Business 33032-01/81/85
Managing the Workplace
Canice Prendergast
Spring 2010
Topic 2
Human Capital and Education
Most of the course is on the issue of how workers should be compensated. The primary determinant
of someone’s pay is their productivity, largely reflecting their human capital. The objective of this
section of the course is to understand the acquisition of human capital, who should pay for it, and
how the returns to human capital have changed over the last number of decades.
We will do this in a number of steps.
1.
2.
3.
4.
Data on Returns to Education
An Investment Rule
Changes in the Returns to Skills Over Time
What Makes Human Capital Different?
Human capital refers to the intellectual capital that individuals hold and perhaps the bottom line of
the lecture is that we should see human capital like any other form of capital. There are really two
kinds of human capital that we will consider:
1. Formal education programs
2. On-the-job training programs
For the first part of the lecture I am going to consider formal education.
I: Some Evidence on Human Capital
Begin by looking at Figure 1. This measures how wages earned vary for workers of different
education. There are a few things worth noting:
1. People with more education earn more (hardly surprising)
2. Age-earnings profiles are concave
3. People with more education have steeper age-wage profiles – in other words, much of
the benefit of education is deferred.
2
Earnigns Per Year (in thousands)
Figure 1
Total Money Earnings (mean) 1981
40
35
Postgraduate
Eduation
30
College
Graduate
25
Some College
20
15
High School
Graduate
10
Elementary
School Only
5
0
1
2
3
4
5
6
7
8
9
Age
Source: U.S. Bureau of the Census. Money Income in 1981 of Families and Persons in the United
States, Current Population Reports. Series P-60, No. 137 (1983) Table 48.
What we want from our theory of skill collection is something that will help explain these
phenomena. To do this we turn to a model of human capital acquisition.
II.
An Investment Rule
To begin, we will treat human capital as if it is any other asset. What this means, in practice,
is that we can ignore the concern that a firm pays for the skill collection of the worker, but where
there is a danger of the worker quitting and taking her skills with her. Instead, what we will assume
here is that the party that pays for the skills gets their benefits, and deal with cases where this may
not be true below. This is essentially an efficiency calculation.
Let us deal with the human capital decision in terms of doing an MBA compared to finishing
with a college education.
3
Suppose that if you do not get the MBA your income will be ytC in period t (C for college).
Alternatively you can decide to go to college and earn ytM in period t (M for MBA). However, you
also have to pay K dollars for a single year to do the MBA. Assume that the worker with the college
degree works from year 0 to year T, while the worker with the MBA also works until T. (This is just
for simplicity.)
The present value of just going to college is
C
C
C
yT C
y1
y2
+
...+
PV = y +
C ,
2
1+ r (1 + r )
(1 + r )T
C
0
C
while the present value of doing the MBA is
M
M
M
yT M
y1
y2
+
...
 K.
PV = y +
M
2
1 + r (1 + r ) (1 + r )T
M
M
0
To keep matters simple assume a similar retirement date for both workers. Then the worker
should go to college if
T
K <
t=0
M
C
yt  yt
(1 + r )t
.
An Example:
Assume that T = 2 and the wages earned are
No MBA: 30,000 and 34,000
MBA : 10,000 and 100,000
Let the interest rate be 10% and let the cost of an MBA be $35,000. Is the MBA worth it to
the worker?
Observations:
1. What factors affect the training decision?
4
2. Do people actually use this model when choosing to go to college?
The next thing that we do is to determine the internal rate of return on education. This is the
critical interest rate, which if the actual interest rate exceeds this, you should not get an education.
How would you compute the rate of return? Clearly, it is the interest rate r at which the costs and
benefits are equalized.
T
K=
t=0
M
C
yt  yt
(1 +  )t
.
Example Continued
Suppose that, again, t = 2 and it costs $100 to get an MBA. Wages are $50 higher for the
MBA while the MBA is being done and $55 higher in the following year. What is the internal rate
of return for education here?
So what if the interest rate is 8%? Should you get the education? How does r change with
the cost of education, later retirement, age of the worker, etc.?
Estimates of r are in the neighborhood of about 7%, which is much the same as in other
assets. Is this just coincidence? Probably not, as people have choices about what assets they should
place their wealth in, and the returns should be equalized if the market is reasonably competitive.
(This assumes, of course, that the misery of doing an MBA is no greater than the worries of holding
stock, for example.)
Caveat: Suppose that you read in, say, The Economist, that the wages of college- educated
people were 50% higher than the wages of high-school-educated workers. Could I extrapolate from
there that the rate of return from education is about 12%, as college takes 4 years?
5
So you have to be very careful in interpreting data; always beware of self-selection. In the
context of education, we will return to this later in the course, when we talk about signaling.
At the beginning of the notes, I mentioned that there were a number of different characteristics of
the data that we would like to explain. Among these were (i) earnings profiles being concave and
(ii) those with more education having steeper age-earnings profiles. How can we explain these with
our theory?
III.
Changes in the Return to Skills over Time
The next thing we look at is how the returns to college education have changed over time.
To see this, consider Figure 2. This measures the extra income earned by a college graduate
compared to a high school graduate.
FIGURE 2
THE COLLEGE WAGE PREMIUM
6
There are two main findings from this graph:
1. A big decline in the college premium in the 1970s
2. A big increase since the 1980s
The next piece of data that is interesting is to look at is how income distribution has changed
over the last 20 years. This is given on Figure 3. This shows how the income of those in the 0-10
decile (the poorest 10%) has changed over time and similarly for those in different parts of the
income distribution. The most striking result is that those in the lowest part of the distribution have
had their wages reduced by 25-30% in real terms over the last 20 years.
FIGURE 3
INDEXED REAL WAGES FOR MEN BY PERCENTILE, 1967-1997
Why have the returns to skills increased so much?
7
The role of trade in explaining the increase in inequality:
What % of US GNP is traded?
How much has this increased in the last 20 years?
How much of US trade is with Less Developed Countries?
How much has trade with LDCs increased in the last 20 years?
IV.
Problems with the Acquisition of Human Capital
A key issue for the collection of human capital is that, unlike other assets, workers cannot be owned,
and the danger is that these trained workers may threaten to leave and take their human capital with
them.
We have to distinguish between two forms of training: (i) general training and (ii) specific
training.
General training: this refers to skills that are useful in many companies, such as an MBA.
Specific skills: this refers to skills that are useful only as long as you remain with your
current employer. Can you think of examples of specific skills?
The key distinction between these two forms of training is the bargaining power that it gives
workers. This is what generates the problem for firms, as workers who have greater bargaining
power may extract some of the returns to skill collection.
One must make a number of considerations when designing training programs. These are (i) how do
I pay the worker? and (ii) who pays for the training? We will see that these two are really the same
question and that the type of skills collected plays an important role in determining the answer to
this question. Consider a general case where a worker is trained in period 0 and then works until
period T. There is a cost k to training the worker and his marginal productivity in period t is yt. I am
going to ignore the issue of whether it is efficient to train the worker, instead assuming that it is.
The question we address here is how the worker should be paid. The total value of the worker’s
productivity is given by
T

t=0
yt
t
(1+ r )
.
8
Let us consider a case where the firms are in a competitive market and earn no profits (the
basic idea here is robust to allowing this assumption to drop). Then is the worker earns a wage wt in
period t the firm designs its wages such that
T
yt
T
wt
=
 k.

t
t
t=0 (1 + r )
t=0 (1 + r )
The question we address is how the worker should be paid over his lifetime.
A.
General Training
Here the worker can use the general nature of his skills to get a wage that is close to his
productivity in the firm. Let’s consider the extreme case where there are no moving costs and the
skills are completely general. Then the worker can earn yt = wt in any period. To put this in more
standard terms, if the worker’s skills are general, he can bid his wage up after training so that the
firm cannot earn much money from him after training.
Does this mean that firms are unwilling to train workers in general skills? (Key point)
$
yg
ym
Time
T
Hence one solution to the problem associated with general skill collection is to offer a wage
schedule that increases rapidly with age. In effect, you are making the worker pay for his own skill
collection by offering a low wage while he trains. An example of this is apprenticeships, where
trainees get badly paid but are well paid after they finish their training.
9
Possible Solutions
B.
Specific Training
Here the firm is not so worried about the worker using his skills to bid up wages, because the
skills he collects are useless elsewhere.
10
$
ys
ym
T
Time
Here the firm has more discretion. It could offer a wage profile like that for a generally
trained worker or it could offer a flat wage profile.
What kind of wage profile should you offer?
There are a number of influences:
1. Can workers pay for their skills?
2. Should workers pay for their skills?
3. How likely is a layoff relative to a quit?
Suppose that a flat wage profile is offered. Then the firm is making a lot of money from the worker
after training but the worker is earning little extra. Hence there is a danger that the worker will quit.
One solution to this is to offer a wage profile that increases after training. However, if the wage
profile is very steep, the worker may be in danger of being laid off by the firm. If this is the case,
one solution is to offer a flat wage profile, as the firm is then earning money from the worker as he
ages, and hence is unlikely to lay him off.
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The Spence Model of Education as Signaling
Another inefficiency in the collection of skills can arise when workers collect costly skills not as a
means of increasing their productivity, but rather to show the market how clever they are.
The Model

There are two kinds of individuals: clever and slow.

Smart people can produce yc while the slow produce ys, independent of education.

However, only the individuals themselves know whether they are clever or slow. Employers
cannot directly infer this information.

The question we ask is whether workers can reveal this information even if it is not directly
observable.
Let the cost of the MBA be cc for the clever worker and cs for the slow worker. The cost of
education for the clever worker is lower.
Assume further that the market is competitive, so that the slow workers, if they admit to being so,
are given ys.
Firms cannot tell whether workers are talented or not; all that they can do is offer one wage to a
worker with the MBA, wm, and another to a worker who will not collect the MBA, wn.
12
Two kinds of outcomes: pooling and separating
There are two conditions required for signaling or separating.
1. Getting the MBA desirable for the talented workers.
The first condition requires that
wm - cc > ys.
2. Not getting the MBA desirable for those who are slow.
This requires that
wm - cs < ys.
Signaling occurs in our model above for all wages between ys + cc and ys + cs. Why?
There is also a pooling equilibrium. This means that not all workers collect the MBA and get
their average product. (So, for example, if 3/4 of the population is smart, everyone gets 3/4yc +
1/4ys.)
Is education efficient here?
Why?
Who gains and who loses by signaling?
13
An example: Let yc = 150, ys = 100, cc = 20, cs = 50, and let 3/4 of the population be clever.
Check who gains and who loses by signaling.
This introduces the possibility of a rat-race phenomenon, where expectations can give rise to
inefficiencies.
Should We Believe The Signaling Story?
1. It's hard to believe that education is completely useless, particularly in technical subjects.
2. Empirical evidence on those least likely to want to impress people.
3. Aren't there cheaper ways of signaling?
4. Maybe the information is useful for productivity reasons
.