3 Human capital

• Human capital is a set of skills that make a worker productive. What are these skills? How to measure them?

• General human capital:

  skills that make a worker productive everywhere. Measures: years of education, labor market experience, IQ or ability test scores (examples: IELTS, GRE, GMAT), personality traits

  (e.g. Big 5: Conscientiousness, Neuroticism, Agreeableness, Openness to experience, Extraversion).

• Specific human capital:

  skills that make a worker productive in a particular firm, less useful elsewhere. Examples: experience of working with equipment (e.g., software packages) used in a particular firm, knowledge of specific markets or customer accounts, corporate culture and decision making processes within a particular fir

1. Innate ability:

   a biologically given, cannot be influenced.

2. Schooling:

   an exposure to useful information in an organized way, development of productive habits. It is universally found that more schooling leads to higher earnings, better health, and lower probability of unemployment.

3. Social influences (family and peers):

   important for the developments of productive habits that ease learning and thus make schooling more productive.

4. On-the-job training:

   education in specific skills that the firm deems useful.

   
   

   —>This lecture focuses on schooling and on-the-job training.

• Schooling requires an expenditure of resources today in return for a higher chance of a better-paid job in the future.

• Therefore, schooling is an investment decision.

• Data relevant for the schooling decisions:

  expected lifetime (T);

  the earnings and other benefits from schooling (𝐾𝑡 );

  the opportunity costs of schooling: fees + earnings in case of dropping out of school in year t, (𝐻𝑡 );

  the discount rate r.

• Net present value of investment in schooling:

• It pays to invest in at least some education (because in the first few years, H is low), but one is very unlikely to spend a large part of life in education.

• Higher costs (higher 𝐻𝑡 ) —>less demand for education. Also, better job —>less demand for education, since the opportunity costs are high.

• Higher interest rate (r) —>less demand for education. Also true for higher uncertainty and personal discount rate (people who see no future will want less education).

• Longer working life (higher T) —>more demand for education.

• More effective learning (higher K) —>more demand for education. (Has to do with ability as well.)

• Can in principle be estimated from a regression of individual wages 𝑤𝑖 on the years of schooling 𝑠𝑖 and controls X (gender, age, tenure, region of residence, etc.):

• Estimate 𝛽1 is the marginal return to schooling:

• 𝛽1 is likely to be biased because schooling may be correlated with ability, which is typically unobserved. (Solutions exist but not covered by the course.)

• For a survey of the literature on estimating returns to schooling since 1950s, see e.g. Psacharopoulos, G., and Patrinos, H. A. (2018). Returns to investment in education: a decennial review of the global literature. Education Economics, 26(5), 445-458

  • In addition, there are non-monetary returns to schooling (e.g. better health and well-being)

  • … and public returns: more educated people are less likely to become unemployed or commit a crime. This is the case for public subsidies for education.

• On-the-job training implies, similarly as general schooling, benefits and costs.

• Main difference: On-the-job training is beneficial to both the firm and the worker, and its benefits depend on whether the worker will stay with the firm or move.

• This difference motivates two questions: 1. What kind of on-the-job training is best for the firm and the worker? 2. Who should pay for on-the-job training?

• General human capital raises worker productivity equally in all firms.

• Firm-specific human capital raises productivity in a particular firm but less so, if at all, elsewhere.

—>Most of the times, human capital is a mixture of general and firm-specific. E.g. in the java-tax example: training 100% in Java is only 80% effective in other firms, because they may be using different Java tools.

—>The distinction between general and firm-specific human capital is useful in deciding to what extent firms should subsidize on-the-job training.

• If the human capital acquired through training is general, that is, it is equally productive in all firms, training has to be paid for by the worker.

• Why? Because doing so maximizes total welfare.

Consider the following example.

Suppose training costs are 5'000 Eur and increases the worker's productivity by 5'200 Eur. The worker's productivity without training is 10'000 Eur. The firm and the worker make an agreement that the firm pays for the training and the worker stays and works for the firm for the wage that would offset the costs of training.

—>Is this agreement renegotiation-proof?

• The firm will compensate its costs of training by paying the worker up to 10'200 Eur after training.

• However, the worker, whose value is now 15'200 Eur will get offers up to 15'200 Eur from the outside, so the firm will have to match, or lose the worker. In any case, it will lose up to 5'000 Eur by paying for the worker's training.

• The firm can anticipate this in advance and will therefore decide not to pay for the worker's training, even though training is welfare-improving: its net benefits were 5200 − 5000 = 200 > 0.

—>This is one example of the hold-up problem: one party in the negotiations invests now anticipating to receive the benefits later, but the other party is tempted to renegotiate once the investment has been made.

—>The most economically efficient action to take is for the worker to finance his own general human capital training and the benefit of training, 5200 − 5000 = 200 > 0, will be realized in terms of higher wage.

• Alternatively, employer and worker may write a contract according to which the worker must return the costs of training if he leaves before a certain date.

• It is a common practice, but not better in terms of welfare than making the worker pay for general training, because the firm will still recover the costs of training by preventing the worker from getting his market wage for the required amount of time.

• Can be a useful alternative when the worker is liquidity-constrained.

This is one example of the hold-up problem:

one party in the negotiations invests now anticipating to receive the benefits later, but the other party is tempted to renegotiate once the investment has been made.

• If the worker has to pay the full costs of training, 5'000 Eur, the firm will have an incentive to renegotiate his salary to 14'400 Eur after training, because that's how much he will be worth outside. The worker anticipates this and will not do the training, even though training is welfare-improving.

• Unlike in the case of general human capital, making the worker pay for specific human capital training does not lead to the highest possible welfare.

• Assume the firm fully pays for the firm-specific training: Now, the worker will hold-up the firm by demanding a wage up to 14'400 Eur (his outside value), whereas the firm can pay up to 10'200 Eur to recoup the costs of training. —>Again, not the welfare-maximizing outcome.

• Let the firm and the worker split the costs and benefits of investment in firm-specific human capital. In our example:

  • The firm must pay to the worker at least 14'400 Eur after training to keep him, so it will earn at most 800 Eur (=15'200 - 14'400).

  • So the firm can subsidize the worker's costs of training by up to 800 Eur.

  • The worker will have to pay at least 4'200 (= 5'000 - 800) for the training, which is worth paying, because he will be earning at least 4'400 more after training.

  • Other splitting schemes are possible, but every feasible scheme must divide the gains from training of 5'200 - 5'000 = 200 in some proportion between the worker and the firm.

  • For example, in the 50-50 split, the worker earns 14'400 Eur after training and 5'700 Eur before the training. His pro t =4'400 Eur (wage gain after) - 4'300 Eur (wage loss before) =100 Eur.

  • Firm's pro t = 800 Eur (net productivity gain after training) -700 Eur (subsidy for the costs of training before) = 100 Eur.

In general:

Firm-specific training results in workers earning less than they could have earned elsewhere during training, but more than their net productivity, and earning at least as much as elsewhere after training, but less than their actual productivity

1. Turnover:

   If training is completely general, it is fully paid by the worker, so firms do not care much about turnover, hire through spot-market type transactions. The more specific training is, the more the parties are to lose from separating, so the more investment is made in developing long-term relationships and the greater is the use of internal labor markets.

2. Training specificity and tenure:

   Workers with longer tenure are more likely to have invested more in firm-specific human capital due to greater incentive to stay with the firm. Thus more investment in firm-specific human capital. So, training is more firm-specific for workers with longer tenure.

3. Tenure, labor market experience, and wages:

   Both total experience and tenure with a particular firm increase wages. Experience, because training has some general component. Tenure, because training has some firm-specific component.

4. Training and labor market thickness:

   A “thick" labor market means that there are many firms that use the same skill mix. Thicker labor market means better outside wage offers. As in such market there are lower benefits from firm-specific training to the firm, there will be more general training.

5. Firm size and training:

   More firm-specific training in larger firms because there are more opportunities to productively employ workers, i.e. lower turnover.

• There is no free lunch: general training means lower salary or a contractual obligation to stay for a prescribed period of time.

• Subsidized general education may be a cost-effective (tax-deductible) way of attracting the right employees, for whom the benefits of education are relatively high.

• A way for firms to signal that they care for their employees. This is good for attracting the right employees.

• Example: UPS-university program for UPS employees; a grant of up to 25'000 UDS for education of UPS employees.