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Topic No: 2
Human Capital
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Lecture Map
Introduction
Definition of human capital
Components of human capital
The human capital theory
Human capital & Physical capital Stages of formation of human capital
Human capital & Economic growth
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Introduction: The Human Capital
Revolution in Economics
Rediscovering the role of education to the
wealth of nations. Searching for clues on income distribution
Paretos remarks (his Power Law) dominated the
field of personal income distribution. Due to this
many economist believed that the distribution of
income followed exogenous forces.
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Introduction: The Human Capital
Revolution in Economics Major contributors:
1. Kuznets, Simon and Milton Friedman. (1945),Income fromIndependent Professional Practices, National Bureau of EconomicResearch.
2. Mincer, Jacob (1958), Investment in Human Capital and PersonalIncome Distribution,Journal of Political Economy, vol. 66(4), pp.281-302.
3. Schultz, Theodore W. (1961), Investment in Human Capital, The
American Economic Review, vol. 51(1), pp. 1-17.4. Schultz, Theodore W. (1962), Reflexions on Investment in Man,
Journal of Political Economy, vol. 70(5, Part 2, Supplement), pp. 1-8.
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Introduction: The Human Capital
Revolution in Economics6. Becker, Gary S. (1962), Investment in Human Capital: A Theoretical Analysis.Journal of Political Economy, vol. 70(5, Part 2, Supplement), pp. 9-49.
7. Mincer, Jacob (1962), On-the-Job Training: Costs, Returns, and Some Implications,Journal of Political Economy, vol. 70(5, Part 2, Supplement), pp. 50-79.
8. Becker, Gary S. (1964),Human Capital: A Theoretical and Empirical Analysis, WithSpecial Reference to Education, New York, National Bureau of Economic Research.
9. Mincer, Jacob (1974),Schooling, Experience, and Earnings, National Bureau ofEconomic Research, New York.
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Definition Of Human Capital
What is capital?
What is human capital?
Ans: human capital refers to the collection ofinnate andacquiredindividual abilities that are substantiallydurable, persisting over some significant portion of thelife of the possessor. Furthermore, the personal attributesreferred to under this rubric are restricted to positiveabilities and capabilities. In other words, their natureis such as would normally yield some stream of benefits,by enhancing the possessors performance in one or moresocially valued activities.
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Specific Aspects Of Human
Capital
1. Human capital comprises a) innate b) acquired component
2. human capital is non-tradable
3. human capital can be acquired formally or informally
4. Human capital has quantitative and qualitative aspects
5. Human capital can be either general or specific
6. Human capital may not be fully utilized
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Components Of Human Capital
Social capabilities(know-how, know-who):
e.g., diligence, loyalty,cooperativeness, trust, etc.
Flexibility:Multi-task performance,
re-trainability.
Problem-solving,
leadership,managing complex tasks.
Psycho-motorbased skills
("know-how","can-do").
HumanCapital
LongevityHealth
Physiologicalcondition:
e.g. Strength,eyesight etc.
Proceduralcapabilities
Cognitivecapabilities
("know-why"'know-what")
Tangible Intangible
Creativeness,innovativeness
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The Human Capital Theory
Introduction
The human capital model
Generalizations and implication of the
human capital model
Criticisms of human capital theory
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Introduction
The early 1960s witnessed what has been
described in the economics literature as the
"human investment revolution in economicthought" (Bowman 1966). Expenditures on
education, whether by the state or
households, have been treated as investmentflows that build human capital.
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Introduction
Basic Concepts Of Investment In HumanCapital. When a firm invests in physical capital, it is acquiring
some assets that is expected to enhance the firms flowof net profits over a period of time. For example, acompany might purchase new machinery designed toincrease the out put and therefore sales revenues over,say, the 10-year projected life of the machinery. The
unique characteristics of investment is that currentexpenditures or costs are incurred with the intent thatthese costs will be more than compensated by for byenhancedfuture revenues or returns.
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Introduction
Once education is treated as an investment, the immediatenatural question is: what is the profitability of thisinvestment in order to compare it to alternatives? Suchcomparison can provide priorities for the allocation of
public funds to different levels of education, or can explainindividual behaviour regarding the demand, or lack ofdemand, for particular levels or types of schooling.
For establishing education investment priorities at themargin the human capital model is the main theoretical
foundation. So, now I present the human capital model.
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The Human Capital Model
Decision to invest in college education.
From purely economic standpoint, a
rational decision will involve a comparison
of costs and benefits.
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The Human Capital Model
Costs (monetary) of college education:
Direct or out of pocket costs.
Expenditure on tuition, special fees, and books and supplies.
Indirect costs.
Opportunity cost.
Benefits of college education.
Enhanced future flow of earnings.
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The Human Capital Model
18 22
Age
Annualearnin
gs
H
H
C
C
65
(3)
Incremental earnings
(2)
Indirect
cost
(1)
Direct
cost
Age-Earnings Profiles with and without college education
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The Human Capital Model
Discounting and net present value. Compare costs and benefits. But one complication arises
because costs and benefits accrue at a different point in
time. This is important because rupees expended andreceived at a different point in time has different value. Ameaningful comparison of the costs and benefitsassociated with the college education requires that thesecosts and benefits be compared in terms of common point
in time, for example, present. So, calculate the net present value ofpresent and future
costs and benefits.
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The Human Capital Model
Time preference.
Why rupees expended or received at different point in time
has different value.
Because of interest payment on borrowed or rentedmoney.
And interest is paid because oftime preference.
Present Value Formula.
Vp (1+i) = V1.
)1(
1
i
VVp
+
=
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Extended Discounting Formula
npi
En
i
E
i
E
i
EEV
)1()1()1()1(3
3
2
210
+
++
+
+
+
+
+
+=
46
64
3
21
2
2019
18)1()1()1()1( i
E
i
E
i
E
i
EEVp
+++
++
++
++=
Formula for High School Graduate
=
+
=64
1818)1(n
n
n
pi
EV
More compact formula
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Decision Rule & Example
NPV Decision rule: Vp > 0
Example
C = 6000
E1 = 2500
E2 = 3000
E3 = 3500
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Internal Rate Of Return
Internal rate of return is that rate of discount
which equates the present value of future cost and
benefits, or stated alternatively, it is that rate ofdiscount at which the net present value of a human
capital investment is 0 (zero)
0)1()1( 11 =
+
+= ==
nn
r
E
r
C
NPV
Internal rate of return
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Internal Rate Of Return
IRR Decision rule: r = i
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Generalization & Implications
Length of income:
Longer the length of income higher the internal rate of
return on human capital investment or more likely thatthe NPV will be positive.
This explains why it is primarily young people who
go to college and why younger people are more
likely to migrate.
It also explains the portion of earnings differentials
that has been traditionally existed between women
and men.
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Generalization & Implications
Costs. Other things being equal lower the costs of human capital
investment, the larger number of people who will find that investmentto be profitable.
If the direct or indirect cost of attending college were to fall, wewould expect enrollment to rise.
Illustration: The guaranteeing of student loans by thegovernment eliminates the risk to the lender and lowers theinterest charged for borrowed funds to attend college. Byreducing the private cost of attending college education, suchloans guarantees increased college enrollments.
Similarly the state of the economy may influence collegeenrollments through its effects on the indirect or opportunity costof attending college.
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Generalization & Implications
For example, if recession reduces the
earnings that high school graduates achieve,
or, alternatively, reduces the probability ofobtaining job, the opportunity cost of
attending college will fall and enrollments
will rise. Lower costs increases the NPV of a
college education, making the investment ineducation profitable for some who
previously found it to be unprofitable.
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Generalization & Implications
Earnings differentials.Not only the length of the incremental earnings stream
critical in making a human capital investment decision,but so as thesize of that differential. The generalization
is that,
Ceteris paribus, the larger the earnings differential
between high school and college graduates, thelarger the number of people who will invest in
college education.
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Criticisms Of Human
Capital Theory Consumption or Investment
Non-wage benefits
The abilityproblem
Thescreeningtheory
C i Of H
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Comparison Of Human
Capital And Physical Capital
Similarities: Both human capital and physical capital has investment aspect
common in them i.e. investment is required to build and accumulate
both human capital as well as physical capital. For both thus theinvestor has to forgo the present consumption in anticipation of thefuture enhanced consumption.
Both have returns. this similarity is a corollary of the first similarity.
Both have their quantity and quality.
Both depreciates. For example, human health depreciates with time.And education also depreciates if not used properly.
C i Of H
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Comparison Of Human
Capital And Physical Capital
Because both human capital and physical capital
depreciates, they both requires maintenances. For
example, human health requires frequent care. And
training and re-training is required to update thedepreciating skills.
The amortization period for a physical capital is the
product cycle and for human capital the same is
working life of the individual. Both have rental value. Both can be rented away.
C i Of H
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Comparison Of Human
Capital And Physical Capital
Differences: There are major differences in terms of the returns obtained from the
investment in human capital and physical capital. The investment in physical
capital has only monetary and market returns whereas investment in humancapital has non-monetary as well as non-market returns.
The returns to human and physical capital tend to behave differently. When
individual invest in physical capital, they are return-takers i.e. the owners
accepts the return dictated by the market and cannot influence them. Since
there are no market for the stock of human capital, investors in human capital
become return-maker, as the amount, the quality and the maintenance of theirhuman capital will dictate what the market will be willing to offer for their
services.
C i Of H
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Comparison Of Human
Capital And Physical Capital
Property rights and marketability:physical capital is
tangible, that can be easily seen or touched. It includes
machineries, factories, plants, raw materials etc. physical
capital can easily be sold and transferred from one ownerto another.
But human capital is inseparable from the human beings
and its ownership is restricted to the individual in whom it
is embodied. Unlike physical capital, the stock of humancapital is not marketable. Only the services that emanate
from this stock are market goods.
C i Of H
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Comparison Of Human
Capital And Physical Capital
Financing: lenders are more willing to lend funds forthe investment in physical capital than in investment inhuman capital because the former is marketable andcontinue to be a good collateral. Physical capital caneasily be sold, seized, jointly owned and transferred bysale or by inheritance.
whereas human capital is intangible and in dissociablefrom its owner. This makes the private finance for theacquisition of human capital harder to obtain.
The gestation period for physical capital is smaller thanfor human capital.
Mobility wise both are different.
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Human Capital Formation
Stages of human capital formation
Primary education
Higher education On-the-job training
Retraining
Retirement
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Human capital and economic growth
Theoretical background
Links through which human capital affects
economic growth (Chain of reasoning).
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Theoretical background
The classical growth theories predicted that,
economies will stagnate after reaching the high
growth levels.And there is no continues rise in economic
growth.
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Theoretical background
Neoclassical growth theory of Solow (the Solowgrowth model) also predicted that economies willstop growing after reaching the steady state growth.
But, There is way out of this problem, and that way is, Technology.
But,
Technology is assumed (it is exogenous and determined
outside the model). SOproblem again. To solve the problem develop models that explain
technological progress.
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Theoretical background
To solve the problem economists developed,
Endogenous growth model.
Paul M. Romer, Increasing returns and long run growth,
Journal of Political Economy 94 (October 1986): 1002-1037,
Robert Lucas Jr., On the Mechanics of Economic
Development,Journal of Monetary Economics 22 (1988):3-42
According to this model New Ideas (Human capital)
becomes important for growth.
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Links of Effects
1. At the macro level human capital can beviewed as a factor of production coordinatewith physical capital (Aggregateproduction function approach) Its contribution of growth is greater larger the stock of
physical capital.
Growth of human capital is both a condition and a
consequence of economic growth. Example: the success of the Marshall Plan in Europeand the failure of foreign aid to LDC's.
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Links of Effects
2. Human Capital and Technology Human capital activities involve not merely the
transmission and embodiment in people of available
knowledge, but also the production of new knowledgewhich is the source of innovation and of technicalchange which propels all factors of production. Thislatter function of human capital generates worldwideeconomic growth regardless of its initial geographiclocus.
Human capital as a source of new knowledge shiftsproduction functions upward and generates worldwideeconomic growth.
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Links of Effects
3. Human capital and population Human capital is a link which enters both the causes
and effects of economic-demographic changes. Three ways.