chapter 6: human capital - johannes kepler … economics 1 chapter 6: human capital • investments...

Personnel Economics 1

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, etc.


Capital and Investments

FinancialCapital: „Make an investment, if present value of the flow of revenues generated by the machine exeeds operating and purchasing cost of the machine.“

Human Capital: people and skills, not plants and 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.

• No collateral

– 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 as well.

Personnel Economics

Why wouldyou invest in skills?

• Firms may be worried that skilled workersmay leave

• So why invest into workers?

• Example: – Firm Acme hires newworkers into level 2 and

promotes their own workers to level 2.

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Personnel Economics

Workersat ACME

• Newly hired external workers have more extreme resultsthan internly promoted ones– Higher turnover

– Higher share of demotion

– More quickly promoted

• External workers have/need more education and moreexperience– Compensation for higher risk for the firm?

– Promoted workers are particularly good match?

– Compensation for less firm-related training?

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Personnel Economics

Investment intoeducationandtraining

• Gary S. Becker, Nobel Prize 1992

• Human capital theory: – Education and training is increasing

productivity

• Signaling theory (Michael Spence)– Education is (only) signaling a generally high

productivity of a worker

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Personnel Economics 6 8

Schooling decision of the worker

• Compare present value of costswith 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 JD

r

− ≡+

2 222(1 )

K JD

r

− ≡+

1 (1 )

Tt t

tt

K Jtotal returns

r=

−=+∑


Schooling decision

Attend year at school if

returns in form of higher wages exceed costs of schooling

0 01 (1 )

Tt t

tt

K JC J

r=

−+ <+∑


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 J

r=

−+ =+∑


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 workersthe 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


Monetary returns to education

• If you go to school one more year, by how much does your income rise?– Winter-Ebmer & Fersterer, 2003, Labour Economics

– Why are returns falling over time?

– Additional returns for health, unemployment, etc

Year Return males Return females

1981 9.4% 11.3%

…

1989 8.3% 8.5%

1997 6.6% 6.6%


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.


Productivity over time

Personnel Economics

Humankapital20

Personnel Economics

Humankapital21


On thejob training

• Example: – Firm fromSilicon Valley develops software for

tax advice

– Workers need knowledge in tax lawand javaprogramming language

– What should they train on the job?• Assume original productivity is € 10000, training

could increase it by 80% (40, 60%),

• Training costs are minor22


Java or taxlaw?

• Should the worker train only java, only tax lawora combination?

• Optimal training is dependent on future plans– Inside the firm

– Outside labor market

– Probability of staying or leaving


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 worker more 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!


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 thelabor market for a long time have the biggestincentive to invest into training.

– Typically more able workers profit more fromtraining


Problem of general training

• If the worker cannot pay for training (e.g. rigid wages, … ) what can the firm do?

• Non-compete agreements of some form

– Worker promises to stay for some time with the firm

– Worker has to pay back training expenses

– Not allowed to work for firm in the same industry (not clear if it is always legal)

– Require workers to train successors

– Offer deferred pay of some sort (pay a bonus later)


Firm-specific training

• Worker cannot go somewhere else to get thereturns 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 andexpects 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 costsas well as the benefits. This can be done with an upward sloping wage profile.


Conclusions – firm specific training

Firm and worker split costs and benefits

� have 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 workers who expect to work long enough that investment pays off will choose investment.

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


Implications for turnover

• The more general human capital is, the less relevant is turnover (both for firms and workers)

• Vice versa for firm-specific HC

• Thick/thin labor market (many/few jobs of a particular type– Thin labor market: firm has bigger incentive to train

firm-specific HC

– For workers with more firm-specific HC, labor market gets thinner

Personnel Economics

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35


Training apprentices

• Austrian apprentice system very interesting case– Fairly general human capital (certification due to

“Lehrabschlussprüfung”

– Problem of turnover (poaching): no firm would train any more!

– Very low training wages: workers pay for their training

– Firms may use apprenticeship as a long probation period to detect the best

– Training in high-tech and low-tech firms different


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?


Seniorityandincentives

• Assume a firm has no promotion possibilities and piece rate contracts are impossible because of measurement problems

• How can you assure that workers work hard all the time, especially if retirement gets closer?


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– Implicit = not written


Seniority model (Fig. 11.1.)

• Worker can choose to work hard (produce V) or shirk (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 to work hard is generated by the threat of dismissal. If dismissed, the worker loses parts of her returns to investment of hard work in previous periods. – Worker has to start with a new firm at a low wage.

• 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?

• 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 model

This 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 toolong!

- Mandatory retirement solves problem!


Predictions about turnover in seniority wage schemes

• Worker will not want to leave the firm (you need

mandatory retirement or dramatic fall in wage)

• Firm will want to fire the worker

• Worker will not shirk in equilibrium. Therefore no firing

for 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

– Firm pension


Wage profilesover thecareer

• Is the wage higher than productivity or lower for olderworkers?– 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‘sformal training, OJT, contacts, networks, etc are very firm-specific and cannot be used somewhere else

chapter 6: human capital - johannes kepler … economics 1 chapter 6: human capital • investments...

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