Human Capital : Theory and Application

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Human Capital Theory and Application

• Sung Jun Jo
• 11.05.2005

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Who Are Workers? (Human Resources)

• Cost?
• Assets?
• Business partner?

3
Agenda

• Introduction
• Schooling and Signaling
• On the Job Training
• Application-Executive Pay Issue
• Discussion

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Introduction

• Human capital refers to the knowledge and
  acquired skills a person has that increase his or
  her ability to conduct activities with economic
  value
• Workers add to their stock of human capital
  throughout their lives, especially via education
  and job experience
• Combination of . (Fitz-enz, 2000)

• traits brought into job
• ability to learn
• motivation to share

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A Model of Human Capital Theory
Individual Input (Investment)
Education
Outcomes
Productivity
Earnings
Social Input (Investment)
Citizenship
Social Efficacy
Source Swanson Holton III, 2001, p.110
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Evolution of Human Capital Theory

• Foundations
• A. Smith, J. S. Mill, A. Marshall
• J. Mincer (1958) Yrs of work forgone to pursue
  education were rationally compensated with high
  wage
• S. Fabricant (1959) Intangible assets
• G. Becker (1960) ROR of difference in education
• T. Schultz (1961) US income has been increased
  in higher rate than combined amount of land,
  working hours and capital used to produce
• Nobel Prize Winners
• T. Schultz, G. Becker,
• M. Friedman, S. Kuznets, R. Solow

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The Schooling Model

• A persons decision maximizes the present value
  of lifetime earnings
• The rate of discount (r) plays a crucial role in
  determining whether a person chooses to go to
  school
• Wage-Schooling Locus salary for each level of
  schooling
• Marginal Rate of Return to Schooling How much
  earnings increase if a person stays in school 1
  more year
• Stopping rule when it is optimal to quit school
  and enter job market (MRRr)

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Potential Earnings Streams
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Schooling Decision
MRR
r
r
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Factors That Lead Different Level of Schooling

• Differences in the Rate of Discount
• Different schooling decisions simply place
  them at different points of the common locus
• Differences in Ability
• Higher ability levels shift the MRR to the
  right, so, earnings gain resulting from an
  additional year of schooling outweighs the
  increase in forgone earning

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Signaling

• Education does(needs) not increase productivity
  at all, but signal a workers qualifications to
  potential employers who do not have private
  information
• Education increases earnings not because it
  increases productivity but because it certifies
  that the worker is cut out for smart worker
• Self selection constraints
• 1. Level of education of signaling must be
  such that non-smart workers are unwilling or
  unable to attain it.
• 2. Achieving given level of education must be
  cheaper for the high smart workers than for
  non-smart worker

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Self-Selection

NSWs edu cost curve
SWs edu cost curve
W
T1
T2
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On the Job Training

• Training increases a workers productivity (HC
  stock) after training
• Training is an investment with initial costs and
  expected future returns
• The returns are lost in the event of a separation
• Should the firm invest?
• Not if the skills are easily portable (worker can
  leave)
• Should the worker invest?
• Not if the skills are firm-specific (firm can
  layoff)

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Who Bears Costs of Firm Specific Training?

• Since there is no commitment to stay on the part
  of the worker after training occurred firms will
  not want to bear the costs of training when
  skills are general
• Since there is no certainty that the job will
  remain profitable in the future, the employee
  will not want to bear the costs of training for
  skills that can be valued only by the current
  employer (specific)

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Transferable Human Capital
The employee will want to bear the full cost by
accepting lower wage during training
VMPW2
w1
Time
training
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Firm-Specific Human Capital
The employer will want to bear the full cost by
paying above the market value to reduce turnover
VMP
w2
w1
Time
training
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Predictions of Human Capital

• When skills are transferable
• Employees should be bearing the cost
• Wages of trainees (compared to non trainees)
  should be lower during training
• Employer can offer what the market pays for the
  new skills acquired after training
• Given that training increases skills
• Wages of trainees (compared to non trainees)
  should be greater after training at a given
  employer

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Predictions of the Human Capital (Cont.)

• To reduce transaction costs after firm-specific
  training
• Workers should be paid above the market value of
  their transferable skills.
• Paying above market should minimize
  transaction(search) cost.
• Butif contracts can be renegotiated, the firm
  does not have to raise wages until faced with a
  potential quit (Beaudry and DiNardo ).

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Mincer Equation (1994)
log w rs ß1t ß2t2 other variables

• The Mincer equation 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

See the attached file for the further discussion
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Executive Pay (Murphy Zabojnik, 2004)

• Base salary and bonuses of Forbes 800 CEOs
  increased from 700,000 in 1970 to 2.2 million in
  2000
• In 1980, CEOs received about 42 times the average
  of workers. By 2000, they were paid 475 times the
  average workers (Milkovich Newman,2002)

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20 Top-Paid CEOs in 2003
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Possible Explanations on CEO Compensation

• Social Comparison relationship to others
• Economic Approach reward to success, depends on
  company size
• Agency Theory self-motivated behavior
• Fat-Cat Theory rent seeking
• Human Capital Theory increasing investment on
  human capital, type of required skill

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Hiring Sources-Internal or External
Source Murphy Zabojnik, 2004
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Hiring from Outside

• Hiring from outside
• foregoes valuable specific skills available only
  through internal promotions
• able to hire from a larger opportunity set of
  managers
• allows better matching of managers and firms
• Demougin Siow (1994)
• Outside hires involve hiring and replacement
  costs which are assumed to be higher than the
  costs of training and promoting from within
• Internal labor market with high value for
  firm-specific skills

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Executives as Human Capital

• As firm-specific capital becomes relatively less
  important, the benefit of better matching becomes
  large relative to the cost of (lost) specific
  capital
• prevalence of outside hires will increase
• higher wages for outside hires as the general
  component of skills becomes relatively more
  important than the firm-specific part of skills
• Potential reason for increasing pay increasing
  outside hire is the change in the composition of
  managerial skills toward more general (market
  valued) skills
• CEOs skills are transferable across firms and
  industries
• Greater breadth of knowledge helps management of
  any company
• Any firm-specific information is more easily
  accessible than before (computerization)

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Discussions

• Is education really improving productivity or
  just signaling?
• How can we measure the value of human capital?
• What are the implications of human capital
  theories for HRD specialists?