CHAPTER 4 - Human Capital Model

What is Human Capital?

Human capital is much broader than education

- incorporates knowledge, information, ideas, skills and health of individuals (ex: athletes and musicians have less # years of education but high human capital)

Who has done seminal work in this field?

Gary Stanley Becker

- won nobel prize in 1992

Differences btwn Human and Physical Capital

- can't be seized by lender if there's non-payment (risks high for private lenders to lend, so they're less willing to give out human capital loans, creates credit constraints)

Similarities btwn Human and Physical Capital

- considered an investment --> investors of human capital are expecting higher returns, like higher profits in the case of physical capital investments

ex: college requires students to to spend now and give up earning money, but benefits would come in future

Human Capital and bank collateral

- unlike housing or machines, banks don't have collateral when students borrow money for college --> banks can't sell collateral to get loans back (like in physical capital)

- federal govt. needs to step in otherwise not many private banks would be willing to give out loans or at reasonable interest rates (may charge increased rates)

Can human capital be sold to another person and what are the gains from Human capital

- Human capital can't be sold to another person (can't be separated from person who undertakes investment --> physical capital CAN be separated)

- gains from human capital would be smaller the later in life you invest -->

implications: working life is limited, invest in college early to enjoy more benefits

--> contrastingly, physical capital can be bought at any point in the life of business

What are stafford loans?

type of federal student loan that are either subsidized - the government pays the interest while you're in school - or unsubsidized - you pay all the interest.

Benefits of extra year of education

- higher earnings (Ys) if you do additional year of schooling and you earn Y0 if you don't do additional year of schooling

- Ys and Y0 remain same throughout

Costs of extra year of education

- DIRECT monetary costs

- Opportunity/INDIRECT cost

Direct vs indirect costs

direct cost: tuition and books (monetary costs)

indirect cost: in terms of foregone earnings if you go to school that year

Why use PV concept?

- because individuals work for several years, need to capture the lifetime changes in earnings and thus use Present Value to calculate

What is discount rate?

could be interest rate (exogenous) or something that is individual specific and depends on individuals preference and behavior

What does higher discount rate mean

means someone values benefits less the further they are in the future... could be possible that someone's credit history isn't good, or they're more present oriented

PV0 vs PVs

PV0 - present value if you don't go to school

PVs- present value if you go to school for the first period

Y0 vs Ys (assuming there are fixed number of T periods)

Y0 - earnings if you don't go to school

Ys - earnings if you go to school in first period

- assumption that both remain same throughout an individual's work life

- both are earned at the end of each period

- however... if you spend F (direct costs of schooling like tuition) at beginning of period 1, you are deciding whether to go to school in period 1 or start working

What is NPVs and what is F?

NPVs - net present value from schooling (equation separate)

F - direct costs (tuition books etc)

direct cost implications from human capital model

- an increase in F (increase tuition), will reduce the NPVs, and hence, reduces enrollment (higher NPVs, better for enrollment)

Is F same for everyone? (human capital model)

no, bc of financial aid, price discrimination is possible --> universities have monopoly power

indirect cost implications from human capital model

indirect costs can vary with (1) individuals and (2) education level

(1) individuals --> Y0 could be different depending on what type of job one is going for, but even if Y0 is the same, Y0 could mean different things for different families (ex: student athletes opportunity cost increases for 16th year)

(2) education level --> opportunity cost of 16th year more than 12th year bc you'll earn much more w 15 than 11 years of schooling

·Factors that affect opportunity cost of education

time required to get education --> more time you take leads to increase in foregone earnings bc you give up earning for more # years

when should you get your education and why?

- getting education later in life means lesser NPVs bc u have less time to reap benefits and indirect costs are higher

- why? --> benefits decrease because T decreases, opportunity cost increases because Y0 increases

- hence, model predicts getting education earlier rather than later

Changes in Benefits (implications from human capital model)

- model predicts that increase in benefits (Ys-Y0 increases) will encourage more ppl to get education

SBTC (implications from human capital model)

- skill based technological change has led to higher demand for college educated workers (shift against manufacturing sector and even within manufacturing, production tech has skewed towards skilled workers)

- returns to skills are greater over time since highly skilled jobs are more dominant

SBTC and college attendance

- SBTC has encouraged more ppl to attend college (demand for skilled labor increases over time so Ys-Y0 increases, thus more ppl what to go to college over time) --> supply of college educated workers is induced by demand for college educated workers

- ex: when housing market was booking, lots of ppl enrolled in housing related classes, but with housing crash, demand for those courses dropped

what is optimal schooling level?

Where marginal rate of return to additional schooling.= marginal cost of additional schooling (intersection point of graph)

- assume marginal cost of schooling remains constant irrespective of level of schooling

--> Why do different ppl attain different levels of education?

(1) differences in MC of schooling

(2) differences in Marginal Benefits to schooling

Differences in MC of schooling - heterogeneity in educational attainment

- marginal costs can increase if federal student loans are insufficient to meet cost

- can lead to credit constraint for the student (means they are either not able to borrow any money or only borrow at low enough level of interest)

- create inefficiencies (not many ppl get education and wealthier families' kids are able to get more education

Differences in Marginal returns/benefits of schooling - heterogeneity in educational attainment

- even at same education level, individuals have different returns due to ability

- Ability bias

- consumption benefit

what is ability bias?

individuals w higher ability have higher earnings, and attain higher level of education

what is consumption benefit

some ppl may just enjoy schooling due to preferences, hence attain higher level of schooling

Racial inequalities in Education attainment

in 2021, 37.9% of population ages 25+ had bachelors degree or higher

whites: 41.9%

blacks: 28.1%

asians: 61%

hispanics: 20.6%

can financial aid help in reducing inequalities in education?

- only if the inequalities are due to credit constraints (a decrease in discount rate for groups of pop where credit more constrained - minorities and low income households- will LOWER MC)

if inequalities not due to credit constraints (like school quality or preferences) does financial aid help? what does?

- financial aid won't help

- early childhood interventions such as head-start program would be useful

- differences in education is because of Marginal Benefit differences

- even if we get rid of MC differences, difference in education will still remain.

Q2: Human capital cannot be pledged as an asset that can be seized by a lender in the event that the borrower defaults on a loan; in other words, human capital cannot be used as "collateral." Does the observation that human capital cannot be collateralized mean that in the absence of government-provided loans interest rates on student loans would be too high, just about right, or too low?

because education can't be collateralized, there is greater risk to the lender, which causes a higher interest rate charge... would lead to credit constraints and underinvestment in education

Q3: Walter is a chemistry teacher who earns $50,000 per year, while Jesse is unemployed. Both Walter and Jesse want to go back to school to earn a business degree to help them operate their new business. The tuition each one would have to pay is the same, and they have agreed each to pay half of the tuition regardless of which one attends. Assume they cannot attend part-time. Do they indeed face the same cost of enrolling in this program? Why or why not?

No, Walter has higher indirect costs in the form of foregone earnings (50000 per year) while Jessie doesn't forego any earnings because he's unemployed

Q4: Suppose you have two friends who have the same underlying ability, took the same courses in college, and have the same GPA. One of them decides to go to a business school for an MBA, while the other one chooses to pursue a PhD in English literature. Given that the expected earnings of an MBA are much higher than the expected earnings of an English PhD, is one of your friends being irrational?

both degrees have difference costs and benefits. Typically, the tuition charged in MBA program is much higher than a doctorate program in english, but MBA will only take 2 years to complete while PhD takes more than 5 years. This leaves the English PhD to accrue the earning benefits of an advanced degree.

To summarize:

the friend pursuing PhD has higher opportunity costs in terms of foregone earnings, but other aspects of PhD can be valued more by one person than another. If the benefits to said program are greater than the costs, then neither are irrational.

8. Why is it more likely that people will invest in education when they are relatively young?

bc there is more time to accrue the benefits of education and a lower opportunity cost of pursuing education in terms of foregone earnings

Q10: In the most recent recession, the earnings of college-educated workers declined. This caused many policy makers and those in the press to claim that college was no longer worth it for students. Does this conclusion necessarily follow from the observed changes in college-educated workers' earnings?

No, what matters in the human capital model isn't the level of earnings but the difference in earnings between those with more and less education. Although earnings have declined during the recession, those without a college degree had a much greater decline in earnings. The result of this was a large increase in the college-high school earnings premium, making college even more lucrative of an investment for students