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Human Capital Theory

Adam Smith (1776, Book I, Chap.X, part I) argued there should be
compensating wage differentials to take account of the whole of the
advantages and disadvantages of a job.

Among other circumstances, he mentioned: the easiness and
cheapness, or the difficulty and expense of learning a business

Smith laid out the basics of human capital theory when he
compared an educated human to an expensive machine:

When any expensive machine is erected, the extraordinary work to
be performed by it, before it is worn out, it must be expected, will
replace the capital laid out upon it, with at least the ordinary profits.

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Human Capital Theory
A man educated at the expence of much labour and time to any of
those employments which require extraordinary dexterity and skill,
may be compared to one of those expensive machines. The work
which he learns to perform, it must be expected, over and above the
usual wage of common labour, will replace to him the whole
expence of his education, with at least the ordinary profits of an
equally valuable capital.

It must do this too in a reasonable time, regard being had to the very
uncertain duration of human life, in the same manner as to the more
certain duration of the machine.

The difference between the wages of skilled labour and those of
common labour, is funded on this principles.
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Human Capital Theory
Basic idea: With human capital theory, investments in human
resources are considered similarly to other types of investments.

Costs are incurred in expectation of future benefits and the
investment in the last unit of human capital is made only if the
benefits are expected to exceed the costs.

That is, individuals decide on their education, training, medical
care, and other additions to knowledge and health by weighing the
benefits and costs.

Benefits include cultural and other non-monetary gains along with
improvement in earnings and occupations, while costs usually
depend mainly on the foregone value of the time spent on these
investments.
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Human Capital Theory
On the supply side: additional schooling entails opportunity costs in
the form of foregone earnings plus direct expenses such as tuition.
To induce a worker to undertake additional schooling, he must be
compensated by sufficiently higher lifetime earnings.

On the demand side: to command higher earnings, more schooled
workers must be sufficiently more productive than their less schooled
fellow workers.

In the long run equilibrium, the relationship between lifetime
earnings and the schooling must be such that
i) the supply and demand for workers of each schooling level
are equated and
ii) no worker wishes to alter their schooling level.
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Human Capital Theory
The study of the effects of investment in schooling and on-the-job
training on the level, pattern and interpersonal distribution of life-
cycle earnings was pioneered by Becker and Mincer.

This leads to one of the most successful empirical equation called
the Mincer earnings function (1974):
c | | | + + + + =
2
2 1 0
E E rS ) w ln(
where w is earnings (or the hourly wage when available), S is years
of schooling, E is years of labour market experience, and is an
error term.
Mincer uses the transformation Experience equals Age minus
Schooling minus 6, E = A S 6.
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Human Capital Theory
The Mincer equation thus captures the important empirical
regularities:

1) increase in earnings with schooling,
2) concavity of log earnings in experience,
3) parallelism in log earnings experiences profiles for different
education groups,
4) U-shaped interpersonal variance in earnings.

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Human Capital Theory
Experience - earnings profiles:
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Human Capital Theory
Age - earnings profiles:
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Human Capital Theory
Experience - variance log earnings:
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Human Capital Theory
Almost all empirical studies find that:
schooling has a positive and significant effect on earnings (r > 0)
that earnings are a concave function of labour market experience (
1

> 0 and
2
< 0 ).

The theoretical foundations of Mincer specification can arise from two
theoretical frameworks:
i. compensating wage differentials (Mincer, 1958)
ii. accounting identity framework (Mincer, 1974).

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Human Capital Theory
I. Compensating Wage Differentials
Let w(s) represent the annual earnings of a representative individual
with s years of education, assumed to be constant over his lifetime, the
present value of earnings is:
) e e (
r
) s ( w
dt e ) s ( w ) s ( V
rT rs
T
s
rt
= =
}
Where r is the interest rate and T is the length of working time.
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Human Capital Theory
I. Compensating Wage Differentials
Letting the compensating differentials take their time to work, we will
have V(s)=V(0) and the earnings difference between an individual with
s years of schooling and 0 years of schooling will be given by:
rS ) ( w ln
e
e
ln rS ) ( w ln ) s ( w ln
) s T ( r
rt
+ =
|
|
.
|

\
|

+ + =

0
1
1
0

Since the last term goes to zero as T gets large.
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Human Capital Theory
This yields the nice interpretation of r as an internal rate of return to
schooling, that is, it is the discount rate which equates the lifetime
earnings streams from different educational choices.

Problems: this framework ignores the direct costs of schooling,
assumes that earnings do not vary over the life-cycle, and that the
age of retirement does not depend on years of schooling.
I. Compensating Wage Differentials
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Human Capital Theory
II. Accounting Identity Framework
Let E
t
be potential earnings at time t.

Investments in training are expressed as a fraction of potential
earnings invested, C
t
=k
t
E
t
, where k
t
is the fraction invested at time t
and let
t
be the return to training investments made at time t.
Then:
) k ( E C E E
t t t t t t t
+ = + =
+
1
1

Repeated substitution yields:
[

=
+ =
1
0
0
1
t
j
j j t
E ) k ( E
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Human Capital Theory
Formal schooling is defined as years spent in full-time investments
(k
t
=1).

Assume that the rate of return on formal schooling is constant (
st
=
s
)
and that formal schooling takes place at the beginning of life.

Also assume that the rate of return to post-school investment,
t
, is
constant over time and equals
0
.

Then, we can write (in logs):

=
+ + + + =
1
0 0
1 1
t
s j
j s t
) k ln( ) ln( s E ln E ln
II. Accounting Identity Framework
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Human Capital Theory
Which yields the approximate relationship (for small
s
and
0
) using
the fact that ln(1+ )~ ,
II. Accounting Identity Framework

=
+ + ~
1
0 0 0
t
s j
j t
k s E ln E ln
Mincer further assumes that the rate of post-school investment is
linearly declining:
)
T
x
( k
x s
=
+
1 k
Where x=t-s>0 is the work experience at age t and T is the length of
working life, assumed independent of years of schooling.
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Human Capital Theory
II. Accounting Identity Framework
Under these assumptions, the relationship between potential
earnings, schooling and experience is given by:
( )
2
0 0
0 0 0
2 2
x
T
x
T
s E ln E ln
s s x
k k
k k
|
.
|

\
|
+ + + ~
+
Observed earnings equal potential earnings less investment costs,
producing the following relationship for observed earnings:
( )
2
1 0 0
2
0 0
0 0 0
2 2
1
x x s
x
T
x
T T
s E ln
)
T
x
( E ln ) x , s ( w ln
s
s
s x
| | o
k k k
k k k
k
+ + + ~

|
.
|

\
|
+ + + + ~
~
+
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Human Capital Theory
In most applications of the Mincer model, it is assumed that the
intercept and slope coefficient are the same across persons and do
not depend on the schooling level.

Allowing and
s
to differ across persons produces a random
coefficient model:



where the terms in brackets are part of the error term, expressed in
deviations from the mean coefficients.

It turns out that this is a crucial extension to the basic model. Since if
individuals were identical, why should they choose different amounts
of education?

| |
2
2 2 1 1 0 0 0 0
2
2 1 0
x ) ( x ) ( s ) ( ) ( x x s ) x , s ( w ln
i i i i s
| | | | | | | | | + + + + + + + =
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Human Capital Theory
However, although heterogeneity explains why we observe different
individuals having different schooling, an additional set of problems
is introduced:
Schooling is endogenous and, if this is not controlled for,
estimated returns may be biased.
Returns as well as schooling may vary across individuals.
This can be read in: Heckman, J., L. Lochner, and P. Todd (2003, May). Fifty
years of mincer earnings regressions. NBER. WP 9732, available on the
library catalogue. This is a very long paper the relevant part is section 2.