Education as an investment in building human capital
Education is an investment in building human capital. And like investment in physical capital, it can be costly. For example, in 2000 the United State spent $443 billion on education. In many developing countries, rapid population growth has caused a large fraction of the population to be school age, so the burden of education spending is particularly large. Appleton. Simon, John Hoddinott and John Mackinnon (1996) provides an overview of Africa’s achievement in the formation of human capital, and it is impact on economic growth and welfare. They agree that human capital, economic growth and welfare are closely interrelated.
Human capital theory
annual earnings C
Incremental earnings H
H Indirect costs
18 Direct costs 22 Age 65
Age- Earnings profiles with and without a college education.
If an individual decides to enter the labor market after graduation from high school at 18, the age earning will be HH in comparison with the CC profile if she or he had gone to college. Attending college entails both direct costs (tuition, fees, books) and indirect cost (forgone earning). But on entering the labor market at age 22, the college graduate will enjoy a higher level of annual earnings over her or his working life. To determine whether it is economically rational to invest in a college education, its net present value must be found by discounting costs and benefits back to the present (age18)
Human capital in the form of education.
People work with their minds as well as their bodies. Indeed, in developed economies, intellectual ability is far more important than physical ability in determining a person’s wage. For this reason, education has become the most important form of investment in human capital. Increase in the education around the world shown in table below represents a large rise in the resources invested in producing the human capital.
Average years of schooling
Complete primary education
Complete secondary education
Complete higher education
Source : David N. Weil (2005) “Economic Growth”,
The table points to a large increase in the number of years of schooling over the period for which these data are available. In the developing countries, education of the adult population increase by 3.1 years, while in the advanced countries, it increased by 2.7 years. The average numbers of years of schooling and the fraction of adults that had finished primary school more than double. Given the initially low levels of education in the developing world in 1960, the percentage increase in the education were large.
Numerous empirical studies have estimates the return of human capital investment at all educational levels. But in Campbell R. McConnell, Stanley L. Brue, David A. Macpherson (2007) more concentrate on those showing private rates of return on investment in a college education. Speaking very generally, most rate-of-return studies have estimated such rates to be on the order of 10-15 percent. For example he estimated the internal rate of return to be 14.5, 13.0, and 14.8 in 1939, 1949, and 1958, respectively. He also indicated that the private rate of return ranged from 8.5 to 11.0 percent over the 1959-1974 period. The social rate of return for the corresponding period estimated to range from 7.5 to 11.1 percent. In a more recent study finds a private rate of return of 11 percent for 1998.
Rate of return per year of college education for males ranges from 8.3 percent in Denmark to 16.7 percent in Finland.
source: Organization for Economic corporation and development, education at a Glance, 2006, all data is foe males in 2003.for poor country government to provide as much basic education as possible, limiting resources allocated to higher education.
Return to investment in education.
Studies indicate very clearly that education brings economic returns that often exceed the opportunity cost of physical capital. More education leads to better jobs and higher income, in part because education improves the worker’s ability to understand and work with new technologies. It turns out that education- especially if expanded to include informal education and on-the –job-training seems to improve the productivity of capital as well because more educated workers make better use of machinery. Most economists believe that education entail substantial external or social benefits- that is, benefits accruing to parties other than the individual acquiring the education.
Rates of return provide a strong economics rationale
Schooling quality based on scores on standardized tests varies widely across the world.
source : “ Schooling, Labor Force Quality, and Economic Growth,” American Economic Review, December 2000.
From a social perspective, these benefits should clearly be included in estimating the rate of return on human capital investments. Ronald. G. Ehrenberg, Robert S. Smith (2006) found four benefit of investment to an education in along run. First, it is well known that more educated workers have lower unemployment rates than less educated workers. Having high unemployment rates, poorly educated workers receive unemployment compensation and welfare benefits with greater frequency and may also find crime a relatively attractive alternative source of income. This means that society might benefit from investing in education by having to pay less in taxes for social welfare programs, crime prevention, and law enforcement. Second, political participation and, presumably, the quality of political decisions might improve with literacy and education. More education might mean that society’s political processes would function more effectively to the benefit society at large. Third, there may be intergenerational benefits which is the children of better educated parents may grow up in a more desirable home environment and receive better care, guidance, and informal preschool education. Fourth, the research discoveries of highly educated people might yield large and widely disbursed benefits to society.
Hundreds of studies have been conducted in the past thirty years on the profitability of investment in education in a large number of countries. Gerald M. Meier and James E. Rauch (2005) said that the impact of education can be divided into two distinct types which is macro and micro. If investment in education yields returns at the individual or social level, this must be reflected at the level of the economy. Growth accounting in the post-World War II period was based on the so called aggregate production function.
Output = f ( Land, Labor, Capital)
They expressing a country’s output as a function of the traditional triad of factors of production. Fitting the above relationship to the time series data for United States left a huge unexplained residual, named “the coefficient of our ignorance,” Output grew much faster than increases in the traditional factors of production could account for. The introduced the quality of labor or human capital into the traditional production function by plugged in the amount of investment represented by expenditures on education and explained a great part of the previously puzzling residual. The macro approach has been replicated by others over the past thirty years with similar result.
Further, qualities of people that are productive, it means that characteristics that enable them to produce more output. Investment in human capital production is a major expense for an economy. Bruce E. Kaufman, Julie L. Hotchkiss (2006) agree that human capital will give some impact at monetary side. Shows that in Japan and Korea are the classics cases in which an educated population base has provided the necessary infrastructure for industrial advance to take place at a later date. Infrastructure plan are related to physical capital. In other words, human capital will make government invest in other things that give benefit to country and population. Performing almost any job requires the use of capital, and most jobs, the worker who has more or better capital to work with will be able to produce more output. The returns to investment in education in advance industrial countries are roughly the same as those of investment in physical capital.
Impact of education is given by David N. Weil (2005) was wider social impact. When a person becomes literate, this person will enjoy higher lifetime consumption path, according to statistics for a large number of countries. Other will also benefit if the country has a more literate population- through lower transaction costs than if they were dealing with illiterates, for example. Many educated female are productive in the variety of goods and services produced within the household that are not marketable. They may provide better sanitation conditions for all members of the family and more nutritional meals. Such impact should be counted as part of the social impact of education. He also found that migration is an illustrative example of the means by the returns to education are realize. To extent that education makes the worker aware of employment opportunities elsewhere, or simply makes him or her employable in other contexts, it will instigate a more efficient allocation of labor to the most productive uses.
Inadequate nutrition and frequent illness reduce the ability of people to learn, to produce goods and services, and to rise healthy children. So poor health contributes to poverty and poverty in turn contributes to poor healthy. A basic requirement for the development of human capital, then, is good health. In Stuart R. Lynn (2002) research conclude that health status is very important part of human well-being. Several studies have shown that literacy and other measures of education are more closely correlated with life expectancy than per capita income is. The mechanism of this relationship is that education helps determine both the level of knowledge about how to combat disease and the ease with which it can be transmitted and utilized. B. Suren (2002) also agree that the positive correlation between health and education. He proposed a simple model that allows us to corporate health-investment decisions into a life cycle framework. The model showed a positive correlation between the health stock, education and savings rate for both high income countries and poor countries.
The relationship between education and fertility is a very complex one, Cochrane, S. H (1979) said although most observes would agree that the link is negative-that increased literacy and school attendance in general delay marriage and increase the opportunity cost of having children. Consequently, families desire and have fewer children. This has been clearly demonstrated in urban areas on a global scale.
In addition, some tentative studies suggest a positive impact of education on agriculture productivity. Evidence from Mexico suggests rates of return above 20 percent from primary education, although other Latin American countries show lower returns. In Ghana, cognitive skills, rather than years of schooling. There are some suggestion that investment in education can have rates of return that easily justify the resources allocates to it by governments. The basic approach is to see how earnings vary with the amount of education. Earnings are “net” that is, they are offset by costs. For private rates of return, these costs involve the income forgone by students who (if old enough to earn income) substitute school for work. Social cost also include the value of resources used to provide education.
Criticisms of human capital theory
A number of criticisms have been made of human capital model and its applications. Campbell R. McConnell, Stanley L. Brue, David A. Macpherson (2007) found four criticism, the first two criticisms are concerned with measurement problems and suggest that estimates of the rates of return for investments in education are likely to be biased, and two other criticisms also have implications for measuring the rate of return on human capital investment but are more profound in that they challenge the very concept or theory of investing in human capital.
Investment or consumption
One criticism of measuring the rate of return on human capital investment is that it is not correct to threat all expenditures for education as investment because, in fact, a portion of such outlays are consumption expenditures. The decision to attend college, for example, is based on broader and more complex consideration than expected increases in labor productivity and enhanced earnings. Some substantial portion of one’s expenditures on a college education yields consumption benefits either immediately or in the long run. The problem , however, is that there is no reasonable way to determine what portion of the expense for an educational is investment and what parts is consumption. The easy way is taken by ignoring the consumption component of educational expenditures and considering all such outlays as investment, empirical researchers understate the rate of return on educational investment.
In calculating the internal rate of return , most researchers simply compare the differences in earnings of high school and college graduates differ in other respects. First, the fringe benefits associated with the jobs obtained by college graduates are more generous-both absolutely and as a percentage of earnings-than those received by high school graduates. By ignoring fringe benefits, empirical studies understate the rate of return on a college education. Second, the jobs acquired by college graduates are generally more pleasant and interesting than those of high school graduates. This means that a calculated rate of return based on incremental earnings understate the total benefits accruing from a college education. Two other related criticisms, labeled the ability problem and the screening hypothesis, question the every concept of human capital investment.
The ability problem
It is widely recognized that average incomes vary directly with the level of education. But it is less well accepted that a strong, clear-cut cause-effect relationship exist between two. Critics of human capital theory contend that other things in fact are not likely to be equal. It is widely acknowledged that those who have more intelligence, more self-discipline, and greater motivation – not to mention more family wealth and better job market connections- are more likely to go to college. The only reason that education is correlated with income is that the combination ability, motivation, and personal habits that it takes to succeed in education happens to be the same combination that it takes to be a productive worker.
The screening hypothesis.
The screening hypothesis is closely related to the ability problem. This hypothesis suggest that education affects earnings not primarily by altering the labor market productivity of students but by grading and labeling students in such a way as to determine their job placement and thereby their earnings. It is argued that employers use educational attainment. A college degree or other credential thus signals trainability and competence and becomes a ticket of admission to higher-level, higher-paying jobs where opportunities for further training and promotion are good. Less educated workers are screened from these positions, not necessarily because of their inability to perform the jobs but simply because they do not have the college degrees to give them access to the positions.
Same like other capital, human capital also have diminishing of return when there are a lot of supply compare to quantity demand. This is the work for government to alter a country’s educational needs. For example, the content of higher education, the allocation of public resources should consider the country’s needs . How many research physicists are likely to be needed? How many lawyers and pilots? How many teachers, nurses, and accountants, armies? How many economists, sociologists, and political scientists? While making these estimates with any precision will be time waste, the use of public resources might well be focused on increasing the number of teachers, medical technicians, statisticians, and agronomists, rather than lawyers and philosophers.
More generally, people will need broad- based knowledge that will enable them to change jobs occasionally, and the importance of liberal art will increase. But many countries are still in desperate need of basic literacy and work skills. The choice that government made in the education sector are likely to indicate how education are delivered. A commitment to needs-oriented education implies that the mechanisms of “education” are not strictly “school”. The World Bank’s experience in lending for education suggest that qualitative investments in curriculum development, better books and teacher training often provide returns than putting up more buildings and providing the latest educational equipment.
The view that increased educational investment increase worker productivity is a natural outgrowth of the earnings of the observation that such investments enhance the earnings of individuals who undertake them. Educational investment is what causes productivity to rise is not the only possible interpretation for the positive relationship between earnings and schoolings. Most economist reject the various criticisms of human capital theory, the believe that education and training directly increasing productivity and earnings, but the also recognize that not all investment in education and training have a positive net present value, some investment are poor ones, and others have diminishing returns.
Thus, human capital theory cannot be used uncritically as a basis for public policy. For example, taken alone, massive government investments in human capital to increase economic growth may yield disappointing results. Such policies need to be balance against alternative policies promoting new technology and greater investment in physical capital. Another interpretations is that the educational system provides society with a screening device that sorts people by their (predetermined) ability. As conclusions, sees the educational system as a means of finding out who is productive not of enhancing worker productivity.
Appleton, Simon, John hoddinott and john Mackinnon (1996), Education and health in sub-Saharan Africa”, journal of International Development, 8(3):307-339.
Bruce E. Kaufman, Julie L. Hotchkiss (2006) “ The economics of Labor Markets” 7th ed, Thomson Higher Education, USA
Campbell R. McConnell, Stanley L. Brue, David A. Macpherson (2007) “Contemporary Labor Economics”, 8th ed, The McGraw-Hill companies, Inc. New York
Cochrane, S. H. (1979). Fertility and Education: what Do We Really know? Baltimore: John Hopkins University Press.
David N. Weil (2005) “Economic Growth”, Pearson Education, Inc. New York.
Gerald M. Meier and James E. Rauch (2005) “ Leading Issues in Economic Development”, 8th ed, Oxford University Press.
Suren. B (2002). “Heterogenous Human Capital, Life Cycle- Investment in health and education” economic Journal.
Ronald. G. Ehrenberg, Robert S. Smith (2006) “Modern Labor Economics, Theory and Public Policy”, 9th ed, Pearson education, Inc. New York
Stuart R. Lynn (2002) “ Economic Development- Theory and Practice for a Divided World” Pearson Education, Inc. New York
Human capital theory
Human capital in the form of education.
Return to investment in education.
Criticisms of human capital theory
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