As Mr Becker points out in the third edition of "Human Capital"
(published this month by the University of Chicago Press), the term was
controversial in the beginning. Many said it treated people as slaves or
machines. Now, the notion that people and firms invest in skills in much the
same way that they invest in plant and machinery--ie, weighing the costs against
the expected returns--seems too obvious to need stating.
Yet one of Mr Becker's most telling insights remains widely
ignored. Discussion of policy towards education and training usually takes it
for granted that markets fail in a particular way. Mr Becker showed otherwise.
Typically the argument goes as follows. When a firm pays for
workers to be trained, the trainees become more productive not only in their
present employment but also in any number of different jobs, with different
employers. If a trained worker should be poached by another firm, the employer
that paid for the training has merely subsidised a competitor. The fact that the
firm cannot capture the benefits of its spending is a kind of market
failure--and firms will spend less on training than they otherwise would. Hence,
there is a case for public subsidy.
The argument has an impressive pedigree: as far back as 1920,
A.C. Pigou, one of this century's most brilliant economic theorists, said that
training was a classic case of "externality". But the argument is wrong.
True, employers cannot directly capture the benefits of their
spending on training--but the workers who receive the training can. Once
equipped with new skills, they will be paid more than untrained workers, either
by their present employer or by some other. So the benefits of training do
accrue chiefly to one of the parties in the transaction; they are not sprayed
over the economy at large.
As far as the decision to invest is concerned, it does not
matter whether this capturing of benefits is done by employers or by workers. If
the benefits are captured by workers, Mr Becker showed, the market succeeds.
The market's answer is simple: workers undergoing an expensive
training will be paid less, for the time being, than the value of their work to
the firm. This came as a surprise to economists, but will strike trainee
lawyers, accountants, architects--and anybody else receiving an education in
highly marketable skills--as terribly obvious.
All such people gain skills that are not firm-specific; skills,
in other words, that will be as valuable to other employers as they are to the
firm that pays for the training. That being so, the market-failure argument
suggests that little on-the-job training should take place. But lawyers, at
least, are hardly in short supply. The reason is that workers, not employers,
meet the cost--by accepting low wages during the period of training.
Less than perfect
The standard market-failure argument for subsidising investment
in human capital may be wrong, but this does not mean that market forces get
everything right. Markets may fail in other, subtler ways. If they do, this will
just as surely upset the calculations that society makes about how much to
invest in training and education.
In principle, an economy should invest in human capital (as in
any other kind of capital) up to the point where the rate of return yielded by
the last bit of investment is just equal to the rate of return yielded by the
best alternative use of the resources. It should invest, that is, up to the
point where the marginal benefit equals the marginal cost. Please note: the idea
that you can never have enough investment in human (or any other sort of)
capital is nonsense. Investment is not free. You can have too much as well as
too little.
To the private investor, weighing costs and benefits means
investing so long as the rate of return exceeds the private discount rate (the
cost of borrowing, plus an allowance for risk). For the economy as a whole, it
means investing so long as the social return (which includes broader benefits to
society, net of all costs) is greater than the social discount rate (which is
the preference that society as a whole has for spending now rather than spending
in the future). Plainly, these criteria are not the same.
Chart 1 plots private and social rates of return against the
amount of investment undertaken*. Both rates of return fall as investment
increases (ie, the two lines slope downwards). This reflects the law of
diminishing returns--a truth that economists take to be self-evident. Also, at
every level of investment, the chart says that the social return is higher than
the private return. There are five reasons why this might be true. In each case,
the cause is indeed a sort of market failure--though not always an obvious one.
o A big stock of skilled labour may deliver economy-wide
benefits over and above the private ones that spring from the fact that skilled
labour is therefore cheaper to buy--the benefit, for instance, of greater
flexibility in responding to economic change. (Michael Porter's best-selling
study, "The Competitive Advantage of Nations", made much of this point.)
o Perhaps, for lack of information, would-be trainees simply
underestimate the return to investing in skills.
o Income taxes, especially "progressive" ones, reduce the
private (post-tax) return to training, relative to the social return. This is a
good example of one form of government intervention creating a "market failure"
that another form of intervention may then be called upon to remedy.
o If unskilled workers are more likely to be unemployed than
skilled ones (as they are), then it follows that the social return to training
will exceed the private return. Here, the economics gets complicated. The idea
is that society gives up less (in terms of output) to train an extra worker than
the typical trainee gives up (in terms of income).
o Another argument is too tricky to go into: if firms have a
degree of monopoly power as buyers in the market for labour (and many do), it
turns out that it will be profitable for them to meet some of the cost of their
workers' training--but not as much as makes sense from society's point of view.
In this roundabout way, a variant of Pigou's "poaching" argument can be valid,
after all.
As well as assuming that the social return to investing in human
capital exceeds the private return, chart 1 says that the private discount rate
is higher than the social discount rate. This is plausible for two main reasons.
Again, the underlying causes are varieties of market failure:
o In several ways, the capital market may be imperfect. For
instance, borrowing to finance an investment in human capital may be difficult
because would-be trainees lack collateral, or because the costs of
administration and collection make such loans unattractive to private lenders.
(These costs, it might be argued, would be lower if the lending were undertaken
by the government, with subsequent debt-collection through the tax system.)
o Potential trainees may be unduly discouraged by the risk they
would incur if they were to give up some of their income today in return for
higher income (maybe) tomorrow. The idea is that private risks can be pooled,
and thereby reduced: it follows that society as a whole should be less
influenced by risk than individuals acting alone.
What is the net effect of all this? If, as in chart 1, (a) the
private return to investing in human capital is lower than the social return and
(b) the private discount rate is higher than the social discount rate, then
there will be too little investment. The investment that is actually undertaken
(the "private optimum") will be lower than makes sense for the whole economy
(the "social optimum").
Some evidence
Most empirical studies of investment in human capital have
looked at education rather than on-the-job training. Quantitative research on
in-firm training is difficult to do (spending on "training" is much harder to
define than spending on "education"); comparative studies are few and far
between and, by necessity, anecdotal.
However, the education studies are interesting in their own
right, and shed some light on the broader issues. Chart 2 on the previous page
comes from a survey of the literature by George Psacharopoulos, an economist at
the World Bank**. His findings appear to confirm (thank heaven) the law of
diminishing returns: the social returns to education fall, by and large, as
national income (and aggregate spending on education) rises.
Judging by their education policies, most governments would be
surprised by another of the study's findings: the returns to primary education
are significantly higher than the returns to secondary education, which are
themselves higher than the returns to higher education.
An important reason for this is expense: university education
costs far more per student than secondary or primary education. Governments
everywhere, but especially in the poorest developing countries (where the social
return on primary education is 23%, against 11% for higher education) would be
well-advised to shift their education budgets away from universities and towards
primary schools.
Composition aside, chart 2 suggests that further spending on all
forms of education may be warranted. To take the worst case--higher education in
the rich OECD countries--the social return, at more than 8%, is probably higher
than the social discount rate appropriate for those countries. Admittedly, that
number is itself a matter of controversy--but many rich-country governments
already use explicit or implicit discount rates of less than 8% to evaluate
public-sector projects.
Another of Mr Psacharo-poulos's findings may strike you as
surprising. Studies that compared "academic or general" secondary education to
"technical or vocational" secondary education found, on average, that returns to
the first were higher--16% compared with 11%. Again, cost is the crucial thing:
vocational education is far more expensive to provide than the academic sort.
Mr Psacharopoulos's figures, and the theoretical arguments
discussed above, suggest that popular demands for a lot more public money to be
spent on training may be overdone. The conviction that firms have no incentive
to provide training (except training that is highly specific to the firm) is
economically unfounded and, for good measure, refuted by the facts. Firms do
train their workers--largely at the workers' expense (which, since the trainees
later reap the rewards, is as it should be).
Economic theory does point to a variety of subtler reasons why
firms may provide less than the socially optimal amount of training. Therefore,
some subsidy may be called for; training the unemployed makes especially good
sense, on social as well as economic grounds. However, within limited public
budgets for investment in human capital, extra spending on primary education
seems likely to offer the best value for money.
Primary goal
Social returns to investment in education, by countries' income
per head, % (Source: World Bank)
