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Family5 Humcap


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Family5 Humcap

  1. 1. Investing in Human Capital <ul><li>Is education a good investment? </li></ul><ul><li>Why do some people invest in education while others do not? </li></ul>
  2. 2. <ul><li>Any activity with current cost and future benefits can be analyzed like an investment. </li></ul><ul><li>Investment in physical capital (man-made goods) contributes to production of more goods/services </li></ul><ul><ul><li>Easily financed </li></ul></ul><ul><li>Investment in human capital (expenditures on education and training) improves quality and/or quantity of production of an individual </li></ul><ul><ul><li>Yields a rate of return (higher earnings) like physical capital </li></ul></ul><ul><ul><li>Embodied in the person investing </li></ul></ul><ul><ul><li>Illiquid asset – can’t sell quickly </li></ul></ul><ul><ul><li>Risky: uncertainty regarding life expectancy, potential ability, returns to a person due to unexpected life events. </li></ul></ul><ul><ul><li>Difficult to finance </li></ul></ul>Investment in Human Capital
  3. 3. Increase in Educational Attainment <ul><ul><li>1970: 36% </li></ul></ul><ul><ul><li>2006: 12% of labor force was high school dropouts </li></ul></ul>
  4. 6. Age-Earnings Profiles of Full Time Workers, 2005
  5. 7. Age-Earnings With and Without College Age Annual Earnings 65 18 <ul><li>High School curve is age-earnings profile if a person does not attend college. </li></ul><ul><li>College curve is age-earnings profile if attends college </li></ul><ul><li>Total cost of college : </li></ul><ul><ul><li>direct costs, tuition (1) </li></ul></ul><ul><ul><li>indirect costs, lost earnings (2) </li></ul></ul><ul><li>Benefit of attending college is increase in earnings (3). </li></ul>22 Future Extra Earnings (3) High School College Indirect Costs (2) Direct Costs (1)
  6. 8. Age-Earnings With and Without College <ul><li>Adult student working full time while earning a degree </li></ul><ul><li>To study or not to study? </li></ul><ul><li>Compare present value of benefits with present value of costs across lifetime </li></ul>Age Annual Earnings 65 18 22 Future Extra Earnings (3) High School College No Indirect Costs (2) Direct Costs (1)
  7. 9. <ul><li>$100 received 1 year from today </li></ul><ul><ul><li>less valuable than $100 today </li></ul></ul><ul><ul><li>can put $95.24 in the bank at 5% to get $100 in a year </li></ul></ul><ul><ul><li>$100 = $95.24*(1+0.05) </li></ul></ul><ul><ul><li>Future Value = $100 </li></ul></ul><ul><ul><li>Present Value = $95.24 </li></ul></ul><ul><ul><li>Interest (Discount) Rate = 5% </li></ul></ul><ul><li>future benefits are discounted to present </li></ul><ul><ul><li>using interest rate </li></ul></ul><ul><ul><li>farther a benefit is in future, less it is worth today </li></ul></ul><ul><li>compare with current costs </li></ul>Present Value of Future Income
  8. 10. <ul><li>Discounting converts the value of future dollars into today’s dollars through interest (discount) rate </li></ul><ul><li>Present value ( PV ) of a payment received one year from now is: </li></ul>Present Value $ 100.00 PV = <ul><ul><li>Ex: </li></ul></ul>where i = 10% PV = <ul><ul><li>Def: </li></ul></ul>Payment 1 year from now 1 + Interest rate $ 110 1.10 =
  9. 11. Discounted Present Value 0 -$ 8,000 1.000 $ -8,000 1 2 3 $ 3,000 $ 4,000 $ 5,000 0.909 0.826 0.751 $ 2,727 $ 3,305 $ 3,755 $ 1,787 <ul><li>Melinda is considering taking a webmaster training program </li></ul><ul><li>Costs: tuition $3,000, forgone earnings $5,000. </li></ul><ul><li>The training program will increase Melinda’s earnings by $3,000, $4,000, and $5,000 for the 3 years she plans on working. </li></ul><ul><li>She can borrow funds at an interest rate of 10%, so we will discount future expected income at 10% rate. </li></ul><ul><li>Find net present value ( PV ) of this training program </li></ul><ul><li>PV of the training program is positive, Melinda should take the training program. </li></ul>Net Present Value of Earnings (4) Discount 1/(1+0.1) (3) Incremental Earnings (2) Year (1) PV of $8,000 Investment in Webmaster Training Program (Interest Rate = 10 %)
  10. 12. Present Value <ul><li>A person should attend college if net present value is greater than 0, or PV (costs) < PV (benefits) </li></ul><ul><li>Differences in time preferences </li></ul><ul><ul><li>presented-oriented people have high r </li></ul></ul><ul><ul><ul><li>discount future earnings heavily </li></ul></ul></ul><ul><ul><ul><li>PV (benefits) lower for them  get less schooling </li></ul></ul></ul><ul><ul><li>future-oriented people have low r </li></ul></ul><ul><ul><ul><li>Do not discount future earnings heavily </li></ul></ul></ul><ul><ul><ul><li>PV (benefits) higher for them  get more schooling </li></ul></ul></ul><ul><li>Present value of a future stream of incremental earnings or costs (E) </li></ul><ul><li>Costs are negative values of E, benefits are positive </li></ul>PV = E 0 + E 1 (1 + r) + E n (1 + r) n E 2 (1 + r) 2 + + . . . . .
  11. 13. <ul><li>Length of income stream </li></ul><ul><ul><li>The longer the stream of positive incremental earnings, the more likely the net present value will be positive. </li></ul></ul><ul><ul><ul><li>Women live longer – higher benefits of education </li></ul></ul></ul><ul><ul><ul><li>Women have interrupted careers – lower benefits </li></ul></ul></ul><ul><ul><ul><li>Younger people – higher benefits </li></ul></ul></ul><ul><li>Costs of attending college </li></ul><ul><ul><li>The lower the cost of attending college, the more likely the net present value is positive. </li></ul></ul><ul><ul><ul><li>Older students - higher opportunity cost of attending college </li></ul></ul></ul><ul><li>Earnings differential </li></ul><ul><ul><li>Larger college-high school earnings differential - more likely positive net present value </li></ul></ul><ul><ul><ul><li>College attendance rose in 1980s as college-high school premium increased. </li></ul></ul></ul><ul><li>Women’s investment in education </li></ul><ul><ul><li>May include quality of husband (extra benefit) </li></ul></ul><ul><ul><li>Total returns may be smaller due to discrimination </li></ul></ul>Generalizations
  12. 14. Diminishing Returns to Schooling <ul><li>Investment in education is subject to the law of diminishing returns. </li></ul><ul><li>The increases in knowledge decline with each additional year of schooling. </li></ul><ul><li>Rate of return schooling = % change in earnings from extra year in school </li></ul><ul><li>Return to 13 th year of schooling = $3,000/$20,000  15% </li></ul><ul><li>Return to 14 th year of schooling = $2,000/$23,000  8.7% </li></ul>
  13. 15. Demand for Human Capital Years of Schooling Discount rate <ul><li>People get education until the point where the benefit of one more year equals its cost </li></ul><ul><li>Al has higher discount rate than Bob </li></ul><ul><li>Why? </li></ul><ul><ul><li>Al more present-oriented </li></ul></ul><ul><ul><li>Al faces higher cost of borrowing (he is poor) </li></ul></ul><ul><li>Bob chooses to graduate from college </li></ul><ul><li>Al’s optimal choice is not go to college </li></ul>Benefit of schooling (return) r AL r BOB 1 2 12 16 Cost of schooling
  14. 16. Rate of Return Per Year of College Education
  15. 19. <ul><li>Hard to measure returns to education </li></ul><ul><li>Those with more ability (i.e., intelligence, motivation, and self-discipline) are more likely to go to college. </li></ul><ul><ul><li>Even without a college degree, they would have earned more than those who decided not to go to college. </li></ul></ul><ul><ul><li>High earnings of college graduates reflect both </li></ul></ul><ul><ul><ul><li>greater ability </li></ul></ul></ul><ul><ul><ul><li>Schooling </li></ul></ul></ul><ul><ul><li>rate of return to schooling is overstated </li></ul></ul>Statistical Problem
  16. 20. <ul><li>You decision to invest in education yields substantial external or social benefits for society </li></ul><ul><ul><li>More educated workers - lower unemployment rates. </li></ul></ul><ul><ul><li>Education raises participation in political process. </li></ul></ul><ul><ul><li>Children grow up in a better home-environment if parents are more educated. </li></ul></ul><ul><ul><li>Research discoveries of more educated persons </li></ul></ul><ul><li>Positive externality: Benefit to the third party </li></ul><ul><ul><li>Immunization, education, inventions </li></ul></ul><ul><ul><li>Free markets under-allocate resources to such activities </li></ul></ul><ul><li>Negative externality: Cost to the third party </li></ul><ul><ul><li>Air pollution by chemical plant, loud music, drunk driving </li></ul></ul><ul><ul><li>Free markets over-allocate resources to such activities </li></ul></ul>Private vs. Social Perspective
  17. 21. <ul><li>General Training </li></ul><ul><li>Skills used in various firms </li></ul><ul><li>Accounting, word processing, college degree </li></ul><ul><li>Firms will offer higher wage for this training </li></ul><ul><li>Trainee willing to bear the cost since higher wages offered for these skills </li></ul><ul><li>Specific Training </li></ul><ul><li>Training useful to the firm that provides the training </li></ul><ul><li>Costs split by the worker and the firm </li></ul>On The Job Training
  18. 22. Implications <ul><li>In case of specific training </li></ul><ul><li>Both worker and firm share returns </li></ul><ul><ul><li>Firm pays worker less than MRP </li></ul></ul><ul><ul><li>Worker received more than in other jobs </li></ul></ul><ul><li>Neither worker nor firm want to terminate contract </li></ul><ul><ul><li>Worker granted lifetime tenure </li></ul></ul><ul><ul><li>Lower overall turnover </li></ul></ul><ul><ul><li>“ Last hired, first fired” in bad times, lower turnover among senior workers </li></ul></ul><ul><ul><li>Specifically trained workers often go on temporary layoffs, wait to be recalled </li></ul></ul>
  19. 23. <ul><li>Investment or Consumption? </li></ul><ul><li>Not all education expenditures are an investment, some part is a leisure. </li></ul><ul><ul><li>Courses such as music appreciation yield consumption benefits rather than investment benefits. </li></ul></ul><ul><ul><li>By ignoring the consumption benefits of education, researchers overstate the investment costs of education and understate the rate of return. </li></ul></ul><ul><li>Non-Wage Benefits </li></ul><ul><li>Studies that examine only earnings of high school and college graduates understate the rate of return for two reasons. </li></ul><ul><ul><li>College graduates have greater fringe benefits as % of pay than high school graduates. </li></ul></ul><ul><ul><li>College graduates tend to work in more pleasant surroundings and have more interesting jobs than high school graduates. </li></ul></ul>Criticisms of Human Capital Theory
  20. 24. <ul><li>1.Human capital theory: </li></ul><ul><li>education improves work productivity </li></ul><ul><li>2. Signaling and screening hypothesis: education does not improve worker’s productivity </li></ul><ul><ul><li>Productivity depends on individual’s innate abilities </li></ul></ul><ul><li>Employers “screen” applicants to choose more productive/able workers </li></ul><ul><li>Employees - “signal” their high productivity/ability with higher level of education </li></ul><ul><ul><li>Education is less costly for higher ability workers </li></ul></ul><ul><ul><li>Low ability do not get education </li></ul></ul><ul><li>If an ability test could achieve the same ends, then education is a waste of resources </li></ul>Criticisms of Human Capital Theory
  21. 25. Increase in Educational Attainment
  22. 26. Rate of Return Per Year of College Education