Human capital theory views workers as long-term investments that increase in value over time through education and experience. The document discusses several key aspects of human capital theory, including: 1) Education and on-the-job training increase workers' human capital and productivity, leading to higher earnings over their career. 2) Signaling theory suggests education may signal skills to employers rather than increase productivity directly. 3) Whether firms or workers invest in training depends on if the skills are transferable or firm-specific. 4) Executive pay has risen dramatically in recent decades, which human capital theory attributes to skills becoming more general and transferable across companies.

1. Human Capital : Theory
and Application

2. Who Are Workers?
(Human Resources)
Cost?
Assets?
Business partner?

3. Agenda
Introduction
Schooling and Signaling
On the Job Training
Application-Executive Pay Issue
Discussion

4. Introduction
Human capital refers to the knowledge and
acquired skills a person has that increase his
or her ability to conduct activities with
economic value
Workers add to their stock of human capital
throughout their lives, especially via education
and job experience
Combination of …. (Fitz-enz, 2000)
• traits brought into job
• ability to learn
• motivation to share

5. Individual Input
(Investment)
Education Outcomes
Social Input
(Investment)
Productivity Earnings
Citizenship
Social
Efficacy
*Source : Swanson & Holton III, 2001, p.110
A Model of Human Capital Theory

6. Evolution of Human Capital Theory
Foundations
A. Smith, J. S. Mill, A. Marshall
J. Mincer (1958) : Yrs of work forgone to pursue
education were rationally compensated with high
wage
S. Fabricant (1959) : Intangible assets
G. Becker (1960) : ROR of difference in education
T. Schultz (1961) : US income has been increased in
higher rate than combined amount of land, working
hours and capital used to produce
Nobel Prize Winners
T. Schultz, G. Becker,
M. Friedman, S. Kuznets, R. Solow

7. The Schooling Model
A person’s decision maximizes the present value
of lifetime earnings
The rate of discount (r) plays a crucial role in
determining whether a person chooses to go to
school
Wage-Schooling Locus : salary for each level of
schooling
Marginal Rate of Return to Schooling : How much
earnings increase if a person stays in school 1
more year
Stopping rule : when it is optimal to quit school
and enter job market (MRR=r)
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8. Potential Earnings Streams

9. MRR
r
r’
Schooling Decision

10. Factors That Lead Different Level
of Schooling
Differences in the Rate of Discount
Different schooling decisions simply place them at
different points of the common locus
Differences in Ability
Higher ability levels shift the MRR to the right, so,
earnings gain resulting from an additional year of
schooling outweighs the increase in forgone earning

11. Signaling
Education does(needs) not increase
productivity at all, but signal a worker’s
qualifications to potential employers who do
not have private information
Education increases earnings not because it
increases productivity but because it certifies
that the worker is cut out for smart worker
Self selection constraints
1. Level of education of signaling must be such that
non-smart workers are unwilling or unable to attain it.
2. Achieving given level of education must be cheaper for
the high smart workers than for non-smart worker

12. $
W
T1 T2
NSW’s
edu
cost
curve SW’s
edu
cost
curve
Self-Selection

13. On the Job Training
Training increases a worker’s productivity (HC
stock) after training
Training is an investment with initial costs and
expected future returns
The returns are lost in the event of a separation
• Should the firm invest?
Not if the skills are easily portable (worker can leave)
• Should the worker invest?
Not if the skills are firm-specific (firm can layoff)

14. Who Bears Costs of Firm Specific
Training?
Since there is no commitment to stay on the
part of the worker after training occurred
firms will not want to bear the costs of
training when skills are general
Since there is no certainty that the job will
remain profitable in the future, the employee
will not want to bear the costs of training for
skills that can be valued only by the current
employer (specific)

15. Transferable Human Capital
training
Time
w1
VMP=W2
The employee will want to bear the full cost
by accepting lower wage during training

16. Firm-Specific Human Capital
training
Time
w1
w2
The employer will want to bear the full
cost by paying above the market value
to reduce turnover
VMP

17. Predictions of Human Capital
When skills are transferable…
Employees should be bearing the cost
• Wages of trainees (compared to non trainees)
should be lower during training
• Employer can offer what the market pays for
the new skills acquired after training
Given that training increases skills
• Wages of trainees (compared to non trainees)
should be greater after training at a given
employer

18. Predictions of the Human Capital
(Cont.)
To reduce transaction costs after firm-
specific training
• Workers should be paid above the market value
of their transferable skills.
• Paying above market should minimize
transaction(search) cost.
But—if contracts can be renegotiated, the
firm does not have to raise wages until
faced with a potential quit (Beaudry and
DiNardo ).

19. The Mincer equation captures the important
empirical regularities
1) increase in earnings with schooling
2) concavity of log earnings in experience
3) parallelism in log earnings experiences
profiles for different education groups
log w = rs + β1t – β2t2 + other variables
Mincer Equation (1994)
*See the attached file for the further discussion

20. Executive Pay
(Murphy & Zabojnik, 2004)
Base salary and bonuses of Forbes 800
CEOs increased from $700,000 in 1970 to
2.2 million in 2000
In 1980, CEOs received about 42 times the
average of workers. By 2000, they were
paid 475 times the average workers
(Milkovich & Newman,2002)

21. 20 Top-Paid CEOs in 2003
Name Company
2003
Salary
and
Bonus
Long-
term
Comp.
Total
Pay
Reuben Mark Colgate-Palmolive 5.1 136.0 141.1
Steven Jobs Apple Computer 0.0 74.8 74.8
George David United Technologies 4.2 66.2 70.4
Henry Silverman Cendant 17.3 37.2 54.5
Sanford Weill Citigroup 30.7 23.4 54.1
Richard Fuld Lehman Brothers 7.4 45.5 52.9
Lew Frankfort Coach 1.9 43.8 45.7
Lawrence Ellison Oracle 0.1 40.5 40.6
Howard Solomon Forest Laboratories 1.4 34.6 36.0
Richard Kovacevich Wells Fargo 8.5 27.4 35.9
Charles Cawley MBNA 7.5 27.4 34.9
James Cayne Bear Stearns 11.2 22.7 33.9
Douglas Berthiaume Waters 1.2 32.2 33.4
James Moffett Freeport McMoRan 11.4 21.9 33.3
Todd Nelson Apollo Group 4.5 28.3 32.8
H. Lawrence Culp Danaher 3.8 28.2 32.0
Ray Irani Occidental Petroleum 4.8 27.1 31.9
Charles Prince Citigroup 7.6 23.8 31.4
Brian Roberts Comcast 8.4 22.6 31.0
R. Lawrence Montgomery Kohl's 1.0 29.2 30.2

22. Possible Explanations on CEO
Compensation
Social Comparison : relationship to others
Economic Approach : reward to success,
depends on company size
Agency Theory : self-motivated behavior
Fat-Cat Theory : rent seeking
Human Capital Theory : increasing investment
on human capital, type of required skill

23. Hiring Sources-Internal or External
*Source : Murphy & Zabojnik, 2004

24. Hiring from Outside
Hiring from outside
• foregoes valuable specific skills available only through
internal promotions
• able to hire from a larger opportunity set of managers
• allows better matching of managers and firms
Demougin & Siow (1994)
• Outside hires involve hiring and replacement costs which
are assumed to be higher than the costs of training and
promoting from within
• Internal labor market with high value for firm-specific skills

25. Executives as Human Capital
As firm-specific capital becomes relatively less
important, the benefit of better matching becomes
large relative to the cost of (lost) specific capital
• prevalence of outside hires will increase
• higher wages for outside hires as the general component of
skills becomes relatively more important than the firm-
specific part of skills
Potential reason for increasing pay + increasing
outside hire is the change in the composition of
managerial skills toward more general (market
valued) skills
 CEOs skills are transferable across firms and industries
 Greater breadth of knowledge helps management of any
company
 Any firm-specific information is more easily accessible than
before (computerization)

26. Discussions
Is education really improving productivity
or just signaling?
How can we measure the value of human
capital?
What are the implications of human
capital theories for HRD specialists?