Human Capital Theory

History

• Schultz, 1961– As economic growth occurs economies tend

to use less traditional capital– Income has risen faster than the combined

growth in land, labor and physical capital

• All these can be explained if we add human capital to our explanations

History (cont.)

• Becker, 1962– Unemployment rate negatively related to skill

levels– Younger workers change jobs more frequently

than older workers– Abler persons receive more training and

education than older workers

Forms of CapitalForms of Capital

• Financial CapitalFinancial Capital

• Human CapitalHuman Capital

• Social CapitalSocial Capital

• Intellectual CapitalIntellectual Capital

• Knowledge CapitalKnowledge Capital

The Theory of Human The Theory of Human CapitalCapital

• When does it pay to invest in higher When does it pay to invest in higher education?education?

• When does it pay to train a worker?When does it pay to train a worker?• How can the training costs and rewards How can the training costs and rewards

be structured so as to make both the be structured so as to make both the shareholders and workers better off?shareholders and workers better off?

• Does a firm have to pay its trained Does a firm have to pay its trained workers more?workers more?


• What kind of training should be given? What kind of training should be given? Should it be as general as possible, or Should it be as general as possible, or should it be idiosyncratic to the current should it be idiosyncratic to the current firm?firm?

• What can be done about retention of What can be done about retention of trained workers? How can they be tied trained workers? How can they be tied to the firm?to the firm?


• What kinds of workers are the best What kinds of workers are the best candidates for the training program?candidates for the training program?

• Who should be laid off if downsizing is Who should be laid off if downsizing is necessary?necessary?

HUMAN CAPITAL: HUMAN CAPITAL: SOME BASIC THEORYSOME BASIC THEORY

• Theodore Schultz and Gary Becker were awarded the Nobel Prize in Economic in 1979 and 1992. Both scholars were pioneers in human capital analysis.

• Human capital theory applies to the acquisition of skills.

Skills can be acquired in a number Skills can be acquired in a number of ways: of ways:

• Formal education• The primary way to acquire human capital. • On-the-job training (OJT)• The most important kind of human capital in

its impact on business practice. • Other human capital investment• Exercise, personal beautification

expenditures, enrichment courses, and health care…etc.

Formal SchoolingFormal Schooling • What made you decide to go to college?• Career considerations.• In the theory of investment in physical capital,

a manager decides to buy a machine if the present value of the flow of additional revenues generated by the machine exceeds the operating and purchasing cost of the machine.

• Similarly, the individual must bear a cost now to pay for schooling or other training in hopes that it will bring higher earnings in the future.

The Cost of Going to SchoolThe Cost of Going to School

• Direct Costs– tuition, books, living expenses

• Opportunity cost– Forgone salary

Choosing Whether to Stay in Choosing Whether to Stay in SchoolSchool

• Kt: salary of those with a high school diploma will earn in year t.

• Dt: salary of those who drop out after 11th grade.

• r: interest rate

• C0: direct cost of schooling.

• The individual will invest in the final year of school if the following condition holds:

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Choosing Whether to Stay in Choosing Whether to Stay in SchoolSchool

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The earning differentials between a high school graduates and a high school dropout.

The discount factor: to bring the earning differentials back to present value.

Year to retirement

Direct cost of schooling

Forgone salary

Why get an Master degree?Why get an Master degree?• Kt: Your monthly salary, assuming starting salary K1=40,000• Dt:Monthly salary of those with a college degree, assuming

starting salary D1=35,000• r: interest rate, assuming r=.06• C0: Direct cost of schooling. Suppose that 2 year expenses

at RSOM is Rs 150,000 . more than a college graduate. • Suppose your salary increase by 5% every year, • A college graduate’s annual increase = 3%

Direct cost (Rs 150,000) + forgone salary (approximately Rs 85,000) = Rs 235,000,.

Suppose that after taking this Suppose that after taking this course, your IQ level improved course, your IQ level improved substantially, say, from substantially, say, from 9090 to to

140140..

As a result, your annual salary As a result, your annual salary increase in the next 20 years will increase in the next 20 years will

be be 10%10% rather than rather than 5%!5%!

For early years of schooling, For early years of schooling, the returns to schooling the returns to schooling

exceed the costs.exceed the costs.• Two reasons:• First, there is much to be learned when an

individual knows very little. • A little bit of school can affect productivity dramatically.

• Second, the costs of going to school are very low during the early years of schooling.

• With public subsidies to education, direct costs are virtually zero up through high school.

• The forgone earnings are low during the early years.

The above discussions implies The above discussions implies that...that...

• It pays for everyone to invest in some formal education, and there is also an optimal stopping date for each individual as well.

• The stopping date is the year when the inequality in the equation switches…

The above example assumes The above example assumes a constant rate of return, but a constant rate of return, but that is usually not the case. that is usually not the case.

The rate of return for an The rate of return for an MHRM is better characterized MHRM is better characterized by an exponential function. by an exponential function.

Are you making a Are you making a wrong investment? wrong investment?

Non-pecuniary benefits of Non-pecuniary benefits of schoolingschooling

• People attend school for other reasons as well. • For example, learning may be regarded as a

form of intrinsic reward in itself…• Additional schooling may put you in a position

for a more rewarding job. The rewards can take the form of higher status, more flexibility, more interesting assignments…etc.

• We need only to think of K as the value of improvement in well-being at work that result from additional schooling...

Effects of Costs and Benefits of Effects of Costs and Benefits of Education on the Optimal Amount of Education on the Optimal Amount of

SchoolingSchooling• Increases in tuition rates decrease school

enrollment.

Individuals who already have high-paying jobs will be reluctant to go back to school to acquire an MBA.

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Effects of Costs and Benefits of Effects of Costs and Benefits of Education on the Optimal Amount of Education on the Optimal Amount of

SchoolingSchooling• Increases in the interest rate mean less

schooling.

The higher the interest rate, the lower is the value of future earning. The higher is the interest rate, the better it is to work and put your money in the bank. Schooling is a better investment when the alternative investment are poor choices.

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Effects of Costs and Benefits of Effects of Costs and Benefits of Education on the Optimal Amount Education on the Optimal Amount

of Schoolingof Schooling• High interest rate increases cost of borrowing.

Banks are generally reluctant to lend to students whose only collateral is their future earning power. This means that children whose parents are poor might face much higher borrowing costs and consequently , would drop out of school to work at an earlier age. Financial aid programs that target the poor could offset this tendency.


of Schoolingof Schooling• The longer the work life, the more

investment in schooling.

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of Schoolingof Schooling• Will women obtain less schooling than men?• Yes. ==> The average woman spends less time

in the labor market than the average man. • No. ==> Even if women are less likely to spend

time in the labor market, their training may be valuable in increasing their productivity at home. Future housewives may take more humanities and education courses, which have more general applicability. More educated people may be better at raising children?


of Schoolingof Schooling• When the difference in earnings between educated and less

educated worker (K - D) increases, school attendance should rise.

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(K - D) is likely to reflect differences in productivity. Improvement in school quality would be expected to have a positive effect on K, and therefore would be expected to increase education. Education is complementary with a technologically advanced society.

On-the-Job TrainingOn-the-Job Training• General on-the-job trainingGeneral on-the-job training: an investment in : an investment in

human capital that is effective in raising human capital that is effective in raising productivity at the firm providing the training productivity at the firm providing the training and at some other firms by an identical amount. and at some other firms by an identical amount.

• Firm-specific on-the-job training:Firm-specific on-the-job training: It makes a It makes a worker more productive at the current firm, but worker more productive at the current firm, but has no effect on productivity elsewhere. has no effect on productivity elsewhere.

• Example: Database programmer at Formosa Plastics. Example: Database programmer at Formosa Plastics. An account manager who knew a great deal about the An account manager who knew a great deal about the idiosyncrasies of the company’s major clients. idiosyncrasies of the company’s major clients.

General On-the-Job TrainingGeneral On-the-Job Training

• Suppose that the firm has the opportunity to Suppose that the firm has the opportunity to provide a 25-year-old worker with one year of provide a 25-year-old worker with one year of on-the-job training. on-the-job training.

• The training costs The training costs Rs 2500Rs 2500 during the first year, during the first year, raises the worker’s productivity by raises the worker’s productivity by Rs 50,000Rs 50,000 per year thereafter. per year thereafter.

• What wage should the firm pay the worker?What wage should the firm pay the worker?


• If the firm leave the worker’s wages unaltered, rival If the firm leave the worker’s wages unaltered, rival firms can easily pick off the worker by giving the firms can easily pick off the worker by giving the worker a raise up to the full Rs 50,000 of increased worker a raise up to the full Rs 50,000 of increased productivity. productivity.

• To keep the worker, the original firm will be forced To keep the worker, the original firm will be forced to raise wages up to the new level of worker to raise wages up to the new level of worker productivity. productivity.

• But why would a firm bear a Rs 25000 cost to make But why would a firm bear a Rs 25000 cost to make the worker more productive when it can capture the worker more productive when it can capture none of the gain to that productivity?none of the gain to that productivity?


• Although the firm will be unwilling to pay for the Although the firm will be unwilling to pay for the investment, the worker will be happy to do so. investment, the worker will be happy to do so.

• By paying Rs25000 at the outset, he buys By paying Rs25000 at the outset, he buys himself a raise of Rs 50000, which persists for himself a raise of Rs 50000, which persists for each year that he works hereafter. each year that he works hereafter.

• Thus the worker should offer to pay the firm for Thus the worker should offer to pay the firm for the on-the-job training and the firm should be the on-the-job training and the firm should be happy to oblige. happy to oblige.

Do workers actually pay firms Do workers actually pay firms for training?for training?

• Workers do pay for their training by accepting Workers do pay for their training by accepting lower wages than they would otherwise receive.lower wages than they would otherwise receive.

• Example: Example: • Apprenticeships in the early days.Apprenticeships in the early days.• Young cooks work in established restaurants at Young cooks work in established restaurants at

low wages. low wages. • Assistant professors are often willing to take Assistant professors are often willing to take

lower salary in major universities.lower salary in major universities.

SummarySummary• When on-the-job training is general, workers When on-the-job training is general, workers

must pay for it themselves through reduced must pay for it themselves through reduced wages. This means that any worker who would wages. This means that any worker who would like to undertake the training program should be like to undertake the training program should be given the opportunity to do so. given the opportunity to do so.

• The workers most likely to select jobs that offer The workers most likely to select jobs that offer training at the cost of low initial wages are training at the cost of low initial wages are young workers and others who plan to remain in young workers and others who plan to remain in the labor market for a long period of time.the labor market for a long period of time.

Firm-specific On-the-job Firm-specific On-the-job TrainingTraining

• Workers’ firm-specific OJT cannot be pirated by Workers’ firm-specific OJT cannot be pirated by other firms. Since the skills are firm specific, the other firms. Since the skills are firm specific, the firm can offer higher wage than outside firm.firm can offer higher wage than outside firm.

• This suggests that the firm should be willing to This suggests that the firm should be willing to pay for firm-specific OJT. pay for firm-specific OJT.

• But such is not the case.But such is not the case.

Firms bear the full cost of Firms bear the full cost of trainingtraining

• Suppose that the firm agreed to finance all the Suppose that the firm agreed to finance all the training, in return for which the firm would training, in return for which the firm would expect to receive expect to receive the entire differencethe entire difference between between productivity and outside wage. productivity and outside wage.

• The worker can ask for a higher wage. The The worker can ask for a higher wage. The worker knows that if he quits, the firm loses its worker knows that if he quits, the firm loses its investment. Further, the worker is indifferent investment. Further, the worker is indifferent between working here and working elsewhere between working here and working elsewhere because the wage is the same. because the wage is the same.

Workers bear the full cost of Workers bear the full cost of trainingtraining

• Since the worker has borne the full cost of Since the worker has borne the full cost of investment, he expects to get the full return. investment, he expects to get the full return.

• But this will make the firm indifferent between But this will make the firm indifferent between hiring the skilled, but highly paid worker and hiring the skilled, but highly paid worker and hiring the unskilled, less well-paid worker. hiring the unskilled, less well-paid worker.

• Now the worker is at a disadvantage. The firm Now the worker is at a disadvantage. The firm can threaten to fire the worker unless the worker can threaten to fire the worker unless the worker takes a lower wage. takes a lower wage.

SolutionSolution• The solution is to split the costs and benefits. The solution is to split the costs and benefits. • Since the firm needs to give up some of the Since the firm needs to give up some of the

profit from investing the worker, it can ask profit from investing the worker, it can ask the worker to bear some of the costs. the worker to bear some of the costs.

• Since the worker knows that the firm will be Since the worker knows that the firm will be able to force him to accept a wage less than able to force him to accept a wage less than his productivity when he is skilled, he can his productivity when he is skilled, he can ask the firm to bear some of the cost. ask the firm to bear some of the cost.

Mutual beneficial Mutual beneficial ArrangementArrangement

• The shared benefits mean that both worker and The shared benefits mean that both worker and firm have incentives to remain together. The firm have incentives to remain together. The worker is worth more to this firm than to any worker is worth more to this firm than to any other. The worker earns more at the current firm other. The worker earns more at the current firm than he does at any other firm.than he does at any other firm.

• The scheme that shares the costs and benefits The scheme that shares the costs and benefits makes separation much less likely to occur. makes separation much less likely to occur.

SummarySummary• Since workers may not always have the best Since workers may not always have the best

information about their departure probabilities information about their departure probabilities and since firms bear costs when workers with and since firms bear costs when workers with firm specific human capital leave, a firm takes a firm specific human capital leave, a firm takes a more active role in selecting workers to offer firm-more active role in selecting workers to offer firm-specific OJT than it does for general OJT. The specific OJT than it does for general OJT. The workers that the firm wants to train are those with workers that the firm wants to train are those with low turnover probabilities whose productivity will low turnover probabilities whose productivity will be greatly enhanced by the training. be greatly enhanced by the training.

Determining specificity of Determining specificity of human capitalhuman capital

• Experience--total time in the labor marketExperience--total time in the labor market• Tenure--experience in a particular firmTenure--experience in a particular firm• If there is no systematic difference in wages If there is no systematic difference in wages

between those who stays with the firm and between those who stays with the firm and those who leaves, then it can be inferred that those who leaves, then it can be inferred that the human capital obtained at the first firm must the human capital obtained at the first firm must be general. If wages are lower for those who be general. If wages are lower for those who leaves the firm than for those who stays, it can leaves the firm than for those who stays, it can be inferred that some of the human capital was be inferred that some of the human capital was probably firm specific. probably firm specific.

Determining specificity of Determining specificity of human capitalhuman capital

• The extent to which skills are general or specific The extent to which skills are general or specific may not be know in advance. A firm may be may not be know in advance. A firm may be trying to decide whether it will lose much by trying to decide whether it will lose much by hiring from the outside rather than training its hiring from the outside rather than training its own workers. own workers.

• The company can also compare the productivity The company can also compare the productivity of workers with 10 years of tenure at the firm to of workers with 10 years of tenure at the firm to that of workers with 10 years of total experience, that of workers with 10 years of total experience, but who has less than 10 years of tenure in the but who has less than 10 years of tenure in the firm. firm.

Human Capital Theory

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