Human Capital Theory and Benefit-Cost Analysis in Education

Human Capital Theory and Benefit-Cost Analysis in Education Ajou University The Principles of Economics I Presentation by D. Kelleher (Based on a presentation originally delivered by Emmanuel Jimenez and Peter Moock, World Bank)

Outline Basic Framework for Analyzing Investments i Human Capital l Relevance for project analysis. . . not l – Issues – Modifying the approach

Human Capital Scale -- Weighing Private Benefits and Costs Benefits Costs

The productivity chain Education Human capital Wages Welfare Productivity

Human Capital and Productivity Human Capital Working with Existing Technology Better Acquiring New Knowledge Processing Information Developing New Technology

Education raises wages for both men and women:

Returns over time Wage ($) S 2 D 1 S 1 D 2 W S 2 D 1 D 2 S 1 G 2 Number of Graduates

Education raises wages for both men and women:

Education and productivity l Better educated farmers get a higher return on their investments in agriculture: – In Africa, farmers who have completed 4 years of education (the minimum necessary for literacy) produce, on average about 8 -10 percent more than farmers who had not gone to school (Moock, Jamison et al. , Jamison & Moock) – Technical and allocative efficiency (Welch, Timmer)

Education and productivity (cont’d) l Production function may matter: – In simple tasks or in settings where technology slow to change, effect of education small – In traditional farming, techniques passed from generation to generation (T. W. Schultz) – In piece-rate work in the Philippines, wage not related to schooling after controlling for gender and physical stature (Foster and Rosenzweig)

Human Capital and Wages Education Human capital Wages Welfare Productivity

Education and productivity (cont’d) – But, if task involves new technology whethere is a premium on learning and information acquisition learning may be very important – For example, large effect of education in Kenya after introduction of new hybrid seed varieties (Moock) – In India, areas with relatively few educated farmers at the onset of the green revolution experienced less growth compared to other, high schooling areas (Foster and Rosenzweig)

Human Capital Scale -- Weighing Private Benefits and Costs Benefits l l Increased market productivity Private non-market effects (e. g. , better personal health, household productivity effects) Costs

Human Capital Scale -- Weighing Private Benefits and Costs Benefits l l Increased market productivity Private non-market effects Costs Direct costs Foregone production or earnings

Graph on Rate of Return Estimation for University-level Education Post-tax earnings University graduates Age 22 65

Graph on Rate of Return Estimation for University-level Education University graduates Returns Secondary school leavers Indirect costs (foregone earnings) Age 18 22 Cost years 65 Benefit years 43 Time (years)

Graph on Rate of Return Estimation for University-level Education Returns University graduates Secondary school leavers Indirect costs (foregone earnings) Age Direct costs (out-ofpocket expenses)

Graph on Rate of Return Estimation for University-level Education University graduates + Costs ------ Benefits +++++++ + + + Secondary ++ + + + school leavers + + Age

Human Capital Scale -- Weighing Private Benefits and Costs Benefits Costs

Graph on Rate of Return Estimation for University-level Education University graduates + Costs age 18, t =0 Benefits +++++++ + + + Secondary ++ + + + school leavers + + ------ Age age 22, t =4 age 65, t = 47

Time Value of Money Now Later Inflation plus real rate of interest

Discounting Now Later

Interest Rate (Discount Rate) FV = PV(1+r)t PV = FV/(1+r)t

Interest Rate (Discount Rate) Future Value ($ in t years) Life of investment FV = PV(1+r)t Principal ($ invested) Interest rate PV = FV/(1+r)t Present Value of FV paid t years from now Discount rate

Weighing Private Benefits and Costs -Without Discounting Costs Benefits

Internal Rate of Return Benefits Costs The discount rate that equates benefits and costs

Returns to Investment in Education by Level (%) -- Private Rates of Return Country/Yr. Bolivia Brazil Greece Israel Japan Mexico Paraguay Taiwan Venezuela 1989 1977 1958 1976 1984 1990 1972 1989 Source: Psacharopoulos (1994). Private Prim. Sec. 9. 8 36. 6 20. 0 27. 0 13. 4 21. 6 23. 7 50. 0 36. 3 8. 1 5. 1 6. 0 6. 9 10. 4 15. 1 14. 6 12. 7 14. 6 Higher 16. 4 28. 2 5. 5 8. 0 8. 8 21. 7 13. 7 15. 8 11. 0

Social Benefits • Private benefits • Increased market productivity • Private non-market effects • Plus. . . • Additional social benefits • Taxes on higher earnings • Externalities • Spillover effects (my education increases your productivity) • Technical innovation • Community non-market effects (e. g. , lower crime)

Marginal Gains in Per Capita GDP Growth per 10% Increase in Enrollment Rate, 1960 -1985 Source: Mingat and Tan, 1996.

Child mortality and education 100 Percent 80 60 40 20 0 1 -3 years 4 -6 years 7+ years Mother's educational level

Total fertility rate (%) Fertility and education 7 6 5 4 3 2 1 0 No schooling 4 -6 years 7+ years Mother's educational level

Human Capital Scale -- Weighing Private Benefits and Costs P R I V A T E S O C I A L Benefits l l l Increase market productivity Private non-market effects Spillover effects Technical innovation Community non-market effects Reduced fertility/child mortality Costs Direct costs Foregone production or earnings Public subsidy P R I V A T E S O C I A L

Measurement Can we measure externalities? l Can we measure monetary value of reduced fertility and reduced mortality? l Can we measure returns to equality? l

Full (“Social”) Rates of Return P R I V A T l E l S O l C I A L Benefits Increased market productivity Private non-market effects Taxes on higher earnings Costs Out-of-pocket expenses Foregone production/ earnings Public subsidy P R I V A T E S O C I A L

Estimated Full Rates of Return by Level of Education and Country Group (%) Level of education Primary Secondary Higher Low-income Middle-income group (74 countries) (19 countries) 47 8 <0 Source: Mingat and Tan, 1996. 39 52 <0 High-income group (20 countries) -<0 20

Studies of rates of return to sector investment Relevant to the economic analysis of projects?

Relevant to economic analysis of projects? lexternalities lmarginal returns vs. average returns lprojects more delimited

Using economic sector work to diagnose sector issues and design appropriate interventions

Cote d’Ivoire: Distribution of Education Subsidies 2 4 All

Ratio of Private to Public Spending Nicaragua Primary Secondary Kenya Primary Secondary 1. 25 2. 57 2. 22 0. 62

Some of the right questions What is the full cost of the project? What are the alternatives to the project? What are the benefits -- to the project? l More students -- what will be the impact of the project on their future productivity? l More efficient education system -- what are the cost savings?

More of the right questions What is the appropriate role of government? l Try and estimate externalities l How large would externalities have to be? What are the incentives (and the disincentives) to reform? l Who benefits from the intervention? l Who loses?

Human Capital Theory and Benefit-Cost Analysis in Education Questions from Participants?