle ways, it leads to more research or discoveries that eventually yield benefits to society or at least, fellow employees.

Many believe the social rate of return, and not just the private rate of return, to education is escalating, particularly as more and more workplaces and jobs rely on ever more sophisticated technology and complex systems. These may require a greater range of skills than workplaces of the past. Some believe this is behind the growing college wage premium. Indeed, if skills with technology are becoming more general than specific in nature, and there is greater turnover and job hopping as a result, we expect that private employers will cut back on such training, leaving universities and the public sector to step in, if workers are to have their skills enhanced and labor productivity is to improve generally.

Investment in Human Capital: Employers

While college and formal education provides general knowledge which may be applied in future work situations, workers gain many of their skills from on-the-job training. Some training may be rather formal programs. However, much training is informal, such as being shown the "do's and don'ts," learning from your (or others') mistakes, or observing and emulating others at work.

There are two broad categories of employer training. General training provides skills that can be applied across jobs, tasks, workplaces, occupations and industries. On the other hand, firm specific training cannot be widely applied. It is only applicable in certain jobs or workplaces. Learning to use the computer programs or equipment and tools at a particular work setting may or may not be a skill transferable elsewhere. The greater the extent that training is indeed transferable, the greater the extent of the burden of learning the skill in terms of time and money invested, will fall upon the employee. The employer has less incentive to invest in training, which has the often huge indirect cost of taking employees and their trainers out of current production for a good deal of time, when the skill learned can be portable with the employee at his or her next job (which may even be with a market rival!). However, if the training provides skills that have value mostly or only with the firm, then the employer has a great incentive to bear the cost of such human capital investments. Additionally, unless they can tie an individual to their firm, most employers don't want to spend their money to train or educate workers.

Clearly there is a complex distribution of the costs of training reflecting the nature and transferability of the skills that they provide workers. Because the return to training investments, as with education, takes time to develop into higher future productivity levels, workers may incur the up-front costs of training in the form of reduced earnings early in one's job tenure, reaping the benefits later with their current employer (if training is more specific) or another employer (if training is more general in nature).