Economics 623 Human Capital: Lecture 1 Spring 2012
Human Capital Today we switch from fertility to human capital investments. Attention to birth rates centers attention (for the most part) on the size of the population. Human Capital focuses on the quality of the population. In models of fertility, we spoke of child quality. It is through parental investments in their children, and specifically, in their children’s human capital that increase “child quality”. What is Human Capital? For a definition and initial conceptualization we turn to T. W. Schultz. I had dinner with T.W. and his wife Esther while a graduate student, when Schultz was about 80, a couple of years after he won the Nobel Prize in Economics. I reread several of his papers a few years ago and re–learned a valuable lesson that it is useful to return to the “classics.” Schultz’s original formulation and discussion of “human capital” (to mimic the Nobel Prize announcement) has a vibrancy and freshness (and yes sometimes confusion over ideas that get sorted out later) that subsequent textbook treatments lack. Much of this discussion appears in his books, but his 1960 Presidential Address to the American Economic Association is representative of his writing and ideas (published in the American Economic Review in 1961 and available from JSTOR). The discussion by Ehrenberg and Smith on the class webpage is a modern treatment and introduces the important ideas. In much of the subsequent work, especially in the formal theoretical work by Gary Becker and Jacob Mincer, defined human capital narrowly, essentially as years of schooling. Schultz’s own research concentrated on schooling, but in his editorial work and intellectual leadership of organizing conferences, he applied a much broader view of human capital than Becker or Mincer. Human Capital to Schultz was the acquisition “of all useful skills and knowledge . . . that is part of deliberate investment.” Rather than offer formal definitions, Schultz defined human capital by example: Much of what we call consumption constitutes investment in human capital. Direct expenditures on education, health, and internal migration to take advantage of better job opportunities are clear examples. Earnings foregone by mature students attending school and by workers acquiring on–the–job training are equally clear examples. Yet, nowhere do these enter our national [income] accounts. The use of leisure time to improve skills and knowledge is widespread and it too is unrecorded. In these and similar ways the quality [emphasis in the original] of human effort can be greatly improved and its productivity enhanced. I shall contend that such investments in human capital accounts for most of the impressive rise in real earnings per worker. (Investments in Human Capital (1961), p.1)
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Let me emphasize the breath of the definition. Clearly, he picks up on education investments by “mature” students. But also, investments that improve or protect one’s health. And movement by workers (internal migration and international immigration) to take advantage of improved job opportunities are investments in human capital. The later because moving generally requires fixed costs, with gains to accrue in the future (at the new location). Notice the investment activity as well — expenditures today for future payoffs. Schultz was not the first to recognize that Human Abilities are a form of capital (as Adam Smith and Irving Fisher did as well). They, however, did not push the investment angle as much, that one can augment one’s abilities and the push to attempt to measure human capital were Schultz’s primary insights. Schultz’s broad notion of human capital is necessary for studying the spatial and occupational mobility of the population. Schooling investments are a form of human capital but only one form of many. In health investments are an important form of human capital investments in many countries. Investments can be made to reduce mortality (or death rates). Yet, even more important are health investments that reduce morbidity (or the relative incidence of disease). Many diseases are not necessarily fatal, at least immediately, but lower quality of life or functionality and productivity. We have all heard of the obesity epidemic. Obesity increases morbidity rates (individuals of poor health or limited functionality), even though it may take years of increased physiological stress to produce fully lethal heart problems or strokes. In many countries mal–nourishment and other diseases (e.g., malaria) produces anemia. Children are particularly susceptible and those infected are less able to learn (poor oxygen flow throughout their systems, but particularly to their brains). Investment into iron supplements to combat the anemia are a low–cost form of investment to raise the productive ability of the children. The notion of human capital supports this form of public intervention. Similarly, public service campaigns to reduce the amount of soft drinks and their high sugar (and calorie content) are attempts to improve the health of children and thus their productivity. Moreover, with the broad view of human capital we can see the omnibus role and the importance of education. The human capital perspective on education is that it raises the skills of the person receiving the education. As a first–order effect, education raises the person’s productivity in the market place (e.g., in the U.S. post–secondary schooling raises earnings). Mincer, Becker and Schultz, the early adherents of human capital pioneered ways of measuring the rate of return to investments in human capital. Competitive economies should exploit profit opportunities, so the rate of return for investments in human capital (adjusting for risk) should be the same as investments in physical capital. But there are higher order effects as well, especially in developing countries. Education raises productivity in the labor market, but also in the home. Parents with more education, say are literate, are more likely to seek and use information. Health practices, and nutrition should be higher in households with more education, even controlling for household income. Education improves their productivity in the household. 2
We see this correlation in all health practices. That smoking rates decline with education, is probably the most stark. Obesity rates also decline with education, healthy behaviors (e.g., following the AMA suggested diet, being active) all increase with education. It’s true that the more educated also have highest income, so the best empirical studies also have to control for income/household resources. The gains of education occur at all levels of education. For the United States with its 9 years of mandatory education, interest centers on higher levels of education, high school graduation versus college. Yet, in many countries the margin is some versus none, or the incremental gain to a couple of years of education. In many countries, we measure the literacy rate and not years of education. And of course, as we will see what’s important is the quality of the educational investment — a year of education Malawi is likely not the same as in the United States. And from our discussion of home production and the importance of the value of time, increases in education that increase the woman’s value of time provides an incentive to reduce her fertility. Thus, programs targeted at raising women’s education can also lower fertility levels. Important to see that Human Capital is a central, unifying concept within population economics. Investments in human capital may be made by parents, in their children’s health or in their children’s education, can be made by the individual in themselves, or by governments that attempt to change incentives in acquiring human capital. Human capital considerations influence fertility, aging/morbidity/mortality and migration/immigration directly and importantly and to a lesser extent, marriage decisions. Because we know the most about schooling and educational investments we’ll study them first. But I wanted to set the stage by considering the “Schultzian” notion of human capital.
Schooling Schooling as a human capital investment is of course that costs are incurred in the near–term with expected payoffs to accrue in the future. Costs classified in three components: • Monetary or direct expenses include tuition, fees, expenditures on books and other supplies. • Forgone earnings (as stressed by Schultz) usually not possible to work full–time. Think of opportunity costs – the value of a resource in its next best use. • Psychic costs. Learning can be tedious or schooling otherwise unpleasant. (Compared to the next best use of time.) What are some of the expected returns? • Higher future earnings, either because the wage (price per unit of time) is higher or because hours of work are higher (e.g., less unemployment) • Higher non–market productivity. 3
• Psychic returns — increased job satisfaction over one’s life time; or greater appreciation of non–market activities. • Increased ability to adapt to new environments; to learn how to learn. Stressed by Schultz. Education made individuals better entrepreneurs. Note the challenge is to separate consumption versus production incentives and payoffs.
Present Value and Future Values The time value of money is one of two fundamental ideas of finance and insurance. Basic idea: a dollar today is worth more than a dollar tomorrow (even in the absence of uncertainty). What is the value in the future value in n periods of Y0 dollars today, assuming constant interest rate r? Answer F V = Y0 (1 + r)t . The present value then of receiving Y dollars t periods in the future is Present Value =
Y (1 + r)t
Thus, as with any investment we convert future streams of income into their present value. Thus, an investment that yields income stream B1 , B2 , . . . , BT for T periods into the future is PV =
T X t=1
Bt (1 + r)t
Costs are just negative benefits, but common to keep track of the cash flows separately for costs and benefits. So, as a simple example, an investment incurs a cost today C0 and yields benefits, Bt T periods into the future, the net present value is: NP V =
T X j=0
Bj − C0 (1 + r)j
N P V is positive if the (discounted) stream of benefits exceeds the costs. There is no reason for costs to be limited to a single initial period. The project may require investment costs spread over several periods, so letting benefits in period t be Bt and costs in period t be Ct , and net benefits in period t as the difference of benefits minus costs, Bt − Ct , yields NP V =
T X Bt − Ct t=0
(1 + r)t
The interest rate r is the opportunity cost of funds, the investor’s cost of capital, the real rate of interest. So, to keep things simple we’ll assume that the inflation rate is zero. Assume that the investor can borrow or lend at rate r per period. 4
Assume the investment is $1,000 and receives $100 per year for the next 20 years. The person’s cost of funds is 3%. What is the NPV? 100 100 100 + + ··· + = 487.75 2 1.03 1.03 1.0320 Notice that the total dollars collected is $2,000, but the timing of the payments is such their PV is $1,487.75. And since the NPV is positive, the person should make the investment. −1, 000 +
Alternatively, one can ask what is the implicit rate of return of an investment that costs $1,000 upfront and produces a stream of income of $100 a year for 20 years? The idea is that we seek rˆ such that −1, 000 +
100 100 100 + + ··· + =0 2 1 + rˆ (1 + rˆ) (1 + rˆ)20
In general, one must use trial and error (or a financial calculator) to find the solution. Guess a value of rˆ and if the difference is positive, increase or decrease the next value of rˆ. One numerical procedure is bi–section: guess a trial value of rˆ that yields a positive balance, and another that yields a negative remainder. Together these bound rˆ, so take the average, and recalculate the difference. If the difference is positive, average the last guess with the value of the rate of return that yielded a negative balance, and vice versa if the remainder is negative. Nothing fancy here it is just trial and error. For this problem the rˆ = 7.75%. rˆ is call the internal rate of return. As you might guess, depending the exact nature of the cash flows there may be one, many or no solutions. If there is one sign change (e.g., negative to positive) and if costs occur in the first year and benefits are positive in the last year then the IRR is positive and unique. The optimal investment decision can be formulated either using the Net Present Value or the Internal Rate of Return. For a given (marginal) cost of funds, calculate the NPV, invest if N P V > 0. Alternatively, if the IRR is greater than the marginal cost of funds, rˆ − r > 0, invest.
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