Economics of Education:

Human Capital and

Personal Income
Distribution
AISHNA SHARMA
12.11.2018
SME, SNU
Introduction

 Income distribution has largely been studied at macro level; for

a nation or a region
 Gary Becker developed theory to understand the inequality in
personal income, linking it with investment in human capital.
 Some arguments before discussing his theory:
 The incentive to invest is related to the number of periods of
investment. Incentive to expand and improve physical resources
depends on the rate of return expected. An increase in the life span
of an activity, controlling for other things, would increase the rate
of return enjoyed. Therefore, younger people have greater
incentive to invest because they can collect returns over more
years. Rate of obsolescence would affect the period during which
return is enjoyed. Also how one shifts from one activity to the
other, for example women.
Introduction

 Some arguments before discussing his theory:

 Rate of return depends upon the ratio of the return per unit of time
to investment costs. Return is measured by absolute income
differential.
 Risk: The actual return is often different from the expected return
due to uncertainty- length of life, ability, other events not
predictable. It is argued that young people overestimate their
ability and chance of good fortune and are more risk taking.
 Capital Market: Capital market is imperfect in nature as human
capital cannot be offered as a collateral. It is difficult to borrow.
But isn’t it equally difficult to borrow in market for investing in
phycial asset (particularly by a young person)? But postponing the
investment to an older age is costlier than that of investing in a
physical capital.
Ability and Distribution of
earnings
 Human capital investment can help explain the difference in earnings. Explained by a link
between ability, earnings and the incentive to invest in human capital.
 Ability was measured by grades, scores, but this was found to be an incomplete
measurement of ability, which included other attributes as well like personality, persistence
and intelligence. It was later argued that persons with more earnings would simply have
more ability than others. When ability is related to earning other factors which affect ability
are controlled.
 Ability is often separated from education, and therefore the amount invested in education is
held constant.
 Since observed earnings are gross of return on human capital they are affected by changes in
the amount and rate of return
 Y=X+ rC, where Y is the earning, X is the earning when there is no investment in human
capital, r is the rate of return and C is the investment in human capital. If we control C, then
r will reflect ability.
Ability and Dsitibution of
Earnings
 C and r are related. Persons receiving high r have an incentive to invest
more than others. Higher earnings would reflect higher ability and better
environment. Earning differentials between college students and high
school graduates do not reflect difference in C alone; college students are
also more able.
 Distribution of earning would the same as distribution of ability, if C was
constant. Distribution of earning would be the same as distribution of C, if r
is constant.
 Even if both r and C is symmetrically distributed, Y would be more than
symmetrically distributed because of higher possibility of correlation
between the two.
 Let us look at X. X reflects income due to unskilled ability. High skilled
individual will have X<Rc and low skilled will have X>rc.
 For simplicity we assume X is constant; all earnings of an individual are
mostly attributed to different kind of investments made by him-health,
education, migration. We also assume that Human Capital is Homogenous.
Ability and Distribution of
Earnings
 The curve D shows the marginal benefit, for simplicity
measured by rate of return and Supply curve is measured by
rate of interest.
 The demand curve is
downward sloping. It depicts
the marginal benefit of
Investment, measured by
Marginal rate of return.
 Demand Curve
 The rate of return is measured by the ratio between return and cost.
 The demand curve is negatively sloped due to the following reasons:
 The human capital is embodied or embedded in the person investing. This
embodiment is the most important reason why marginal benefits decline as
additional capital is accumulated.
 1. The memory and physical capacity of each investor is limited. As they keep on
investing the diminishing returns set in, resulting in increasing marginal costs of
producing a dollar of returns.
 2. Investor’s own time is important in the production of his own human capital.
Increase in the amount invested leads to increase in the time spent investing. The
cost of this time has been measured by foregone earnings. One could have avoided
giving importance to own time if own time could have been substituted with other
inputs like teachers, books, infrastructure and capital could still have been
accumulated. But human capital entails spending time as it is invested.
 Demand Curve
 3. With finite lifetime, the later investment would not produce return for as long as earlier
ones and usually would have smaller total benefits.
 4. At young ages the value of time is small. As one continues to invest the capital
accumulated becomes valuable and so does their time. The later investments use more
valuable time and therefore as one continues to invest the marginal costs of later
investments compared to earlier ones increase.
 5. Productivity of time does not remain the same. The increased productivity of time is
not as much as its increased value over time. Due to diminishing returns.
 6. The uncertainty about future benefits also contributes to a negatively inclined demand
curve if there is increasing marginal aversion to risk as more capital is accumulated.
 Thus, it is the combination of monetary benefits and monetary equivalent of psychic
benefits which determine the shape of the demand curve.
Supply Curve

 The supply curve shows the marginal cost of financing an additional unit of
capital. Measured by the rate of interest that must be paid to finance an
additional dollar of capital.
 Market for human capital is segmented: there are local subsidies to schools,
state subsidies to college students, transaction costs that make own funds
cheaper than borrowed funds, limitations on borrowing, etc. Therefore, the
amount available to any one person from the cheaper sources are limited/
rationed. This means that a person investing in human capital would
eventually shift from cheapest sources to second cheapest and eventually to
expensive sources. It is this shift which is responsible for a positively sloped
supply curve.
 Supply Curve
 Greater segmentation means greater diversity in the cost of different sources, with smaller
amounts available from each.
 The cheapest source could be gift from parents, relatives, foundations and governments
that can be used only for investment in human capital. The cost to investor is nil and is
represented by Og segment. Highly subsidized (but not free) education are somewhat
more expensive for the investor. Represented by g΄u segment. Foregone opportunities
come next, represented by u΄h segment. After these funds are exhausted the investor must
turn to commercial loans in the marketplace; these funds are available at considerably
higher costs represented by upward sloped segment h΄S.
 As human capital is accumulated more slowly the rate of increase in financing cost is less.
During the initial period the accumulation would reduce the need to rely on more
expensive sources.
Equilibrium
 The rational decision is to chose investment such that
present value of net benefit is maximized. At the point of
intersection of demand and supply curves, the marginal
benefit is equal to the marginal cost; marginal rate of return
is equal to the marginal rate of interest.
The distribution of earnings

 The model implies that total amount invested (C) differs

among persons because of differences in either demand or
supply conditions. For instance, those with higher demand
would invest more than others. This will determine the
distribution of earnings
 Before starting with variation in both supply and demand,
we deal with certain special cases.
 Egalitarian Approach

 Demand conditions (marginal rate of return) are the same for every one and that
the only cause of inequality is differences in supply conditions (opportunities). It
assumes that everyone has more or less the same capacity to benefit from
investment in human capital. Investment and earnings differ because of difference
in the environment: in luck, family, wealth, subsidies, etc. which lead to different
opportunities to invest in education.
 The most important cause of difference in opportunities is difference in
availability of funds. Sometimes, cheaper funds are more accessible to some than
others and former have more favourable supply conditions.
Egalitarian Approach

 If only supply conditions varied: p1, p2, p3, p4 are a few

positions giving equilibrium with a common demand curve
Egalitarian Approach

If demand curve for capital was perfectly elastic, then r would be the same for
everyone, no diminishing returns, and the variation in earnings would be
dependent on variation in investment. But the demand curve is usually
negatively inclined due to embodiment of human capital in investors. Thus as
C increases r falls. Therefore Y would be more equally distributed than C.
Elite Approach

 At the other end of spectrum is the assumption that supply conditions are
identical and that demand conditions alone vary among persons.
 Capacities are measured by the demand curve.
 For a given amount invested in HK, a person with high ability will get higher
rate of return. Higher demand curves lead to higher rate of returns. Demand
curve would be higher only if more units of capital are produced by a given
expenditure. It is natural to say that the person who produces more capital is
abler. This means that those with higher demand curves are abler.
Elite Approach

 The opportunities are the same but demand (ability) is

different.
Elite Approach

 Earnings are more unequally distributed and skewed the

more unequal is the ability..
 The greater the elasticities of demand and supply curves the
more unequal the distribution is.
A comparison of the two
approaches
 The inequality of earnings tends to be less than that in supply conditions in
egalitarian approach and greater than that of demand conditions in elite
approach because the former implies a negative and the latter implies a
positive correlation between the rates of returns and the amount invested.
 An observed inequality in earnings presumes a greater inequality in
opportunities (in case of egalitarian approach) and a less inequality in
abilities (in case of elite approach).
 Inequality of earnings in a bigger problem in egalitarian approach because
an observed inequality in earnings tells us of greater underlying inequalities
in opportunities, than the elite approach tells us greater underlying
inequalities in abilities.
A more general approach

 There is a correlation between both demand and supply

 Supply conditions do not vary independently of the demand conditions.
Abler persons are more likely to receive public funding and private
scholarships and thus have their supply curves shifted downwards.
Similarly, those families which are educated and have higher resources
in hand might lead to development in able individuals (educated
parents on an average tend to spend time on their children or take
interest in their children’s education) (There could be no correlation or
negative correlation as well)
Different Possibilities
 There could be a positive correlation (p11, p22, p33), negative
corr0elation (p31, p22, p13) as well as no correlation (p31, p32, p33)
between abilities and opportunities.
Correlation between demand and supply:
Relation with earnings

 In the previous diagram, in case of a positive correlation

between demand and supply conditions, the variation in
earnings is determined largely by variation in investment.
 In case of a negative correlation between demand and
supply, the less the variation in earnings is explained by
variation in investments (but also by ability)
 In case of no correlation, ability also plays an important
role.