Tutorial on Human Capital Theory

Because the number of viable policy options for raising wages appears thin, much attention is given to education and training. It is standard analysis to believe that skills gained through education and training can alter the wages individuals receive. The logic of this statement relies upon the fact that skilled workers must necessarily be in lower supply relative to less skilled workers. After all, any more skilled worker can always enter the labor market for less skilled work.

Because the supply of skilled labor is generally to the left of the supply for skilled labor, then we can expect higher wages for these workers. A number of exceptions can and do occur. When unskilled work is disagreeable, risky, or unsatisfying, the supply of these unskilled workers will likely be reduced and higher wages may be necessary to command an adequate work force. Likewise, when monopolistic controls prevent entry into less-skilled jobs, wages again may be higher than those of skilled workers. Finally, when the supply of skilled workers is high relative to the demand for a particular occupation, say in teaching, social work, or for other occupations, monetary wages may not be significantly (if at all) higher for highly educated workers. But those factors aside, we typically assume that skilled workers will receive a positive return on the investments that they make in their human capital.

Once a return on investment in skills is known to exist, it is logical to ask how much a worker should expend acquiring the skills that provide higher wages. To explore this idea, it is helpful first to backtrack and consider standard investment analysis. If we assume that an individual can invest money at some relatively riskless rate of return, than we can calculate how much a sum invested today (the present value) will generate in some future time period (the future value). This, it turns out, is another way of asking how much a person should spend to acquire skills leading to better paying jobs.

If we take 100 and invest it in a guaranteed certificate of deposit that yields 10% interest, we would have $110 in one years time.

i.e.

Present Value (1+r)	=	Future Value
100 (1.10)	=	110

In two years time that same investment would yield $121.

i.e.

Present Value (1+r) (1+r)	=	Future Value in two years
100 (1.10) (1.10)	=	Future Value in two years
100 (110)²	=	121

We could also reverse the calculation and ask, how much should a person pay today to receive 121 in two years time? The question amounts to asking what is the present value of a future sum.

i.e., Because

Present Value (110)²

Future Value in two years

We can substitute in 121 and divide both sides by the discount factor (1=r)²

Present Value (110)²/(110)²

=

121/(110)²

or

Present Value	=	121/(110)²
or
Present Value	=	100

Thus, in principle, we can figure out exactly how much an individual should spend on skills that yield returns over time. For example, investing in a medical career may yield returns over 20 years. Assume that it raises income by $50,000 each year for 20 years, then the present value of this increased earning could be calculated as follows:

PV = 50,000/(1=r) + 50,000/(1=r)2 + 50,000/(1=r)3 …..50,000(1=r)20

Or PV = ·Returns/(1=r)n (or the PV is sum of the discounted future returns)

Where n is the number of years and PV is Present Value

This present value is the maximum amount an individual should expend on their medical education if they wish not to lose money on it. All this is to say, if an individual were to be very calculating he or she could decide exactly how much to spend on training to maximize income. Of course, most of us don't do this with precision, but we do have a sense about whether the returns on our investments in skills and education justify the costs. So, let's consider those costs and returns.

When it comes to returns, we can consider both monetary (pecuniary) and non-monetary returns. Monetary returns are the amount over and above what you would earn without a further investment. So, if you are fresh out of high school and are considering going to college, then the monetary returns of a college education consists of the additional salary (let's say $10,000) over what you would have made if you took no further education (let's say $20,000). To restate this, if you were to earn $30,000 only $10,000 would be considered a return on your investment. If you were considering being a teacher and you found working with kids so agreeable that you were willing to take $5,000 less than what you could have made elsewhere, then you take $5,000 in non-monetary (non-pecuniary) returns.

What is the maximum you should pay for this stream of $10,000 in returns over the next 20 years till you retire? That is, once again, to ask what is the discounted present value of those future returns.

Figuring out the cost of an investment is not always obvious. You might very easily calculate your tuition costs--let's say they are $5,000 per year. So the present value of these costs over the next five years would be a little under 20,000 and would depend upon the interest rate involved. But this is only the explicit cost of training. Some costs are implicit. In going to school you may be forgoing the $20,000 job a year job that you could have had by not attending school. Together tuition and forgone earnings would add up to a sum of$100,000, although that should be discounted by using an appropriate interest rate for costs occurred in the future.

Discounting the future costs and against the future benefits would tell you what limits to place on an investment in education, again assuming you valud education only as an investment in skills that raises your earning power. As long as the discounted returns exceed the discounted costs, the investment is worthwhile. [Note: most college professor's hope that there is a consumption value to education as well as an investment value. If college adds to your immediate appreciation of life, then this value should offset some or all of the costs of a college education).

While schooling frequently involves both explicit tuition costs and implicit costs, particularly loss of earnings, other kinds of training may not involve that explicit tuition cost. On-the-job training, in particular, involves only a loss in income over what you might have earned without training. Here the employer simply deducts training costs from your wages so that most workers never pay money out-of-pocket tuition for on-the-job training.

Finally, we can now consider two types of human capital investments. Some skills are useful only to one employer, while other types of skills have broader applicability. Much sales knowledge, for example, is specific to a particular employer because you are learning much about one firm's line of products. In switching jobs to another sales outfit, much of that knowledge learned at the previous job will be irrelevant. These kinds of skill investments are called specific human capital and involve a different dynamic than do investments in general human capital that have applicability to numerous employers. For example, learning to keep and read accounts is broadly useful in many financial capacities.

Skills that are specific to one employer create monopoly power for an employer (economists actually call this monopsony or buying power rather than monopoly or selling power). There may be many individuals who invest in skills relevant to the employer, but only one employer who has any use for those skills. Skills that are general, however, involve competitive markets so that if one employer refuses to pay the market value for a person's skills, another employer may be able bid an undercompensated employee away.

It is easiest to consider cases involving general skills first. In these cases, because competition ensures that wage premiums go to trained employees, there is clearly a future return after training. In the graph below, we can see that the horizontal axis is labeled time and is divided into two periods, training and post-training. During the post-training period, competition requires wages to equal workers' productivity. Consequently, workers may compete for these positions by offering their services below their alternative wages. Ultimately, firms will not hire these workers unless wages are low enough to offset training costs. Consequently, wages in the pre-training period also equal worker productivity (here productivity is defined as the value of the work produced minus training costs).

In the case of specific human capital the big difference is that nothing guarantees a firm will pay a worker an amount equal to their productivity. No other firm is competing for workers trained with skills specific to this firm. Consequently, there appears to be no reason to pay such workers any more than the wages they might receive in their best alternate employment which involved no investment in human capital. If this actually happened, however, then workers would certainly not accept lower wages during the training period, as they would be better off taking positions without training. Wages would be flat and equal to the wages of untrained individuals for the entire training and post-training period. However, the worker does have one trick up his or her sleeve. If that workers quits, the employer stands to lose the investment made in that employee's training. Consequently, to prevent turnover and loss of their investments, firms employing specifically trained workers may offer wages slightly higher those available to untrained workers once training has been completed. In this way, workers share in some of returns on the training investment that would otherwise go only to the employer. This makes these jobs somewhat more attractive than jobs in which no wage increases are offered. This makes these jobs more attractive than those with no training and consequently workers will compete for them. This may lower the training wage a little below that of untrained workers. The net result is that theory suggests specific human capital involves shared investments and shared returns by employers. That sharing may serve to change relations between employers and employees in a number of ways, giving each a longer term outlook.