Human Capital Theory 1

Human Capital Theory

wage differences are due to differences in productivity (labor is heterogeneous!)

1 Introduction

• Definition of Human Capital (HC):

Stock of individual knowledge, capability, and skills that are economically
usable (all characteristics of an employee that may raise his or her salary)

−→ all those skills that are acquired through education, but also talents, I.Q.,
practical experience, etc. (important for empirical examinations: estima-
tion of wage equations)

• Analogy to Real Capital:

– sluggish – because the stock can change only slowly

– investment – current expenditures are interchanged with future re-
turns
– return – the effect of an additional year on earnings
– depreciation – due to new knowledge or technical progress, but also
because people forget knowledge once it has been acquired

• Difference to Real Capital:

i) Human Capital cannot be sold or mortgaged

ii) Human Capital cannot be separated from its owner

• Reasons for investment in HC:

a) future pay off, i.e. higher wages → indirect utility

b) element of consumption, i.e. generates fun → direct utility
−→ Dynamic problem (optimal allocation over time): maximization of the
intertemporal utility function, where the decision on labor supply also
depends on the formation of human capital

2 Assumptions

1. perfect capital markets → free entry

2. wage is a function of human capital:

wt = rtH Ht ,
 Human Capital Theory 2

where Ht denotes the stock of human capital which is assumed to be ho-

mogeneous (we abstract from different kinds of human capital and differ-
t
ent occupations for simplicity) and rH represents the given rate of return
to human capital

3. T periods - complete information, no uncertainty

4. intertemporal utility function – discounted life time utility

T
X
β t−1 U Ct , L − Lt − ItZ , Ht ; t ,


(1)
t=1

with leisure being defined as Ft = L−Lt −ItZ , ItZ denotes the time attributed
for the accumulation of human capital, Ht is the stock of human capital
for the t-th period, β being the subjective discount rate of the individual.
Since Ht is directly included in the utility function, it is assumed that it
generates direct utility.

5. Ht is accumulated by the following process:

Z G


Ht = (1 − δ)Ht−1 + Ψ It−1 , It−1 , Ht−1 ; t
Z G


∆Ht = Ψ It−1 , It−1 , Ht−1 ; t − δHt−1 , (2)

where Ψ(·) denotes a general human capital investment function (gross

output), ∆Ht−1 the change in the stock of human capital from period t − 1
to t, δHt−1 represents the human capital that is ”lost” (depreciation) at
a constant depreciation rate δ, ItZ is the time investment needed for ac-
quiring human capital and ItG is the investment in goods needed for the
human capital investment.

→ put in words: the change in the stock of human capital from last period
to today is a linear combination of human capital acquirement in the pre-
vious period (investment) and the stock of HC once acquired that is ”lost”
(depreciation).

6. intertemporal budget restriction:

T
X T
X
(1 + r)−t+1 wt Lt + V0 ≥ (1 + r)−t+1 Pt Ct + PtG ItG + PtZ ItZ


(3)
t=1 t=1

the left hand side of equation (3) describes the present value of the in-
dividual’s life-time wealth and the right hand side represent the present
value of life-time consumption being a linear combination of consumption
(Ct ) but also of the investment in time attributed to the accumulation of
human capital (ItZ ) and goods needed for accumulating human capital (ItG )
at market prices.
 Human Capital Theory 3

3 Optimal Investment in Human Capital

• maximization problem

T
X
β t−1 Ct , L − Lt − ItZ , Ht ; t


max
{Ct }T T T Z T G T
t=1 ,{Lt }t=1 ,{Ht }t=1 ,{It }t=1 ,{It }t=1 t=1

T
X T
X
−t+1
(1 + r)−t+1 Pt Ct + PtG ItG + PtZ ItZ ≥ 0


s.t. (1 + r) wt Lt + V0 −
t−1 t=1
Z G


∆Ht = Ψ It−1 , It−1 , Ht−1 ; t − δHt−1
wt = rtH Ht ,

H0 and V0 are given

• optimal investment
Z G


– It−1 , It−1 ↑ if
1. Ψ(·) ↑ – efficiency of investment increases
2. T ↑ – longer time for amortization of HC investment
3. U (..., Ht , ...) ↑ – higher utility of human capital
4. rtH ↑ – higher returns to human capital
Z G


– It−1 , It−1 ↓ if
1. δ ↑ – higher depreciation rate - faster ”loss” of HC
2. r ↑ – present is more important than future

4 Financing Human Capital

Types of Human Capital

1. general human capital

transferable to every other job and thus improves overall productivity and
thus wage

2. industry-specific human capital

transferable to other industries only with some wage loss

3. firm-specific human capital

not transferable to any other firm and therefore does not improve produc-
tivity and thus wages anywhere else
 Human Capital Theory 4

wage (W) wage (W)

productivity (rH H) productivity (rH H)
W(t)
rH (t)H(t)

Wa (t) = rH (t)H(t) W(t)

Wa (t)

age/time (t) age/time (t)

• General human capital

no possibility for the firm to get the return to invested money back (poach-
ing, high mobility of employees)

→ employee has to pay for it

→ under credit rationing, the individual can bear the cost of HC investment
by a reduction in wage (relative to the productivity) during the education
period

• Specific human capital

bilateral monopoly −→ negotiation: both have to pay and share the return
education period: individual receives a higher wage (relative to his pro-
ductivity in the firm)
→ employee has no incentive to quit, since the remuneration is always
higher than the alternative wage (W a -curve)

1 Theory
5 Criticism of the Human Capital

Everything that is stated above is based on the assumption that schooling in

fact improves productivity and can thus explain higher wages
→ questionable

• ability hypothesis: education only serves for signaling/selection

• family background is very important (society circles), financing capacity

• unions regulate the wage and do not directly take individuals into account
 Human Capital Theory 5

• discrimination: complicated, starts already before working life

• depends on industry

• regions