CHAPTER 6 – Human Capital

6-1 Education in the Labor Market:

Stylized facts
6-2 Present Value
6-3 The Schooling Model
6-4 Education and Earnings
6-5 Estimating Rate of Return to
Schooling
6-7 School Quality & Earnings (R)
6-8 Do Workers Maximize Life-
time Earnings?
6-9 Schooling as a Signal
6-10 Post School Human Capital
Investments
6-11 PA: Evaluating Gov. Training
Programs
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Introduction
• Theory of compensating differentials:
Variation in wages  Heterog. jobs vs worker attributes
• Workers bring a unique set of abilities and acquired
skills, known as human capital, into the labor market.
• Focus on:
o How to decide on amount of schooling?
o Methodology: earnings generated today vs future
o Estimate rate of return to schooling
• Main assumption:
o Individuals optimize
o Schooling = Investment (self)
o Optimal choice = Maximum PV of lifetime earnings
6-2
 6-1 Education: Stylized Facts

• Education is strongly correlated with:

o Labor force participation rates
o Unemployment rates
o Earnings
6-3
 Labor Market Indicators by Educational Attainment (Turkish Data - Overall)

Education is strongly correlated with: Gender differences:

o +vely with LFPR and Earnings o Higher % of males are educated.
o -vely with Unemployment rates o Women earn less at every level.
 6-2 Present Value Calculations
• Present value allows comparison of dollar amounts
spent and received in different time periods.
• Present Value

o y is the future value.

o r is the per-period discount rate.
o t is the number of time periods.

Higher the discount rate, lower the present value of

future payment.

6-5
 Potential Earnings Streams Faced
by a High School Graduate
Dollars
 A person who quits school after
getting her high school diploma
can earn wHS from age 18 until
retirement.
Goes to College
wCOL
 If she decides to go to college,
she foregoes these earnings and
Quits After incurs a cost of H dollars for 4
wHS High School years and then earns wCOL until
retirement.
 Hence, college education can be
0 Age viewed as an investment that
18 22 65
requires an immediate cost
outlay of “H” dollars with future
-H payments of “wCOL” dollars upon
completion.
6-6
6-3 The Schooling Model
• Assumption: Ignore +ve externalities of education, focus on
monetary rewards only. No training in the post-school
period, skills don’t depreciate across time
• Real earnings (earnings adjusted for inflation).
Age-earnings profile: the wage profile over a worker’s
lifespan.
• The higher the discount rate (r), the less likely someone
will invest in education (present-oriented).
The discount rate depends on:
o the market rate of interest.
o time preferences: how a person feels about giving up
today’s consumption in return for future rewards. 6-7
6-3 The Schooling Model
• Example
o Two periods only (simplicity)
o Two schooling choices: High School vs College
o WHS = $20,000 WCOL=$47,500 with H=$5,000
o Assume a discount rate of 5%, i.e. r=5%
Choose the option with highest PV of earnings:

Since PVCOL> PVHS

go to college!

If r=15%, then PVHS ($37,391) > PVCOL($36,304), would have

remained as a high school graduate instead!
6-8
 The Wage-Schooling Locus
Dollars • The salaries firms are willing to pay
workers depend on the level of
30,000
schooling.

25,000 • Properties of the wage-schooling locus.

23,000
o The wage-schooling locus is upward
20,000
sloping. (compensate OCEduc)
o The slope of the wage-schooling
locus indicates the increase in
earnings associated with an
additional year of education.
0
12 13 14 18
Years of o The wage-schooling locus is
Schooling
concave, reflecting diminishing
returns to schooling.
6-9
 The Schooling Decision
Rate of
 The MRR schedule gives the marginal
Discount rate of return to schooling, or the
percentage increase in earnings
resulting from an additional year of
school.
r
 A worker maximizes the present value
of lifetime earnings by going to school
until the marginal rate of return to
r
schooling equals the rate of discount.
 A worker with discount rate r goes to
MRR school for s* years.
Years of
 Problem: May not be easy to forecast
s s* Schooling future returns to education (MRR).

6-10
In-class exercise:
6-6. Suppose Carl’s wage-schooling locus is given by

 Derive the marginal rate of return schedule.

 When will Carl quit school if his discount rate is 4 percent?
 What if the discount rate is 9 percent?

2-11
In-class exercise:
6-6. Suppose Carl’s wage-schooling locus is given by

 Derive the marginal rate of return schedule.

 When will Carl quit school if his discount rate is 4 percent?
 What if the discount rate is 9 percent?

2-12
 6-4 Education and Earnings
• Observed data on earnings and schooling does not
allow us to estimate returns to schooling, because more
able persons tend to get more education.

• Ability bias: The extent to which unobserved ability

differences exist affects estimates on returns to
schooling, since the ability difference may be the true
source of the wage differential.

6-13
Schooling and Earnings When Workers
Have Different Rates of Discount
Rate of
Interest Dollars

wHS
PBO
rAL
wDROP
PAL
rBO
MRR

11 12 Years of 11 12 Years of
Schooling Schooling

6-14
 Schooling and Earnings When Workers Have
Different Abilities
Rate of
Interest Dollars Z

wHS Bob
B

wACE Ace

wDROP C
r A

MRRBOB
MRRACE
11 12 Years of 11 12 Years of
Schooling Schooling

 Ace and Bob have the same discount rate (r) but face a different wage-schooling locus.
 Ace drops out of high school (11yrs) and Bob gets a high school diploma (12 yrs).
 The wage differential between Bob & Ace (wHS - wDROP) arises both because of schooling
& ability.
 Consequently, this wage differential does not tells us by how much Ace’s earnings
would increase if he were to complete high school (wACE - wDROP). 6-15
6-5 Estimating the Rate of Return to
Schooling
• A typical empirical study conducts regression analysis
and estimates the following specification:

Log(wi) = b0+b1Schoolingi + b2Xi

o “w” is the wage rate of individual “i”
o “Schooling” controls for the educational attainment of individual “i”
o “X” is the matrix that contains other relevant information about individual
“i” such as industry, occupation, experience, tenure, region, etc.

 “b1” provides an estimate for the percentage change in wage rate as a

result of an additional year of schooling completed (on average, holding
other variables constant).
Empirical consensus: 9%
Problems with estimation: Biased estimates due to endogeneity (ability)
6-16
 Evidence: Natural Experiments
• In studies of twins, presumably holding ability constant,
valid estimates of rate of return to schooling can be
estimated.

Estimates range from 3%-15% annual return to a year of

education.

• Another interesting question:

Given that twins have similar abilities, why do they
choose different levels of schooling?
Different discount rates? They are not so similar after
all...

6-17
6-7 PA: School Quality & Earnings (R)
• Prior to 1992, literature had a consensus:
High level of school expenditures had little impact on labor
outcomes of students.
• Card & Krueger (1992):
 Influential study  Public schools in US
 Corr(Sch. Quality, Rate of return to schooling) >0
Corr(Student/Teacher, RoR to schooling) < 0 (Small)
Corr(Teacher Salaries, RoR to schooling) > 0 (Fair)
 Perspective:
S/T by 10  RoRtS by 1%
Teacher Salaries by 30%  RoRtS by 0.3%

6-18
 School Quality and the Rate
of Return to Schooling
8 8
7
Rate of return to schooling

Rate of return to schooling

6 6

5 5

4 4

3 3
2 2
15 20 25 30 35 40 0.5 0.75 1 1.25 1.5 1.75 2
Pupil/teacher ratio Relative teacher wage

Source: David Card and Alan B. Krueger, “Does School Quality Matter? Returns to Education and
the Characteristics of Public Schools in the United States,” Journal of Political Economy 100 (

Homework: Experimental Evidence from STAR: Compare & Contrast to Card

& Krueger
6-19
6-8 Do Workers Maximize Lifetime
Earnings?
• The schooling model assumes that workers select their level
of education to maximize the present value of lifetime
earnings.

• To test this hypothesis directly, we must observe the

age-earnings profile at two points in time.
o Unfortunately, once a choice is made, we cannot observe the
earnings associated with the non-choice (counterfactual).
o Thus, using the observed wage differential to determine if the
worker selected the “right” earnings stream yields meaningless
results.

6-20
6-8 Do Workers Maximize Lifetime
Earnings?
• Unfortunately, once a choice is made, we cannot observe the
earnings associated with the non-choice (counterfactual).
• Thus, using the observed wage differential to determine if the
worker selected the “right” earnings stream yields meaningless
results.
Example:

6-21
• Example
o Two periods
o Two people: Billy (B) vs Wendy (W)
o Two jobs: Blue collar (BC) vs White collar (WC)
o WC requires one period of schooling with no cost
o Assume a discount rate of 10%, i.e. r=10%

Individuals Blue-collar Earnings White-collar Earnings

Billy $20,000 $40,000
Wendy $15,000 $41,000

Choose the option with highest PV of earnings:

6-22
Homework:
6-1 Debbie is about to choose a career path. She has narrowed her
options to two alternatives:

 She can either become a marine biologist or a concert pianist.

 Debbie lives two periods. In the first, she gets an education. In the
second, she works in the labor market.

 If Debbie becomes a marine biologist, she will spend $15,000 on

education in the first period and earn $472,000 in the second period.

 If she becomes a concert pianist, she will spend $40,000 on

education in the first period and then earn $500,000 in the second
period.

2-23
Homework:
(a) Suppose Debbie can lend and borrow money at a 5 percent rate of
interest between the two periods.
o Which career will she pursue?
o What if she can lend and borrow money at a 15 percent rate of
interest? Will she choose a different option? Why?

(b) Suppose musical conservatories raise their tuition so that it now

costs Debbie $60,000 to become a concert pianist. What career will
Debbie pursue if the interest rate is 5 percent?

2-24
 6-9 Schooling as a Signal
• Assumption: Education reveals a level of attainment
which signals a worker’s qualifications or innate ability
to potential employers (otherwise unobserved).
• In the absence of signal (education), there would be a
pooling equilibrium. Not beneficial to firms and high-
productivity workers.
• Education enables a “separating equilibrium.”
o Low-productivity workers choose not to obtain X
years of education, voluntarily signaling their low
productivity.
o High-productivity workers choose to get at least X
years of schooling and separate themselves from
the pack.
6-25
Nuts & Bolts of the Signaling Model
 Two types of workers:
o Low-productivity (L), Proportion in population  q
MPL =$200,000
o High Productivity (H), Proportion in population  (1-q)
MPH =$300,000
 If productivity is observed, firms would pay:
o WL  $200,000 to a low-productivity (L) worker
o WH  $300,000 to a high-productivity (H) worker

If productivity is unobserved, firms cant distinguish worker

type when hiring, hence offer the same wage to everyone
based on expected productivity (pooling equilibrium):

E(Wages) = q*MPL + (1-q)*MPH

E(W) = q*$200,000 + (1-q)*$300,000 = $300,000 – 100,000q 6-26
 Education as a Signal
Dollars
Dollars
Costs

300,000 300,000
Costs
250,001
y Slope = 25,000
200,000
200,000
Slope = 20,000
20,000
y

y Years of y Years of
0 0
Schooling Schooling
(a) Low-Productivity Workers (b) High-Productivity Workers

 Consider the case where schooling is available to workers.

 Schooling is costly (tuition, books, tutoring, etc.).
 Cost of schooling is higher for low-productivity workers ($25,000) than it is for high-
productivity workers ($20,000)
 Firm adopts the following rule: If Schooling is less than ybar, offer W L, and offer WH if
schooling is equal to or greater than ybar years (threshold). 6-27
In-class
Suppose 40exercise:
percent of all potential workers are highly skilled and
contribute $50,000 to the firm each year.

The remaining 60 percent of potential workers are less-skilled and

contribute only $30,000 to the firm each year.

Schooling costs a highly skilled worker y per year, while it costs a less-
skilled worker 2y per year.

a) When schooling is not used as a signaling device, how much is the

firm willing to pay a worker chosen at random?

b) What range of y will support a signaling equilibrium?

2-28
Implications of Schooling as a Signal
• For schooling to act as a signal, schooling must be more “costly”
for low-ability workers compared to high-ability workers.
• Which model’s arguments are empirically sound? Hard to verify
since both have identical predictions: Higher wages with more
schooling Ferrer & Riddell (2002)
• Social return to schooling (percentage increase in national
income) is likely to be positive even if a particular worker’s
human capital is not increased.
• Although education may incorporate a signaling aspect, it is well-
accepted that education is more than a signal. Education is at
least partially an investment in human capital.
6-29
 6-11 Post-School Human Capital Investments

• Three important properties of age-earnings profiles:

o Highly educated workers earn more than less educated
workers.
o Earnings rise over time at a decreasing rate.
o The age-earnings profiles of different education cohorts
diverge over time (they “fan outward”).
o Earnings increase faster for more educated workers.
6-30
Age-Earnings Profiles of Women
(Full-time)

6-31
 6-11 On-The-Job Training
• Most workers augment their human capital stock through
on-the-job training (OJT) after completing education
investments.
• Two types of OJT:
o General: training that is useful at all firms once it is
acquired. (ex: computer use, typing, writing, etc.)
o Specific: training that is useful only at the firm where it
is acquired. (ex. Driving a tank)

6-32
 Implications
• Firms only provide general training if they do not pay the
costs.

• In order for the firm to willingly pay some of the costs of

specific training, the firm must share in the returns to
specific training.
• Engaging in specific training eliminates the possibility of
the worker separating from the job in the post-training
period.

6-33
Costs, Benefits, and Financing of
Training
Specific training as a shared investment

Wages VMP*
VMP Employer’s benefits
W*
Employee’s benefits
Wa = VMPa
Employee’s costs
Wt
Employer’s costs
VMPt

0
Training t* Time
6-34
 6-13 Policy Application: Evaluating
Government Training Programs
• Aimed at exposing disadvantaged & low-income workers
(poor labor markert outcomes) to training programs. $4
billion of federal spending per year.
• Question: How to measure the effectiveness of these
government programs?
Before-after comparison:
WageBefore= $300 vs WageAfter= $1500
Δwages = $1500 - $300 = $1200
Not meaningful: Selection bias, counter-factual outcome, Average
Treatment on Treated (ATT) vs Average Treatment Effect (ATE)
6-35
 Social Experiments
• National Supported Worker Demonstration (NSW)
 Random assignment of applicants into two groups
Treated (T): Job placement for 9-18 months
Control (C): No placement
 Cost of the program: $12,500 ($1998) per worker

 Average Treatment on the Treated (ATT):

Δwages = Y1T – Y0T where Y=wages, T: Treatment group
Problem:
Y1T is observed (wages of the worker after receiving treatment)
Y0T is unobserved (what would a worker earn if not treated), substitute it
with Y0C since they have similar motivation & prior labor market outcomes
6-36
 Social Experiments
• National Supported Worker Demonstration (NSW)

 Results of the NSW suggest a 10% return to investments in

human capital for workers treated under the program.
Return= $1407/$12,500=11.2%
 Concern: What about Average Treatment Effect?
 Other potential issues: Attrition bias, Substitution via other
programs (violation of ceteris paribus)
6-37
Homework:
Suppose there are two types of persons: high-ability and low-
ability.

A particular diploma costs a high-ability person $8,000 and costs

a low-ability person $20,000. F

Firms wish to use education as a screening device where they

intend to pay $25,000 to workers without a diploma and $K to
those with a diploma.

In what range must K be to make this an effective screening

device?

2-38