Transcript Topic No: 2

Topic No: 2
Human Capital
Lecture Map
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Introduction
Definition of human capital
Components of human capital
The human capital theory
Human capital & Physical capital
Stages of formation of human capital
Human capital & Economic growth
Introduction: The Human Capital
Revolution in Economics
 Rediscovering the role of education to the
wealth of nations.
 Searching for clues on income distribution
 Pareto’s remarks (his “Power Law”) dominated
the field of personal income distribution. Due
to this many economist believed that the
distribution of income followed exogenous
forces.
Introduction: The Human Capital
Revolution in Economics
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Major contributors:
1. Kuznets, Simon and Milton Friedman. (1945), Income from
Independent Professional Practices, National Bureau of
Economic Research.
2. Mincer, Jacob (1958), Investment in Human Capital and Personal
Income Distribution, Journal of Political Economy, vol. 66(4),
pp. 281-302.
3. Schultz, Theodore W. (1961), Investment in Human Capital, The
American Economic Review, vol. 51(1), pp. 1-17.
4. Schultz, Theodore W. (1962), Reflexions on Investment in Man,
Journal of Political Economy, vol. 70(5, Part 2, Supplement), pp.
1-8.
Introduction: The Human Capital
Revolution in Economics
6. Becker, Gary S. (1962), Investment in Human Capital: A
Theoretical Analysis. Journal of Political Economy, vol.
70(5, Part 2, Supplement), pp. 9-49.
7. Mincer, Jacob (1962), On-the-Job Training: Costs,
Returns, and Some Implications, Journal of Political
Economy, vol. 70(5, Part 2, Supplement), pp. 50-79.
8. Becker, Gary S. (1964), Human Capital: A Theoretical
and Empirical Analysis, With Special Reference to
Education, New York, National Bureau of Economic
Research.
9. Mincer, Jacob (1974), Schooling, Experience, and
Earnings, National Bureau of Economic Research, New
York.
Definition Of Human Capital
• What is capital?
• What is human capital?
– Ans: human capital refers to the collection of innate
and acquired individual abilities that are substantially
durable, persisting over some significant portion of the
life of the possessor. Furthermore, the personal
attributes referred to under this rubric are restricted to
positive “abilities” and “capabilities”. In other words,
their nature is such as would normally yield some
stream of benefits, by enhancing the possessor’s
performance in one or more socially valued activities.
Specific Aspects Of Human
Capital
1. Human capital comprises a) innate b) acquired
component
2. human capital is non-tradable
3. human capital can be acquired formally or
informally
4. Human capital has quantitative and qualitative
aspects
5. Human capital can be either general or specific
6. Human capital may not be fully utilized
Components Of Human Capital
Human
Capital
Tangible
Intangible
Health
Longevity
Physiological
condition:
e.g. Strength,
eyesight etc.
Psycho-motor
based skills
("know-how",
"can-do").
Cognitive
capabilities
("know-why"'
know-what")
Procedural
capabilities
Creativeness,
innovativeness
Problem-solving,
leadership,
managing complex tasks.
Social capabilities
(“know-how”, “know-who”):
Flexibility:
e.g., diligence, loyalty, Multi-task performance,
cooperativeness, trust, etc.
re-trainability.
The Human Capital Theory
• Introduction
• The human capital model
• Generalizations and implication of the
human capital model
• Criticisms of human capital theory
Introduction
• The early 1960s witnessed what has been
described in the economics literature as the
"human investment revolution in economic
thought" (Bowman 1966). Expenditures on
education, whether by the state or
households, have been treated as investment
flows that build human capital.
Introduction
• Basic Concepts Of Investment In Human
Capital.
– When a firm invests in physical capital, it is acquiring
some assets that is expected to enhance the firm’s flow
of net profits over a period of time. For example, a
company might purchase new machinery designed to
increase the out put and therefore sales revenues over,
say, the 10-year projected life of the machinery. The
unique characteristics of investment is that current
expenditures or costs are incurred with the intent that
these costs will be more than compensated by for by
enhanced future revenues or returns.
Introduction
• Analogously, investment are made in human
capital. When a person (or person’ s parents or
society at large) makes a current expenditure on
education and training, it is anticipated that the
individual's knowledge and skills and therefore
future earnings will be enhanced. The important
point is that expenditures on education and
training can be fruitfully treated as investment in
human capital just as expenditure on capital
equipments can be understood as investment in
physical capital.
Introduction
• Once education is treated as an investment, the immediate
natural question is: what is the profitability of this
investment in order to compare it to alternatives? Such
comparison can provide priorities for the allocation of
public funds to different levels of education, or can explain
individual behaviour regarding the demand, or lack of
demand, for particular levels or types of schooling.
• For establishing education investment priorities at the
margin the human capital model is the main theoretical
foundation. So, now I present the human capital model.
The Human Capital Model
• Decision to invest in college education.
• From purely economic standpoint, a rational
decision will involve a comparison of costs
and benefits.
The Human Capital Model
• Costs (monetary) of college education:
– Direct or out of pocket costs.
• Expenditure on tuition, special fees, and
books and supplies.
– Indirect costs.
• Opportunity cost.
• Benefits of college education.
– Enhanced future flow of earnings.
The Human Capital Model
C
(3)
Incremental earnings
Annual earnings
H
(2)
Indirect
cost
H
18
C
(1)
Direct
cost
22
65
Age
Age-Earnings Profiles with and without college education
The Human Capital Model
• Discounting and net present value.
– Compare costs and benefits. But one complication arises
because costs and benefits accrue at a different point in
time. This is important because rupees expended and
received at a different point in time has different value. A
meaningful comparison of the costs and benefits
associated with the college education requires that these
costs and benefits be compared in terms of common point
in time, for example, present.
– So, calculate the net present value of present and future
costs and benefits.
The Human Capital Model
• Time preference.
– Why rupees expended or received at different
point in time has different value.
• Because of interest payment on borrowed or
rented money.
– And interest is paid because of time
preference.
• Present Value Formula.
– Vp (1+i) = V1.
V1
Vp 
(1  i )
Extended Discounting Formula
V p  E0 
E3
E1
E2
En




LLL
2
3
(1  i ) (1  i )
(1  i )
(1  i ) n
• Formula for High School Graduate
E19
E20
E64
E21
V p  E18 


 LLLL 
2
3
(1  i) (1  i)
(1  i)
(1  i) 46
• More compact formula
64
En
Vp  
n 18
n 18 (1  i )
Decision Rule & Example
• NPV Decision rule: Vp > 0
• Example
–
–
–
–
C = 6000
E1 = 2500
E2 = 3000
E3 = 3500
Internal Rate Of Return
• Internal rate of return is that rate of discount
which equates the present value of future cost and
benefits, or stated alternatively, it is that rate of
discount at which the net present value of a human
capital investment is 0 (zero)
 n C   n E 



NPV   

0

  
 
  1 (1  r )    1 (1  r ) 
Internal rate of return
Internal Rate Of Return
• IRR Decision rule: r
=i
Generalization & Implications
• Length of income:
– Longer the length of income higher the internal rate of
return on human capital investment or more likely that
the NPV will be positive.
• This explains why it is primarily young people who
go to college and why younger people are more
likely to migrate.
• It also explains the portion of earnings differentials
that has been traditionally existed between women
and men.
Generalization & Implications
• Costs.
• Other things being equal lower the costs of human capital
investment, the larger number of people who will find that
investment to be profitable.
• If the direct or indirect cost of attending college were to fall,
we would expect enrollment to rise.
– Illustration: The guaranteeing of student loans by the
government eliminates the risk to the lender and lowers
the interest charged for borrowed funds to attend college.
By reducing the private cost of attending college
education, such loans guarantees increased college
enrollments.
– Similarly the state of the economy may influence college
enrollments through its effects on the indirect or
opportunity cost of attending college.
Generalization & Implications
• For example, if recession reduces the
earnings that high school graduates achieve,
or, alternatively, reduces the probability of
obtaining job, the opportunity cost of
attending college will fall and enrollments
will rise. Lower costs increases the NPV of a
college education, making the investment in
education “profitable” for some who
previously found it to be unprofitable.
Generalization & Implications
• Earnings differentials.
– Not only the length of the incremental earnings stream
critical in making a human capital investment decision,
but so as the size of that differential. The generalization
is that,
• Ceteris paribus, the larger the earnings differential
between high school and college graduates, the
larger the number of people who will invest in
college education.
Criticisms Of Human
Capital Theory
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Consumption or Investment
Non-wage benefits
The ability problem
The screening theory
Comparison Of Human
Capital And Physical Capital
• Similarities:
– Both human capital and physical capital has investment aspect
common in them i.e. investment is required to build and
accumulate both human capital as well as physical capital. For
both thus the investor has to forgo the present consumption in
anticipation of the future enhanced consumption.
– Both have returns. this similarity is a corollary of the first
similarity.
– Both have their quantity and quality.
– Both depreciates. For example, human health depreciates with
time. And education also depreciates if not used properly.
Comparison Of Human
Capital And Physical Capital
– Because both human capital and physical capital
depreciates, they both requires maintenances. For
example, human health requires frequent care. And
training and re-training is required to update the
depreciating skills.
– The amortization period for a physical capital is the
product cycle and for human capital the same is
working life of the individual.
– Both have rental value. Both can be rented away.
Comparison Of Human
Capital And Physical Capital
• Differences:
– There are major differences in terms of the returns obtained
from the investment in human capital and physical capital. The
investment in physical capital has only monetary and market
returns whereas investment in human capital has non-monetary as
well as non-market returns.
– The returns to human and physical capital tend to behave
differently. When individual invest in physical capital, they are
return-takers i.e. the owners accepts the return dictated by the
market and cannot influence them. Since there are no market for
the stock of human capital, investors in human capital become
return-maker, as the amount, the quality and the maintenance of
their human capital will dictate what the market will be willing to
offer for their services.
Comparison Of Human
Capital And Physical Capital
– Property rights and marketability: physical capital is
tangible, that can be easily seen or touched. It includes
machineries, factories, plants, raw materials etc.
physical capital can easily be sold and transferred from
one owner to another.
– But human capital is inseparable from the human
beings and its ownership is restricted to the individual
in whom it is embodied. Unlike physical capital, the
stock of human capital is not marketable. Only the
services that emanate from this stock are market goods.
Comparison Of Human
Capital And Physical Capital
– Financing: lenders are more willing to lend funds for
the investment in physical capital than in investment in
human capital because the former is marketable and
continue to be a good collateral. Physical capital can
easily be sold, seized, jointly owned and transferred by
sale or by inheritance.
– whereas human capital is intangible and in dissociable
from its owner. This makes the private finance for the
acquisition of human capital harder to obtain.
– The gestation period for physical capital is smaller than
for human capital.
– Mobility wise both are different.
Human Capital Formation
– Stages of human capital formation
• Primary education
• Higher education
• On-the-job training
• Retraining
• Retirement
Human capital and economic growth
• Theoretical background
• Links through which human capital affects
economic growth (Chain of reasoning).
Theoretical background
• The classical growth theories predicted that,
– economies will stagnate after reaching the high
growth levels.
– And there is no continues rise in economic
growth.
Theoretical background
• Neoclassical growth theory of Solow (the Solow
growth model) also predicted that economies will
stop growing after reaching the steady state
growth. But,
• There is way out of this problem, and that way is,
– Technology.
• But,
– Technology is assumed (it is exogenous and determined
outside the model). SO………problem again.
– To solve the problem develop models that explain
technological progress.
Theoretical background
• To solve the problem economists developed,
– Endogenous growth model.
• Paul M. Romer, Increasing returns and long run growth,
Journal of Political Economy 94 (October 1986): 1002-1037,
• Robert Lucas Jr., On the Mechanics of Economic
Development, Journal of Monetary Economics 22 (1988):3-42
– According to this model New Ideas (Human capital)
becomes important for growth.
Links of Effects
1. At the macro level human capital can be
viewed as a factor of production coordinate
with physical capital (Aggregate
production function approach)
– It’s contribution of growth is greater larger the stock of
physical capital.
– Growth of human capital is both a condition and a
consequence of economic growth.
– Example: the success of the Marshall Plan in Europe
and the failure of foreign aid to LDC's.
Links of Effects
2. Human Capital and Technology
– Human capital activities involve not merely the
transmission and embodiment in people of available
knowledge, but also the production of new knowledge
which is the source of innovation and of technical
change which propels all factors of production. This
latter function of human capital generates worldwide
economic growth regardless of its initial geographic
locus.
– Human capital as a source of new knowledge shifts
production functions upward and generates worldwide
economic growth.
Links of Effects
3. Human capital and population
–
–
Human capital is a link which enters both the causes
and effects of economic-demographic changes.
Three ways.