Human Capital : Theory and Application

Who Are Workers? (Human Resources)

Cost?

Assets?

Business partner?

Agenda

IntroductionSchooling and SignalingOn the Job TrainingApplication-Executive Pay IssueDiscussion

Introduction

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

Individual Input(Investment) Education Outcomes

Social Input(Investment)

Productivity Earnings

CitizenshipSocial

Efficacy

*Source : Swanson & Holton III, 2001, p.110

A Model of Human Capital Theory

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 wageS. Fabricant (1959) : Intangible assetsG. Becker (1960) : ROR of difference in educationT. Schultz (1961) : US income has been increased in higher rate than combined amount of land, working hours and capital used to produceNobel Prize Winners

T. Schultz, G. Becker, M. Friedman, S. Kuznets, R. Solow

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 schoolingMarginal Rate of Return to Schooling : How much earnings increase if a person stays in school 1 more yearStopping rule : when it is optimal to quit school and enter job market (MRR=r)

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Potential Earnings Streams

MRR

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Schooling Decision

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

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

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NSW’s edu cost curve SW’s

edu cost curve

Self-Selection

On the Job Training

Training increases a worker’s productivity (HC stock) after trainingTraining is an investment with initial costs and expected future returnsThe 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)

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 generalSince 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)

Transferable Human Capital

training

Time

w1

VMP=W2

The employee will want to bear the full cost by accepting lower wage during training

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

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

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 ).

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

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)

20 Top-Paid CEOs in 2003

Name Company

2003 Salary

and Bonus

Long-term

Comp.Total Pay

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

Possible Explanations on CEO Compensation

Social Comparison : relationship to othersEconomic Approach : reward to success, depends on company sizeAgency Theory : self-motivated behaviorFat-Cat Theory : rent seekingHuman Capital Theory : increasing investment on human capital, type of required skill

Hiring Sources-Internal or External

*Source : Murphy & Zabojnik, 2004

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

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)

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?