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Investment in Human Capital Model-Part I

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  1. Topic 3 Part III Investment in Human Capital Model-Part I

  2. Differences Between the Models of Education • Education as signaling model • Education as human capital investment

  3. Education as Signaling Model • Assumes the existence of differences in innate abilities (productivity types) of individuals and that these innate abilities are observable only by the worker • Underlines the role of education as a signaling device, used for the high type worker to obtain the desired type of job and earnings

  4. Education as Signaling Model • Abstracts for the role of education on productivity enhancement • Remember that it assumes that the firm gets the same profits from educated or non-educated workers • What matters for the firm is the productivity type or innate abilities of the worker

  5. Human Capital Investment Model • Underlines the role of education on human capital enhancement (i.e., increase of productivity through education) • Abstracts for differences in innate abilities of individuals, and therefore, it does no consider the role of education as signaling

  6. Human Capital Investment Model • Our discussion of the human capital theory is based on the work of Gary Becker (Nobel Prize in Economics, 1992) “Investment in Human Capital: A Theoretical Analysis,” Journal of Political Economy, 1962

  7. Human Capital Investment Model • The essence of the human capital theory is that investments are made in human resources so as to improve their productivity and therefore, their earnings • Costs are incurred by potential workers in the expectation of future benefits. For this reason, the term “investment in human resources” is used

  8. Human Capital Investment Model • Is investment in human capital economically worthwhile for an individual? • The answer depends on whether or not the benefits from the investment exceed the costs incurred

  9. Economic Analysis of Investment in Human Capital • We will perform an inter-temporal analysis of economic costs and benefits of acquiring education • This framework is analogous to the one used in the investment in physical capital decision

  10. Economic Costs of Human Capital Acquisition • In calculating the costs of human capital acquisition, we will need to use the “economic cost” concept • Explicit costs incurred in acquiring education (books, tuition fees, etc.) • The opportunity cost or income forgone while people acquire education (while people enhance their human capital)

  11. Economic Benefits of Human Capital Acquisition • Economic benefits from human capital acquisition are represented by the higher wages related to the higher educational attainment • The higher wages are not seen as a payment for innate ability but merely as a compensation to the individual for making the investment in education (for the resources spent in education cost), which enhances his/her productivity

  12. Economic Benefits of Human Capital Acquisition • Only the outcome of the educational process, i.e., productivity enhancement and therefore, increase in earnings, is important in the analysis • The individual does not receive any direct utility or disutility from the educational process

  13. Stream of Costs and Benefits • The model assumes that there is no uncertainty involved in the inter-temporal decision making • The lifetime earnings and costs associated with the different amounts of education are known with certainty

  14. Stream of Costs and Benefits • The model assumes that individuals can always borrow and lend at the real interest rate “r”

  15. Inter-temporal Choice • To make decisions that involve different periods of time, we need first to set the quantities in the same period of time • The present value (PV) concept is the way to convert a stream of payment into today’s value

  16. Present Value Concept • X dollars invested today at an annual interest rate “r” would increase in value to X (1 + r) dollars in one year to [X(1 + r)] (1 + r) = X (1 + r)2 in two years to X(1 + r)t in t years

  17. Present Value Concept • Let Q = X(1 + r)t Hence, the PV of Q dollars received t years from now is Q/(1 + r)t = Qt = X • Note that  = 1/(1 + r) is the discount factor we have used previously to compute the PV of a stream of payments in infinitely repeated games

  18. Inter-temporal Choice • Similarly, the promise (from a bank, for example) to pay Y dollars t years from today has a present value PV = Y/(1 + r)t = Y t

  19. Inter-temporal Choice • Suppose we have more than 2 periods, starting with the current period, called “period 0” • Suppose that we receive V0 in period 0, V1 in period 1, …, Vt in period t

  20. Inter-temporal Choice • Then, the PV of receiving V0 in period 0, V1 in period 1, …, Vt in period t PV = V0/(1 + r)0 +V1/(1 + r)1 +V2/(1 + r)2 + . . . +Vt/(1 + r)t where Vi = value on period i i = 0,1,…t (period number; from period 0 to period t)

  21. Inter-temporal Choice • Assume now that we receive V0 in period 0, and V1 in period 1 to period t • Then, the PV of the stream of payments V1 received during t periods is  V1 + 2 V1 + 3 V1 + … + t V1 This sum of finite terms can be seen as ( V1 + 2 V1 + 3 V1 + …+ t V1 + t+1 V1 + …) – (t+1 V1 + t+2 V1 + … + …)

  22. Inter-temporal Choice • Where, the first sum of infinite terms ( V1 + 2 V1 + 3 V1 + …+ t V1 + t+1 V1 + …) =  V1 ( 1 +  +2+ 3+ …+ t+ t+1 + …) =  V1/(1 – )

  23. Inter-temporal Choice • And the second sum of infinite terms (t+1 V1 + t+2 V1 + … + …) = t+1 V1 ( 1 + +2+ 3+ …+ t+ t+1 + …) = t+1 V1/(1 – )

  24. Inter-temporal Choice • Then, the PV of the stream of payments V1 received during t periods  V1 + 2 V1 + 3 V1 + … + t V1 =  V1/(1 – ) – t+1 V1/(1 – ) =  V1 ( 1 – t)/(1 – )

  25. Inter-temporal Choice • Given that  = 1/(1+ r), then the PV of the stream of payments V1 received during t periods is  V1 + 2 V1 + 3 V1 + … + t V1 = V1 {1 – [1/(1+r)]t}/r(annuity formula)

  26. Inter-temporal Choice • Hence, the PV of the payments received from period 0 to period t, assuming that we receive V0 in period 0 and V1 in period 1 through period t is PV = V0 +V1 {1 – [1/(1+r)]t}/r

  27. An Application of the Education as Human Capital Investment Model • Suppose an 18-year-old high-school graduate needs to decide whether to pursue a university degree • Assume that our 18-year-old person knows that she will work until age T. So, she has a maximum of T – 18 remaining working years (or T – 18 + 1 total periods)

  28. An Application of the Education as Human Capital Investment Model • The decision about pursuing a university degree implies • To compare the lifetime stream of net benefits from not pursuing and from pursuing higher a university degree Or • To compare the lifetime stream of costs and benefits from education • We will then use the concept of inter-temporal choice (PV)

  29. An Application of the Education as Human Capital Investment Model • If the person doesn’t pursue the university degree, the PV of the stream of earnings of a high school degree (H) is PV(H) = Y18H / (1 + r)0 + Y19H / (1 + r)1 + … + YTH / (1 + r)T-18, where Y18H, Y19H are the earnings after high school degree at age 18, at age 19, etc.; T is the age of the individual at the last working year; T -18 is the maximum number of remaining working years

  30. An Application of the Education as Human Capital Investment Model • Using the summation notation, the stream of earnings of a high school degree (H) is PV(H) = t=0T-18 [Yt+18 H / (1 + r)t]

  31. Aside: A Numerical Example to Clarify Notation • Suppose that the person starts working at age 18 and can work at most for 5 years (i.e., until age 22) • Working years: year 1 at age 18, year 2 at age 19, …, year 5 at age 22 • T = 22 represents the age of the individual during the last working period

  32. Aside: A Numerical Example to Clarify Notation • T -18 = 4 represents the maximum number of remaining working years (not including year 1 at age 18) • T-18 + 1 = 5 represents the total number of working years (including year 1 at age 18)

  33. Aside: A Numerical Example to Clarify Notation • Then, PV of income stream of earnings of a high school degree (H) is PV(H) = Y18H/(1+r)0+Y19H/(1+r)1+Y20H/(1+r)2+Y21H/(1+r)3+Y22H/(1+r)4 • Using the summation notation, PV(H) = t=04 [Yt+18 H/(1 + r)t]

  34. An Application of the Education as Human Capital Investment Model (cont.) • If the person gets the university degree • She will earn nothing for 4 years during studies and incur in explicit cost D (D18 … D21) each year she is in the university • However, her earnings YU (Y22U…YTU) will be higher when she graduates

  35. An Application of the Education as Human Capital Investment Model • Then, the PV of net earnings (PV of the stream of earnings and costs) of a university degree (U) is PV(U) = (-D18)/(1+r)0 + (-D19)/(1+r)1 +…+ (-D21)/(1+r)3 + Y22U /(1+r)4 + … + YT U / (1+r)T-18 Using the summation notation, PV(U) = t=0 3 {[-Dt+18/(1 + r)t]} + t=4T-18 {[Yt+18U/(1 + r)t]}

  36. An Application of the Education as Human Capital Investment Model • The rational investment decision is to pursue the university degree if PV(U) = t=0 3 {[-Dt+18/(1+r)t]} + t=4T-18 {[Yt+18U/(1+r)t]} > PV(H) = t=0T-18 [Yt+18 H / (1 + r)t]

  37. An Application of the Education as Human Capital Investment Model • Alternatively, this decision can be expressed in terms of benefits and costs of the university degree, where costs include both the explicit costs and opportunity costs

  38. An Application of the Education as Human Capital Investment Model • The benefit (B) of pursuing the university degree is the increase in earnings from age 22 PV(B) = t=4T-18 { [Yt+18U -Yt+18H ] / (1 + r)t }

  39. An Application of the Education as Human Capital Investment Model • The cost (C) of pursuing the university degree is the explicit cost of university, plus the opportunity cost (forgone earnings while attending university) during 4 four years until age 21 PV(C) = t=0 3 { [Yt+18H + Dt+18 ] / (1 + r)t }

  40. An Application of the Education as Human Capital Investment Model • The high-school graduate should pursue the university degree if PV(B) > PV(C) • Obviously, both decision criteria PV(B) > PV (C) and PV(U) > PV(H) are identical

  41. Optimal Human Capital Investment • The optimal human capital investment is the educational attainment that maximizes the lifetime net earnings • The optimal educational attainment can be obtained in two equivalent rules • Marginal Cost and Benefit Rule • Internal Rate of Return of the Investment Rule

  42. Marginal Cost and Benefit Rule • A rational individual chooses the human capital investment that maximizes the net PV of her/his lifetime earnings • The net PV of her lifetime earnings is maximized when Marginal Benefit (Mg B) = Marginal Cost (Mg C)

  43. Marginal Cost and Benefit Rule • The individual should increase the number of years of education until the PV of the benefits of an additional year equals the PV of the costs of an additional year • Mg B generally declines with years of education due to a diminishing return to education and to the shorter period over which higher income accrues • Mg C rises with years of education because forgone earnings increase with educational attainment

  44. Internal Rate of Return of the Investment Rule • For any specific amount of education, the internal rate of return “i” can be defined as the implicit rate of return earned by an individual acquiring that amount of education

  45. Internal Rate of Return of the Investment Rule • The internal (implicit) rate of return “i” of the investment on a level of education “j” is computed by calculating the discount rate that yields a Net PV of zero for the investment on level of education “j” • ij s.t. Net PV = PV(B)j - PV(C)j = 0 or • ij s.t. PV(B)j = PV(C)j

  46. Internal Rate of Return of the Investment Rule • The rational individual will continue investing in education as long as the internal rate of return “i” exceeds the market interest rate “r” (that represents the opportunity cost of financing the human capital investment)

  47. Internal Rate of Return of the Investment Rule • That is, if at specific level of education i > r, the individual can increase the net present value of lifetime earnings by acquiring more education, which may involve borrowing at the market interest rate r, or allocating his own funds in education investment instead of lending the funds at the market interest rate r • That is, investing in education is the best investment alternative for the individual

  48. Internal Rate of Return of the Investment Rule • Remember that PV of the Mg B is a decreasing function of education and the PV of the Mg C is an increasing function of education • Then, the internal rate of return (that reflects the net return to the individual from the investment on education) falls as educational attainment rises

  49. Internal Rate of Return of the Investment Rule • The optimal level of investment in education is achieved when (internal rate of return) i = r (market interest rate)

  50. Graphically, • MgB = MgC at the optimal • level of educational • attainment MgB, MgC MgC MgB Years of education (E) E* (b) Internal rate of return i = market interest rate r at the optimal level of educational attainment i, r r i Years of education (E) E*