Topic 2 - Human Capital

8/14/2019 Topic 2 - Human Capital

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Topic No: 2

Human Capital


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Lecture Map

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


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Introduction: The Human Capital

Revolution in Economics

Rediscovering the role of education to the

wealth of nations. Searching for clues on income distribution

Paretos 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.


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Revolution in Economics Major contributors:

1. Kuznets, Simon and Milton Friedman. (1945),Income fromIndependent Professional Practices, National Bureau of EconomicResearch.

2. Mincer, Jacob (1958), Investment in Human Capital and PersonalIncome 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.


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Revolution in Economics6. 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, WithSpecial Reference to Education, New York, National Bureau of Economic Research.

9. Mincer, Jacob (1974),Schooling, Experience, and Earnings, National Bureau ofEconomic Research, New York.


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Definition Of Human Capital

What is capital?

What is human capital?

Ans: human capital refers to the collection ofinnate andacquiredindividual abilities that are substantiallydurable, persisting over some significant portion of thelife of the possessor. Furthermore, the personal attributesreferred to under this rubric are restricted to positiveabilities and capabilities. In other words, their natureis such as would normally yield some stream of benefits,by enhancing the possessors performance in one or moresocially valued activities.


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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


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Components Of Human Capital

Social capabilities(know-how, know-who):

e.g., diligence, loyalty,cooperativeness, trust, etc.

Flexibility:Multi-task performance,

re-trainability.

Problem-solving,

leadership,managing complex tasks.

Psycho-motorbased skills

("know-how","can-do").

HumanCapital

LongevityHealth

Physiologicalcondition:

e.g. Strength,eyesight etc.

Proceduralcapabilities

Cognitivecapabilities

("know-why"'know-what")

Tangible Intangible

Creativeness,innovativeness


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The Human Capital Theory

Introduction

The human capital model

Generalizations and implication of the

human capital model

Criticisms of human capital theory


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Introduction

The early 1960s witnessed what has been

described in the economics literature as the

"human investment revolution in economicthought" (Bowman 1966). Expenditures on

education, whether by the state or

households, have been treated as investmentflows that build human capital.


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Introduction

Basic Concepts Of Investment In HumanCapital. When a firm invests in physical capital, it is acquiring

some assets that is expected to enhance the firms flowof net profits over a period of time. For example, acompany might purchase new machinery designed toincrease the out put and therefore sales revenues over,say, the 10-year projected life of the machinery. The

unique characteristics of investment is that currentexpenditures or costs are incurred with the intent thatthese costs will be more than compensated by for byenhancedfuture revenues or returns.


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Introduction

Once education is treated as an investment, the immediatenatural question is: what is the profitability of thisinvestment in order to compare it to alternatives? Suchcomparison can provide priorities for the allocation of

public funds to different levels of education, or can explainindividual behaviour regarding the demand, or lack ofdemand, for particular levels or types of schooling.

For establishing education investment priorities at themargin the human capital model is the main theoretical

foundation. So, now I present the human capital model.


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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.


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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.


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18 22

Age

Annualearnin

gs

H

H

C

C

65

(3)

Incremental earnings

(2)

Indirect

cost

(1)

Direct

cost

Age-Earnings Profiles with and without college education


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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 andreceived at a different point in time has different value. Ameaningful comparison of the costs and benefitsassociated with the college education requires that thesecosts and benefits be compared in terms of common point

in time, for example, present. So, calculate the net present value ofpresent and future

costs and benefits.


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Time preference.

Why rupees expended or received at different point in time

has different value.

Because of interest payment on borrowed or rentedmoney.

And interest is paid because oftime preference.

Present Value Formula.

Vp (1+i) = V1.

)1(

1

i

VVp

+

=


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Extended Discounting Formula

npi

En

i

E

i

E

i

EEV

)1()1()1()1(3

3

2

210

+

++

+

+

+

+

+

+=

46

64

3

21

2

2019

18)1()1()1()1( i

E

i

E

i

E

i

EEVp

+++

++

++

++=

Formula for High School Graduate

=

+

=64

1818)1(n

n

n

pi

EV

More compact formula


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Decision Rule & Example

NPV Decision rule: Vp > 0

Example

C = 6000

E1 = 2500

E2 = 3000

E3 = 3500


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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 ofdiscount at which the net present value of a human

capital investment is 0 (zero)

0)1()1( 11 =

+

+= ==

nn

r

E

r

C

NPV

Internal rate of return


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Internal Rate Of Return

IRR Decision rule: r = i


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Generalization & Implications

Length of income:

Longer the length of income higher the internal rate of

return on human capital investment or more likely thatthe 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.


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Costs. Other things being equal lower the costs of human capital

investment, the larger number of people who will find that investmentto be profitable.

If the direct or indirect cost of attending college were to fall, wewould expect enrollment to rise.

Illustration: The guaranteeing of student loans by thegovernment eliminates the risk to the lender and lowers theinterest charged for borrowed funds to attend college. Byreducing the private cost of attending college education, suchloans guarantees increased college enrollments.

Similarly the state of the economy may influence collegeenrollments through its effects on the indirect or opportunity costof attending college.


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For example, if recession reduces the

earnings that high school graduates achieve,

or, alternatively, reduces the probability ofobtaining 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 ineducation profitable for some who

previously found it to be unprofitable.


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Earnings differentials.Not only the length of the incremental earnings stream

critical in making a human capital investment decision,but so as thesize of that differential. The generalization

is that,

Ceteris paribus, the larger the earnings differential

between high school and college graduates, thelarger the number of people who will invest in

college education.


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Criticisms Of Human

Capital Theory Consumption or Investment

Non-wage benefits

The abilityproblem

Thescreeningtheory

C i Of H


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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 theinvestor has to forgo the present consumption in anticipation of thefuture 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.

C i Of H


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Comparison Of Human


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 thedepreciating 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.

C i Of H


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Comparison Of Human


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 humancapital 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 theirhuman capital will dictate what the market will be willing to offer for their

services.

C i Of H


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Comparison Of Human


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 ownerto 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 humancapital is not marketable. Only the services that emanate

from this stock are market goods.

C i Of H


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Comparison Of Human


Financing: lenders are more willing to lend funds forthe investment in physical capital than in investment inhuman capital because the former is marketable andcontinue to be a good collateral. Physical capital caneasily be sold, seized, jointly owned and transferred bysale or by inheritance.

whereas human capital is intangible and in dissociablefrom its owner. This makes the private finance for theacquisition of human capital harder to obtain.

The gestation period for physical capital is smaller thanfor human capital.

Mobility wise both are different.


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Human Capital Formation

Stages of human capital formation

Primary education

Higher education On-the-job training

Retraining

Retirement


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Human capital and economic growth

Theoretical background

Links through which human capital affects

economic growth (Chain of reasoning).


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The classical growth theories predicted that,

economies will stagnate after reaching the high

growth levels.And there is no continues rise in economic

growth.


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Neoclassical growth theory of Solow (the Solowgrowth model) also predicted that economies willstop 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). SOproblem again. To solve the problem develop models that explain

technological progress.


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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.


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Links of Effects

1. At the macro level human capital can beviewed as a factor of production coordinatewith physical capital (Aggregateproduction function approach) Its 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 Europeand the failure of foreign aid to LDC's.


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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 knowledgewhich is the source of innovation and of technicalchange which propels all factors of production. Thislatter function of human capital generates worldwideeconomic growth regardless of its initial geographiclocus.

Human capital as a source of new knowledge shiftsproduction functions upward and generates worldwideeconomic growth.


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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.

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Topic 2 - Human Capital