Chapter 5

Human Capital Theory

1. Investment in
Human Capital:
Concept
 Investment in Human Capital

• Expenditures on education, health , training

and other factors that increase productivity of
labor can be treated as an investment in
human capital just like investments in physical
capital.
– Human capital yields a rate of return (higher
earnings) like physical capital.
• According to Theodro schultz the following
five activities contribute for human capital
formation.
1.Health
2.Formal education
3.On job training
4.Study programs for adults
5.Migration
Indicators of human capital formation
 Harbison and Myer consider the
following two indicators for comparison
of human capital formation . Number of
persons who completed
1.Level of education Attainment
a.Primary
b.Secondary
c.Higher education
 continued............
2. Number of scholars in relation to
population
a.Number of teachers per 10,000 pop.
b.Engineers per 10,000 pop.
c.Number of doctors per 10,000 pop.
d.Pupils enrolled at primary level per as % of
estimated total pop. b/n age 5-14
e.Pupils enrolled in secondary level as % of
estimated total pop. b/n age 15-19
f. Third level enrolment as % of total pop. b/n
age 20-24
2. Human Capital
Model
 Human Capital Model
 It is a simple model to analyze the decision to invest
education say, college education
 The decision should be made by comparing the costs and
benefits (higher earnings) of college.
 Costs of attending college
– direct costs: are the cost of tuition, fees, and books.
• Room and board are not included since they are
needed regardless of whether you go to college.
– indirect cost is the forgone earnings you give up while you
attending college.
– Psychic costs : stress, anxiety, , boredom associated with
class and exam. ,etc
Benefits : benefits associated with education
( Higher education).
a.Direct benefits : higher earning , more
pleasant jobs, low expected unemployment
rates
b.Indirect Benefits : enjoyment being college
student or being holder of degree, Social
status
 Present Value
• Discounting converts the value of future
dollars into today’s dollars through the interest
rate.
 The present value (Vp) of a payment
received one year from now is:
Payment 1 year from now
 Def: Vp =
1+Interest rate
where i = 10%

 Ex: Vp = $ 110 = $ 100.00

1.10
 Present Value
 The present value of a future
stream of incremental earnings or
costs (E) :
E1 E2 En
Vp = E0 +
(1 + i)
+
(1 + i)2
+ . . . . . +
(1 + i)n

 Costs are represented as negative

values of E.
Decision Rule
 A person should attend college if
the net present value (Vp) is greater
than 0.
continued......................

 E0 not need to be discounted because it is

immediately incurred .
 n is the duration of earning stream or
individual expected working life
 For high school graduate Who enter labor
force at age 18 and whose working age is
up to 65.
E E En
 VP=E0 (1 +18i) +
+ 19 +…+
(1 + i)
2 (1 + r)n
Example assume that after graduating high school
Mr. Gemechu contemplates in enrolling in one year
data processing course . The direct cost is Br 1000
and opportunity cost is Br. 5000. Upon completion
he has promised by employment by ABC Trading
PLC . Expecting to receive a large inheritance , he
plans to retire after working only 3 years. The
incremental earnings anticipated as Br. 2500 , Br.
3000, Br. 3500 for the first, 2nd and 3rd year
respectively and relevant interest rate at that time is
10%. Is the decision to enroll in this data processing
course rational? –VP= -Br.6000+2273 Br. + Br
2479+Br. 2630=Br. 1382
 Discounted Present Value
PV of $8,000 Investment in Webmaster Training Program
(Interest Rate = 10 Percent)

Incremental Discounted Value Present Value

Year Earnings (10 Percent Rate) of Earnings
(1) (2) (3) (4)
0 -$ 8,000 1.000 $ -8,000
1 $ 3,000 0.909 $ 2,727
2 $ 4,000 0.826 $ 3,305
3 $ 5,000 0.751 $ 3,755
$ 1,787

• Suppose Ayantu is considering taking a webmaster training program that

involves direct costs of $3,000 and forgone earnings $5,000. The training
program will increase Ayantu’s earnings by $3,000, $4,000, and $5,000
for the 3 years she plans on working.
• Because she can borrow the funds at an interest rate of 10%, we will
discount the future expected income at 10% rate.
• What is the present value (PV) of this training program?
• The PV of the training program is positive, Ayantu should take the
training program.
 Internal Rate of Return

 The internal rate of return, r, is the rate of return at

which Vp = 0:
E1 E2 . . . . .
En
Vp = 0 = E0 + (1 + r) + (1 + r)2 + +
(1 + r)n

 A person should attend college if the rate of return

(r) exceeds the market interest rate (i).
 Generalizations
• Length of income stream
– The longer the stream of positive investment
incremental earnings, the more likely the net present
value of an investment in human capital will be positive.
• As a result, younger people are more likely to attend
college than old.
• It also explain earning differential that traditional
exists between women and men.
• Costs of attending college
– The lower the cost of attending college, the more likely
the net present value is positive.
• Older people have a higher opportunity cost of
attending college, less likely to attend.
• The net present value and internal rate of return
will be lower.
 Generalizations
• Earnings differential
– The larger the college-high school earnings differential
is, the more likely the net present value is greater.
– =>the larger the number of people who will invest in a
college education
• College attendance rose in the 1980s as the college-
high school premium increased.
Private vs. Social Perspective
• so far we have seen the cost of education only from the
perspectives of individuals, but education yields
substantial external or social benefits that society reaps.
 More educated workers have lower unemployment rates
than less educated ones. Having high unemployment rate
poorly educated workers receive unemployment
compensations and welfare benefits with greater
frequency and commit crime more frequently.=>benefit
 Education raises the amount and quality of participation in
the political process.
 Children grow up in a better home environment if the
parents are more educated.
 The research discoveries of more educated persons yield
benefits to society.
Why distinction b/n private & social
rate of return is significant?

1. Because efficiency demands that the economy’s total

investment outlay be allocated so that rate of return
on human and physical capital should be equal at margin.

2. It’s concerned with policy: the social benefit

associated with education provide the rationale for the
subsidization of education with public fund. In the
interest of allocative efficiency, the size of these public
subsidies to education should be determined on the basis
of the magnitude of the social benefit
Human capital investment & distribution
of earnings
• Why do people vary significantly in the amount
of human capital they acquire?

• The reasons are many and complex, but by

presenting a model of demand and supply of
human capital, we can get a good insight to
understand the question.

• In so doing we can achieve some understanding

as to why earning are quite unequally distributed.
Diminishing Rate of Return
• The marginal rate of
return to education
declines as additional

Rate of Return
schooling is acquired.
• Investment in education
is subject to the law of
diminishing returns. The
increases in knowledge
decline with each
additional year of
schooling. r
• The return also falls
because the explicit cost
and opportunity cost of
education rises with Years of Schooling
additional schooling so as to
reduce the internal rate of
return.
 Demand for Human Capital
• Since individuals should
increase schooling so that the

r, i
marginal rate of return of
schooling (r) is equal to the
interest rate (i).
• Using the r = i rule, at 1
i1 S1
interest rate i2, the optimal
level of schooling is e2. 2
i2 S2
• At i1 the optimal level is e1.
3
• At i3 the optimal level is e3. i3 S3
r, DHC
• Each equilibrium point (1,2,3)
indicates the “price” and
quantity demanded of human
capital. In other words, the e1 e2 e3 Years of
demand for human capital. Schooling
 Ability Differences
• Abebe is low-ability person.
He has low mental/physical

r, i
talents and/or low motivation
and self-discipline. His demand
for schooling is DA.
• Bob is a high-ability person. A B
He has a greater demand for i S
schooling at DB because he
can better translate schooling
into higher productivity and
earnings. DB
• For a given interest rate, Bob DA
will obtain more schooling
which will compound the
earnings differential between
low and high ability persons. eA eB Years of
Schooling
 Discrimination
• Albert is black and is
discriminated against in the
labor market. His demand for

r, i
schooling is DA since he has
low ability to convert additional
schooling into higher earnings.
A D
• David is white and has a i S
greater demand for schooling
at DB as he can reap the
benefits of additional
schooling. DD
DA
• For a given interest rate,
David will obtain more
schooling which will compound
the earnings differential eA eD Years of
between whites and blacks. Schooling
 Cost of Funds

r, i
• Almaz is from a wealthy
family and faces a low cost of
borrowing funds (iA). Her
optimal level of schooling is eA. B
iB SB
A
iA SA
• Betty is from a poor family
and faces a high cost of
borrowing funds (iB). Her
optimal level of schooling is eB. DA = DB

eB eA Years of
Schooling
 Interactions
• The ability, discrimination, and cost of funds factors
that affect schooling levels may interact to cause even
larger earnings inequality.

– If a person faces labor market discrimination, lenders

may charge a higher interest rate since they are less
certain of getting repaid.

• Discrimination will reduce both the supply and

demand for schooling.

• Anti-discrimination policies may reduce earnings

inequality as a result.
 Capital Market Imperfections
• The capital market is biased in favor of
physical rather than human capital.
– Lenders can’t repossess human capital.
– Young people, who are most likely to invest in
human capital, don’t have established credit
ratings.
• The government may have to intervene by
subsidizing human capital loans in order to
make the returns on physical and human
capital equal.
4. On-the-Job Training
 Costs and Benefits
• Firms will invest in on-the-job training if the
present value of the benefits of the training
exceeds the present value of the costs.
• The costs to the firm include:
– Direct costs such as classroom instruction and
greater worker supervision.
– Indirect costs such as reduced worker output
during training.
• The benefit is greater worker productivity.
 General and Specific Training

o General training is training that is usable

at all firms and industries.
• Word processing skills or accounting skills
o Specific training is training that is usable
at only at the firm that provides the
training.
• Assembly procedure unique to a firm’s
product
o Most training is a mixture of general and
specific training.
 General Training
• Wu and MRPu are the wages

Wage & Marginal Revenue Product

and marginal revenue product
for an untrained worker.
Marginal revenue product is the
increase in total revenue
associated with the
employment of an additional
worker. Wp= MRPp
• Since general training is
usable at other firms, workers
must pay for the entire cost of
the training. They receive a Wu= MRPu
lower wage (Wu> Wt) that is
equal to their diminished
productivity (MRPt). Wt= MRPt
• After the training period,
workers receive a higher wage
Wp that is equal to their new Trainin Post Training
higher level of productivity g
MRPp.
 Specific Training
• Since specific training is not

Wage & Marginal Revenue Product

transferable to other firms, the
employer must pay for the
training.
• During training, the employer
pays a wage greater than the
worker’s productivity (Wu> MRPp
MRPt).
• After training, the employer
gets a return on her training Wp’
investment by paying a wage Wu= MRPu
less than the worker’s
productivity (Wu < MRP).
MRPt
• The employer may pay a
higher wage to decrease
worker turnover and thus
protect her training investment Trainin Post Training
(Wp’ ). g
 Modifications
• Faced with a minimum wage, some firms
may pay for general training.
– The firms recoup their expenses by paying
workers less than their MRP after the training is
completed.
• This is possible because workers are not perfectly
mobile across jobs—there are costs to switching jobs.
• Workers with the most formal education also
receive more on-the-job training.
– They have shown they can receive training more
readily and thus less cost.
Factors affecting human capital

1. interest rate
2. Age of individuals
3. Cost of education
4. Wage differentials
5. Criticisms of Human
Capital Theory
Investment or Consumption?
• Not all education expenditures are an
investment because some part is a
consumption expenditure.
– Courses such as music appreciation yield
consumption benefits rather than investment
benefits.
– By ignoring the consumption benefits of
education, researchers overstate the
investment costs of education and understate
the rate of return.
 Non-Wage Benefits
• Studies that only examine the earnings
of high school and college graduates
understate the rate of return for two
reasons.
1. College graduates have greater fringe
benefits as a percent of pay than high
school graduates.
2. College graduates tend to work in more
pleasant surroundings and have more
interesting jobs than high school graduates.
 Ability Problem
• Those with more ability (i.e., intelligence,
motivation, and self-discipline) are more
likely to go to college.
– Even without a college degree, they would have
earned more than those who decided not to go to
college.
– To the extent that the higher earnings of college
graduates reflects their greater ability rather than
schooling, the rate of return is overstated.
• Omission of ability biases the rate of return estimates
by a small amount.
 Screening Hypothesis
• The screening hypothesis argues that
schooling increases earnings not by
increasing productivity but providing a way
to identify high-quality workers.
– Screening does not affect the private rate of
return, since college graduates still have
higher earnings.
• The social rate of return is overstated, as screening
does not increase productivity.
– The empirical evidence shows screening
appears to play a small role.
Manpower Planning

• Manpower Planning is also called as

Human Resource Planning
• Scientific forecasting of future manpower
requirement
• consists of putting right number of people,
right kind of people at the right place, right
time, doing the right things for which they
are suited for the achievement of goals of
the organization
 It is the future pattern of man power
requirment that determines or guides
today’s educational decision.
 Trained manpower is the most fundamental
resources for economic development
 It takes a long time to produce man power
required in quality and and quantity.
Steps In manpower planning
1st step ; setting targets of national income
and its sectorial contribution
2nd estimating total employment within each
sector
3rd dividing future employment in each sector
into occupational categories
 The following methods can be used to
forcaste occupational categories
i. Past trends
ii. Occupational structures prevailing in
other countries with higher level of
income . If it is firm level experience of
advanced industries
Continued.......................

4th step : translating the above forecasts into

forecast of the numbers of required having
each level and type of education through
I. Analysis of the skill requirement of each
occupation
II. Based on present trends of actual qualification
of workers in different occupation
III. Adapting of the pattern of qualification in
developing nations
 Procedures /steps in human resources planning
( organization)
1. Analysing the current man power inventory
 Types of org.
 Number of dept
 Employees in these work units
2. Making future man power forecasts
 Manpower forecasting techniques
i. Expert forecasts: includes informal decisions,
formal expert survey, delphi tech
.
 ii. Trend Analysis: Manpower needs can be
projected through extrapolation (projecting past
trends), indexation (using base year as basis), and
statistical analysis (central tendency measure).
iii. Work Load Analysis: It is dependent upon the nature
of work load in a department, in a branch or in a
division.
iv. Work Force Analysis: Whenever production and time
period has to be analysed, due allowances have to be
made for getting net manpower requirements.
v. Other methods: Several Mathematical models, with
the aid of computers are used to forecast manpower
needs, like budget and planning analysis, regression,
new venture analysis.
3. Developing employment programmes- Once the
current inventory is compared with future forecasts,
the employment programmes can be framed and
developed accordingly, which will include recruitment,
selection procedures and placement plans.
4. Design training programmes- These will be
based upon extent of diversification,
expansion plans, development programmes,
etc.
Importance of Manpower Planning
• Key to managerial functions- The four
managerial functions, i.e., planning,
organizing, directing and controlling are based
upon the manpower
• Efficient. Settings of large scale enterprises
require management of large scale manpower
• Motivation- Staffing function not only includes
putting right men on right job, but it also
comprises of motivational programmes, i.e.,
incentive plans to be framed for further
participation and employment of employees in
a concern.
• Better human relations-. Human
relations become strong trough effective
control, clear communication, effective
supervision and leadership in a concern.
• Higher. Higher productivity is a result of
minimum wastage of time, money, efforts
and energies. This is possible through the
staffing and its related activities
( Performance appraisal, training and
development, remuneration)
Need of Manpower Planning
 Manpower Planning is advantageous to firm
in following manner:
• Shortages and surpluses can be identified
• All the recruitment and selection
programmes are based on manpower
planning.
• It also helps to reduce the labour cost as
overstaffing can be avoided.
• It also helps to identify the available talents
Continued......................
• It helps in growth and diversification of
business. Through manpower planning,
human resources can be readily available
and they can be utilized in best manner.
• It helps the organization to realize the
importance of manpower management
which ultimately helps in the stability of a
concern.
 
FUNCTIONS OF COM
INTRODUCTION
 Digital systems obtain
informationthat arecontinu
somemanner.
 Manyfunctionssuchas:
1) decodingandencoding-chang
codetoanother,