1.Is education a good investment?

2.Why do some people invest in education while others do not?

• Any activity with current cost and future benefits can be analyzed like an investment.

• Investment in physical capital (man-made goods) contributes to production of more goods/services– Easily financed

• Investment in human capital (expenditures on education and training) improves quality and/or quantity of production of an individual– Yields a rate of return (higher earnings) like physical capital– Embodied in the person investing– Illiquid asset – can’t sell quickly– Risky: uncertainty regarding life expectancy, potential ability,

returns to a person due to unexpected life events.– Difficult to finance

Investment in Human Capital

Increase in Educational Attainment

0%

20%

40%

60%

80%

100%

1960 1970 1980 1990 2005

Perc

ent

Percent High School Graduate or More

Percent College Graduate or More

• 1970: 36%• 2006: 12%

of labor force was high school dropouts

Age-Earnings Profiles of Full Time Workers, 2005

Age-Earnings With and Without College

Age

Annual Earnings

6518

•High School curve is age-earnings profile if a person does not attend college.

•College curve is age-earnings profile if attends college

•Total cost of college :• direct costs, tuition (1) • indirect costs, lost

earnings (2)

•Benefit of attending college is increase in earnings (3).

22

Future Extra Earnings (3)

High School

College

Indirect Costs (2)Direct Costs (1)

Age-Earnings With and Without College• Adult student

working full time while earning a degree

• To study or not to study?

• Compare present value of benefits with present value of costs across lifetime

Age

Annual Earnings

6518 22

Future Extra Earnings (3)

High School

CollegeNo Indirect Costs (2)

Direct Costs (1)

• $100 received 1 year from today– less valuable than $100 today– can put $95.24 in the bank at 5% to get $100 in a

year– $100 = $95.24*(1+0.05)– Future Value = $100– Present Value = $95.24– Interest (Discount) Rate = 5%

• future benefits are discounted to present– using interest rate– farther a benefit is in future, less it is worth today

• compare with current costs

Present Value of Future Income

PV = Ex:

where i = 10%

PV = Def:

• Discounting converts the value of future dollars into today’s dollars through interest (discount) rate

• Present value (PV) of a payment received one year from now is:

Present Value

Payment 1 year from now

1 + Interest rate

$ 100.00$ 110

1.10 =

NetPresent Value

of Earnings(4)

Discount1/(1+0.1)

(3)Incremental

Earnings(2)

Year(1)

PV of $8,000 Investment in Webmaster Training Program(Interest Rate = 10 %)

Discounted Present Value

0 -$ 8,000 1.000 $ -8,000123

$ 3,000 $ 4,000 $ 5,000

0.9090.8260.751

$ 2,727$ 3,305$ 3,755

$ 1,787

• Melinda is considering taking a webmaster training program • Costs: tuition $3,000, forgone earnings $5,000. • The training program will increase Melinda’s earnings by $3,000,

$4,000, and $5,000 for the 3 years she plans on working. • She can borrow funds at an interest rate of 10%, so we will

discount future expected income at 10% rate.• Find net present value (PV) of this training program• PV of the training program is positive, Melinda should take

the training program.

Present Value

PV = E0 + E1

(1 + r) + En

(1 + r)n

E2

(1 + r)2 + +. . . . .

A person should attend college if net present value is greater than 0, or PV (costs) < PV (benefits)

• Differences in time preferences•presented-oriented people have high r

•discount future earnings heavily•PV (benefits) lower for them get less schooling

•future-oriented people have low r•Do not discount future earnings heavily•PV (benefits) higher for them get more schooling

Present value of a future stream of incremental earnings or costs (E)

Costs are negative values of E, benefits are positive

• Length of income stream– The longer the stream of positive incremental earnings, the

more likely the net present value will be positive.• Women live longer – higher benefits of education• Women have interrupted careers – lower benefits• Younger people – higher benefits

• Costs of attending college – The lower the cost of attending college, the more likely the

net present value is positive.• Older students - higher opportunity cost of attending college

• Earnings differential– Larger college-high school earnings differential - more likely

positive net present value• College attendance rose in 1980s as college-high school premium

increased.

• Women’s investment in education – May include quality of husband (extra benefit)– Total returns may be smaller due to discrimination

Generalizations

Diminishing Returns to Schooling• Investment in education is

subject to the law of diminishing returns.

• The increases in knowledge decline with each additional year of schooling.

• Rate of return schooling = % change in earnings from extra year in school

• Return to 13th year of schooling = $3,000/$20,000 15%

• Return to 14th year of schooling = $2,000/$23,000 8.7%

Demand for Human Capital

Years of Schooling

Dis

coun

t ra

te

• People get education until the point where the benefit of one more year equals its cost

•Al has higher discount rate than Bob

•Why?• Al more present-oriented

• Al faces higher cost of borrowing (he is poor)

•Bob chooses to graduate from college

•Al’s optimal choice is not go to college

Benefit ofschooling (return)

rAL

rBOB

1

2

12 16

Cost ofschooling

Rate of Return Per Year of College Education

17.314.9 13.9

11.49 8.1

6.5

02468

101214161820

Rat

e of

Ret

urn

(%

)

• Hard to measure returns to education• Those with more ability (i.e., intelligence,

motivation, and self-discipline) are more likely to go to college. – Even without a college degree, they would have earned

more than those who decided not to go to college.– High earnings of college graduates reflect both

• greater ability • Schooling

– rate of return to schooling is overstated

Statistical Problem

• You decision to invest in education yields substantial external or social benefits for society– More educated workers - lower unemployment rates.– Education raises participation in political process.– Children grow up in a better home-environment if

parents are more educated.– Research discoveries of more educated persons

• Positive externality: Benefit to the third party– Immunization, education, inventions – Free markets under-allocate resources to such activities

• Negative externality: Cost to the third party– Air pollution by chemical plant, loud music, drunk

driving– Free markets over-allocate resources to such activities

Private vs. Social Perspective

General Training• Skills used in various firms• Accounting, word

processing, college degree• Firms will offer higher wage

for this training• Trainee willing to bear the

cost since higher wages offered for these skills

Specific Training• Training useful to the

firm that provides the training

• Costs split by the worker and the firm

On The Job Training

Implications• In case of specific training• Both worker and firm share returns

– Firm pays worker less than MRP– Worker received more than in other jobs

• Neither worker nor firm want to terminate contract– Worker granted lifetime tenure– Lower overall turnover– “Last hired, first fired” in bad times, lower turnover

among senior workers– Specifically trained workers often go on temporary

layoffs, wait to be recalled

• Investment or Consumption? • Not all education expenditures are an investment,

some part is a leisure.– Courses such as music appreciation yield consumption

benefits rather than investment benefits.– By ignoring the consumption benefits of education,

researchers overstate the investment costs of education and understate the rate of return.

• Non-Wage Benefits• Studies that examine only earnings of high school and

college graduates understate the rate of return for two reasons.– College graduates have greater fringe benefits as % of pay

than high school graduates.– College graduates tend to work in more pleasant

surroundings and have more interesting jobs than high school graduates.

Criticisms of Human Capital Theory

1.Human capital theory: education improves work productivity

2. Signaling and screening hypothesis: education does not improve worker’s productivity• Productivity depends on individual’s innate abilities

• Employers “screen” applicants to choose more productive/able workers

• Employees - “signal” their high productivity/ability with higher level of education• Education is less costly for higher ability workers• Low ability do not get education

• If an ability test could achieve the same ends, then education is a waste of resources

Criticisms of Human Capital Theory

Increase in Educational Attainment

0%

20%

40%

60%

80%

100%

1960 1970 1980 1990 2005

Perc

ent

Percent High School Graduate or More

Percent College Graduate or More

Rate of Return Per Year of College Education

17.314.9 13.9

11.49 8.1

6.5

02468

101214161820

Rat

e of

Ret

urn

(%

)