Chapter 6: Human Capital - Department Home · Personnel Economics 6 1 Chapter 6: Human Capital ... – expectations about time in the labor force will influence ... Personnel Economics

1Personnel Economics 6

Chapter 6: Human Capital

• Investments– require current costs – bring future returns

• There are many investments that individuals and firms can make that can be thought of as investments in “human capital.”– Formal education: Schooling

– On-the-job training (OJT)

– Health care, beautification, etc.


Capital and Investments

Financial Capital: „Make an investment, ifpresent value of the flow of revenuesgenerated by the machine exeeds operatingand purchasing cost of the machine.“

Human Capital: people and skills, not plantsand equipment


Human Capital (HC)

Human capital has some characteristics that make it different from financial capital

– HC is not very liquid. If an investment doesn’t work out, there is not much to sell.

– HC adheres to the individual, so there is a problem for the firm if the individual leaves.

– There may be benefits to society from training.– There may be consumption returns in its

acquisition.


Schooling decision of the worker

• Compare present value of costs with present value of benefits. Does the present value of the benefits exceed the present value of the costs?

• Costs include both – direct costs (tuition, books) and – indirect costs = opportunity costs: foregone earnings


Schooling decision of the worker

TIME

Ear

ning

s

Income w/o schooling=A

Direct Costs

Foregone Earnings

Returns from schooling

Income with schooling=B


Consider whether to drop out of school in graduation year

• Costs of staying in school for one year and graduate:– C0 ... Tuition, books– J0 ... Earning of drop out in this year

• Benefits of staying in school for one year and graduate:– Ki ... Earnings of high school graduate in year i after graduation– Ji ... Earnings of high school dropout– r ... Interest rate– T ... Number of years worked

– Year i = 1: Year i = 2:

– All Years:

1 11(1 )

K J Dr

−≡

+2 2

22(1 )K J D

r−

≡+

1 (1 )

Tt t

tt

K Jtotal returnsr=

−=

+∑


Schooling decision

Attend year at school if

returns in form of higher wages exceedcosts of schooling

0 01 (1 )

Tt t

tt

K JC Jr=

−+ <

+∑


Implications for the worker

• Early years of schooling: returns typically exceed the costs– Much is to be learned if one knows very little– Costs of school are very low (subsidies)– Forgone earnings are low

• It pays for everyone to invest in formal education, optimal stopping date when

0 01 (1 )

Tt t

tt

K JC Jr=

−+ =

+∑


Implications for the worker

• Higher tuition rates decrease school enrollment• The longer work life T, the more investment in schooling

– education done at a young age– expectations about time in the labor force will influence investments

• The higher the relative earnings of skilled workers the higher investments– The higher wage dispersion the more incentive to invest in education– The higher the appreciation of a high skilled job (can be subsumed

under K: higher status, more flexibility, more interesting tasks) - the more investment


On-the-job training (OJT)

• Training implies increasing age-earnings profiles

• Age-earnings profiles will tend to be convex.

– Diminishing marginal returns, payoff to investment declines after more of it has been done.

– Less time is spent in acquiring skills over time.


On-the-job training

• General on-the-job training: investment in human capital that raises productivity of worker at current and other firms.

• Firm-specific on-the-job training: makes workermore productive at the current firm, but has no effect on productivity elsewhere.

• Examples?


General Human Capital

Worker gets general training, costs $500, raises productivity by $1000 per year.

Suppose the firm makes the investment:

– What wage should the firm pay afterwards?– What is an equlibrium strategy for wages and

for training expenses?


General Human Capital

• Workers pay for training?

• In form of lower wages!– Formal apprenticeships– Young attorneys, cooks – will be able to open

own business later!


Application: machinist vs. technical artisan

• Machinist: no training• Technical artisan: training

– initially: lower productivity– later: higher productivity

• More able individuals: get more out of training

• How should jobs be assigned?• Who benefits from training?


Conclusions – general training

• Workers have to pay themselves for general on-the-job training through reduced wages.

• Because workers are paid their productivity, anyone who wants general training should begiven the opportunity to receive it.

• The young, able workers who plan to stay in the labor market for a long time have the biggestincentive to invest into training.


Firm-specific training

• Worker cannot go somewhere else to get the returns to training

• Suppose firm finances all the training and expectsto get the full rent: What can the worker do?

• Suppose worker finances all the training and expects to get all the returns: What can the firm do?


The problem

• If the worker pays for the investment: The firm does not need to increase wages if the training is specific because the worker has no better job alternatives.

• If the firm pays for the investment: The worker can threaten the firm with quitting because the firm will lose its investment in training.

• Therefore, it is likely that the firm and worker will agree to share the training costs as well as the benefits. This can be done with an upward sloping wage profile.


Conclusions – firm specifictraining

Firm and worker split costs and benefitshave incentives to stay together after investment!

– Worker receives higher wage than outside wage– Firm pays below productivity

productivity w/o training

productivity with training

wage with training

returns to worker

returns to firm

investment of firm

investment of worker

Wage

Experience


Who to train?

• General training: workers self-select, firm indifferent

• Firm-specific training: – if investment and returns are split 50:50 also here

workers will self-select appropriately. Only those workerswho expect to work long enough that investment pays off will choose investment.

– BUT: if worker makes a mistake – has wrong expectationsof how long he‘ll stay with firm: harms firm also! Thereforefirm should take more active role when selecting workersfor firm-specific training.


Age and earnings

• Firm-specific HC predicts that long term employees are more productive relative to their wage. Often this is not what we observe past “prime-age.”

• Other explanations for age-specific wage profiles?


Chapter 11: Seniority and incentives

• Assume a firm has no promotionpossibilities and piece rate contracts areimpossible because of measurementproblems

• How can you assure that workers work hardall the time, especially if retirement getscloser?


Deferred compensation

• Deferred compensation can give incentives for workers to work hard today in exchange for returns tomorrow.

• This requires an implicit contract between the worker and the firm about employment.



Seniority model (Fig. 11.1.)

• Worker can choose to work hard (produce V) orshirk (produce V‘)

• Alternative use of time (Alt) is increasing over age (retirement/leisure is increasingly more attractive)

• T is optimal retirement day. Why?• W is a possible wage profile: the present value of

the compensation scheme must be equal to the present value of the productivity stream of the worker.


Seniority model

• The incentive for hard work is generated by the threat of dismissal. If dismissed, the worker loses parts of her returns to investment of hard work in previous periods.

• What would happen if the worker gets wage profile V? How big would be her incentive to work hard on the last day T?

• What about the wage profile W?• What is the effect of a steeper wage profile?• Subtle point: can a firm really afford to pay profile V?


Seniority model vs. Firm-specific HC

Now the worker earns less than productivity at the beginning and more at the end of her career, which is the exact opposite to the predictions of the human capital story. The worker “lends” to the firm!

time with company

wage, output

productivity

wage


Seniority modelThis can only work if the firm has sufficient reputation from prior history to get the workers to believe that the firm will live up to the implicit contract, since the firm has incentives to get rid of the workerbefore the worker has made a return on her investment. (What would be the optimal time for firm to fire the worker?)

time with company

wage, output

productivity

wage


Work decisions

Caution: Steep profile distorts work-leisuredecision, older workers want to work toomuch! - Mandatory retirement solves problem!


Predictions about turnover in seniority wage schemes

• Worker will not want to leave the firm (you needmandatory retirement or dramatic fall in wage)

• Firm will want to fire the worker

• Worker will not shirk in equilibrium. Therefore no firingfor cause

• Threat of punishment should be relatively severe as compared to the seriousness of the misdemeanor


Deferred Compensation

• Seniority profile just one case

• Other examples:– Severance pay (Abfertigung)– Retirement bonus


Now I‘m confused• Is the wage higher than productivity or lower for older

workers?– Specific HC would say lower– Seniority wage model would say higher– Union contracts might complicate the picture

• Firms will use seniority profiles if they are– Old, well established, with good reputation– operating in growing or stable industries

• Firm uses firm-specific HC earnings pattern if the firm‘s formal training, OJT, contacts, networks, etc are very firm-specific and cannot be used somewhere else

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Chapter 6: Human Capital - Department Home · Personnel Economics 6 1 Chapter 6: Human Capital ... – expectations about time in the labor force will influence ... Personnel Economics