Chapter 4: Labor Quality:

Investing in Human
Capital

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page
3. Human Capital
Investment and the
Distribution of Earnings

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 Diminishing Rate of
•
Return
the percent increase in earnings that
comes from having an additional year
of schooling.

Rate of Return
• The marginal rate of return to
education declines as additional
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.
• The return also falls because the

explicit cost and opportunity r

cost of education rises with
additional schooling.

Years of Schooling

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 Demand for Human
Capital
• Since individuals should

r, i
increase schooling so that the
marginal rate of return of
schooling (r) is equal to the
interest
• Usingrate
the (i).
r=i rule, at interest 1
rate i2, the optimal level of i1 S1
schooling is e2. 2
i2 S2
•
At i1 the optimal level is e1.
3
•
At i3 the optimal level is e3. i3 S3
• Each equilibrium point (1,2,3)
r, DHC
indicates the “price” and
quantity demanded of human
capital. In other words, the
demand for human capital. e1 e2 e3 Years of
Schooling

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 Ability Differences

r, i
• Alfonse is low ability person. He
has low mental/physical talents
and/or low motivation and self-
discipline. His demand for
schooling is DA. A B
• Bob is a high ability person. i S
He has a greater demand for
schooling at DB because he can
better translate schooling into
higher productivity and DB
earnings.
• 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

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 Discrimination
Albert is black and is

r, i
•

discriminated against in the labor

market. His demand for
schooling is DA since he has low
ability to convert additional A B
schooling into higher earnings. i S
• Brett is white and has a greater

demand for schooling at DB as

he can reap the benefits of
additional schooling. DB
• For a given interest rate, Bob DA
will obtain more schooling
which will compound the
earnings differential between
whites and blacks. eA eB Years of
Schooling

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 Cost of Funds

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

eB eA Years of
Schooling

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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.
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5. Criticisms of Human
Capital Theory

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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.

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Non-Wage Benefits

Studies that only examine the earnings of
high school and college graduates
understate the rate of return for two
reasons.
 College graduates have greater fringe
benefits as a percent of pay than high
school graduates.
 College graduates tend to work in more
pleasant surroundings and have more
interesting jobs than high school
graduates.

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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.
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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.

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 End
Chapter 4

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