College Education as an Investment in Human Capital

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College education as an investment in human capital. From the viewpoint of individualsBenefitCostFrom the view point of entire society, External economies of higher educationDesirable social norm and valuesHigher literacy enhance communication and democracyProduce competent leaders who has favorable effects on the societyIt is the private costs and benefits that influence an individual's college-going behavior..

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College Education as an Investment in Human Capital

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1. College Education as an Investment in Human Capital Reading: Arai (1998) Cohn and Geske (1992)

3. Analytical methods Cost-Benefit Analysis Attend college if Benefit>Cost, Methods Calculate the “present value” of education Calculate the “rate of return to education” Mincer’s earnings function (Mincer 1974) Measure the return to schooling

4. Why do you go to college? Cost-Benefit Analysis Private cost Tuition Forgone earnings and work experience Private benefit Earnings Non-monetary benefits

5. Private Cost (opportunity cost) Direct cost: tuition fees, books (Room and board should not be included as part) Forgone earnings: Upon attending college, the potential earnings as a high-school graduate worker during the school years will be lost. For a full-time college student, one-year college education incurs one-year forgone earnings (i.e. one-year salary of semi-skilled workers with high school diploma) For a part-time college student, the forgone earnings equals the one-year forgone earnings for full-time students minus the part-time earnings. Efforts and psychological cost Depends on academic ability

6. Private Benefit Monetary benefit “College wage premium”: Wage difference between college and high school Lower the probability of unemployment Higher the probability to be promoted as a section leader/manager More likely to engaged in jobs with better fringe benefits and working conditions than high school graduates

7. Private Benefit Non-monetary benefit Psychological benefits (social acceptance) Improve ability to communicate, collect information, and make wise decisions; Yield benefits in capital and marriage markets Family planning: number of children Bearing and education of children Health management of the family Culture and values Adoption of new technologies

8. Option value An investment in college education makes the following options available for the future: go to graduate school after graduation; dropout if better career opportunities arise. In addition to the monetary and non-monetary benefits listed earlier, the benefit to invest in college education also includes the values of future options available upon the investment.

12. Private cost-benefit analysis: A simple model Arai (1998, p. 17, Fig. 2.1) Area A: college wage premium from the time of college graduation to the time of retirement Positive except for the first a couple of years after graduation Area B: forgone earrings Area C: direct cost of attendance Remark: college earnings can be smaller than high school earnings in the first a few years because of the loss of work experience while in college. Total private costs of college education = B+C Net private benefits = A-(B+C)

13. Basic theory of college-going decision making (1) 1. The present-value method: Cash flow T indicates the year when you retire from job markets Present value of the cash flow i denotes the discount rate (e.g. the market interest rate)

14. The net present value of the investment Decision: Investment in a college education is worthwhile only if V(i)?0

15. Example Two periods: Period 1: attend college period 2: work Cash flow Net present value

16. Basic theory of college-going decision making (2) 2. Internal-rate-of-return method: The internal rate of return (i*) of a investment equals the break-even discount rate.

17. Continued from the previous example:

18. The internal rate of return of higher education: I won’t ask complicated numerical questions in exam. However, the concept of internal rates of interest of the investment in education is very important.

19. Determinants of the internal rate of return to education Costs (-) Benefits (+) Number of years (T) in which the individual expects to acquire benefits (+) The older the age of retirement, the longer the harvest period and thus the more likely to increase the PV of investment and the internal rate of return Market rate of interest (-) The lower the rate of interest, the more likely to invest in college education

20. Mincer’s earnings function Describe the determination of an individual’s wage level. J. Mincer (1974) found that under certain circumstances, the log of earnings (lnY) can be determined by the following function: lnY = ? + ?S + ?X + ?X2 + ?Z + e where ?, ?, ?, ? and ? are parameters (coefficients) S is the number of years of college education X is work experience Z is a vector of characteristics (race, gender…) e is initial earning potential as a high school graduate, which usually cannot be fully observed.

21. Consider twin brothers, one attending college for a year (S1=13,X1=0), the other living under welfare as a high school graduate (S0=12,X0=0). Suppose that they share the identical earning potential and assume that the potential does not depend on education or work experience (e1=e0). Because they have identical characteristics (Z1=Z0), work experience(X1=X0) and earning potential, the Mincer’s wage function tells us that lnY1 = ? + ?S1 + ?X1 + ?X12 + ?Z1 + e1 lnY0 = ? + ?S0 + ?X0 + ?X02 + ?Z0 + e0 Taking difference in the expectations E[lnY1- lnY0]= ?(S1-S0) +E[e1-e0] = ? in this case. In general, The parameter ? can be interpreted as the rate of return to college education per school year after controlling for work experience, individual characteristics, and earnings potential: = (lnY1-lnY0)/(S1-S0) See Arai (1998, p. 35, Fig 2.4)

22. Note An individual’s decision to attend college doesn’t incorporate social benefits and costs. Thus an individual’s decision to attend college is not necessarily optimal from the viewpoint of society as a whole. This leads to an under-investment in education. Externalities Remedy: How to achieve social optimal? If the social internal rate of return to education is higher than the private rate, the government can induce more individuals to invest in college education by using policy tools such as tuition subsidies (e.g. grants, low-interest-rate loans, and tax reduction).

23. Statistics College wage premium Compare wage level between college attendees and high school graduates On average, the college wage is higher than the high school wage by 36%. After controlling for race, gender, family background, and academic ability, the college wage is higher than the high school wage by 19%. Potential problems (ability or taste for education cannot be observed): Ability bias: overstate the college wage premium Discount bias: understate

24. Two ways to measure the rate of return to education In Human Capital Theory, we calculate the return to education: PV methods (internal return to education i ) Mincer’s earnings function (?) Essence of Human Capital Theory: Causal effects of schooling on earnings Higher education ? an increase in productivity ? an increase in wage

25. Problems of Human Capital Theory Does college education really increase your productivity? Or it is just a screening devise to select more productive people and give them diploma as a signal in the job market!? Signaling theory (next class)

26. Measurement issues Estimates of ? or i may not necessarily capture the causal effect of education on earnings. Ability Bias (Upward Bias): The potential earnings ability can be correlated with education and experience. The observed college premium can be a spurious consequence of unobserved earning ability. Other factors that cannot be measured by data analysts but affect schooling and earnings ability include communication ability and family network. May be the college wage premium only captures the return to ability or family network, instead of the return to education!? We may have overstated the true rate of return to education. We call this upward bias as “ability bias”

27. Downward bias: We might have ignored non-pecuniary benefits of investment in HE, including benefits in capital and marriage markets, fridge benefits and working conditions…. In Japan, wage inequality among college attendees is lower than that among high school graduates. I.e. Not investing in college can be risky. Thus, one of the benefit to attend college is to avoid the earnings risk or unemployment risk. In US, the opposite Cause understatement

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