human capital approach

Education and Economics: Disciplinary Evolution and Policy Discourse
Saumen Chattopadhyay
https://doi.org/10.1093/acprof:oso/9780198082255.001.0001
Published: 2012 Online ISBN: 9780199082070 Print ISBN: 9780198082255
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2 2 The Human Capital Approach to Education 
Saumen Chattopadhyay
https://doi.org/10.1093/acprof:oso/9780198082255.003.0002 Pages 17–55

Published: October 2012
Abstract
This chapter initiates a discussion on human capital with a brief historical account of how economists
over the years have dealt with education from an economic perspective. The main focus of the chapter
is to provide an overview of the main tenets of the human capital approach as a major eld of study and
research which has been enriched by the pioneering contributions from Schultz, Becker, and Mincer.
The concept of private and social rate of return and their usefulness in guiding investment decisions at
the micro and macro level are examined critically. Mincerian wage equation and the demand–supply
model of determination of human capital are discussed to highlight the linkages between investment
in education, earnings, and income inequality.
Keywords: education, human capital, private rate of return, social rate of return, wage equation, income
inequality, egalitarian approach, elite approach
Subject: Economic Development and Growth, Education and Research Institutions
Collection: Oxford Scholarship Online
The subject of education is amenable to economic analysis since the delivery of education, both formal and
informal, entails the use of resources in terms of time and e ort, and more importantly, the use of
monetary resources. In view of the resource constraint faced by an individual as well as by an economy at
the macro level, the pertinent question is one of determining how much resources should be allocated
optimally towards education at the two levels, individual and societal. Supply of and demand for education
involves economic decision-making in the sense that economic factors play a crucial role in shaping the
decisions of the providers, the institutions, and the purchasers, that is, students and parents. The
institutions invest resources to set up infrastructural facilities and employ teachers to deliver education.
Similarly, individuals invest in themselves in various ways like acquiring skills and health, which entails a
sacri ce of current consumption with the purpose of an income gain in the future. This is not to deny that
there are factors other than economic which in uence both supply and demand. As long as delivery of
education entails economic costs and bene ts to individuals and institutions, and to society as a whole,
delivery of education could be subject to an economic analysis. Further, developments in the two domains of
p. 18 education—institutions (or societal) and individuals—and the bene ts arising out of education to
society drive home the point that valuation of the costs and bene ts in economic terms both at the
individual and societal levels are critical in determining the resources to be dedicated to the delivery of
education.
For the economy as a whole, fostering human resource development has remained an important agenda for
all nations for long. The state has to make budgetary provisions for the delivery of education and skill
development to supplement and encourage individual e orts. It is therefore an imperative that we subject
education to an economic analysis both at the micro as well as at the macro level for the study of the
education sector in general.

In economic theory it is argued that there is no free lunch. Having more of one thing requires giving up of
something else. Scarcity of resources means that trade-o s become a basic fact of life. The objective is to
understand the trade-o s involved in the process of delivery of education and guide decision-making for
resource allocation both at the micro as well as at the macro level.
It is argued in the realm of economic theory that decision-makers respond to incentives mostly in pecuniary
terms. For understanding the process of choice making, the underlying incentive structure has to be
understood. Economic theory would help in analysing the functioning of an educational institution and
decision-making of an individual, student, and parent. In fact, incentivization remains a key to the reform
of the education system the world over. The other key aspect of economic theory is exchange of goods and
services. Exchange in a market place is crucial for an understanding of how resources are allocated, what is
produced, and how it is produced. Exchange is an outcome of decision-making by two sets of agents,
providers and buyers. Exchange takes place at a mutually agreed price which re ects the opportunity cost of
supply to the supplier and marginal bene t to the purchaser. Delivery of formal education is envisaged as an
exchange in a market place in main-line economics. Information or its absence plays an important role in
determining the nature of markets and the ability of private markets to ensure that the economy’s scarce
p. 19 resources are used e ciently. Students need information to make informed decisions. Markets
determine how the goods and services are produced in an economy, and how resources are allocated by
government institutions, and by private and philanthropic ones for imparting education to the community.
However, for education, whether the role of the market is desirable and if so to what extent is taken up for
discussion in Chapter 7.
Economics of education and the development of the concept of human capital can be said to have originated
from the contributions of Schultz (1961), Becker (1964), Mincer (1958), and Denison (1962). This chapter
focuses on the human capital approach to the study of education. In the next section, we begin with the
concept of human capital while the section that follows discusses the important concepts of rate of return
and its usefulness in decision-making. The following section discusses a model developed by Becker which
gives a comprehensive account of two di erent aspects of human capital formation, the supply and the
demand side to help explain income distribution. The primary aim of the model is to understand the
underlying factors behind income di erentials among individuals.
Developments in the Theory of Human Capital
The fact that individuals invest in themselves to acquire skills and knowledge failed to draw enough
attention from economists notwithstanding the fact that human beings are at the centre of any
developmental agenda. Individual demand for education was studied mainly from the perspective of
education as a consumption good as price of education (fees), income of the household, and ‘tastes’ among
other factors were considered to be the determinants of demand for education (Blaug 1976a). As Schultz
(1961: 2) says:
Our values and beliefs inhibit us from looking upon human beings as capital goods, except in
slavery, and this we abhor … hence to treat human beings as wealth that can be augmented by

investment runs counter to deeply held values.
p. 20 One way of looking at economic theory as per the neo-classical approach is all about choice, rational
decision-making which entails allocation of scarce resources, and arriving at an optimum decision based on
marginal cost (MC) and marginal bene t (MB) or, to put it simply, an exercise in constrained optimization.
Mincer (1958: 288) was interested in nding out the factors behind income distribution or di erential
earnings. But, what could be the possible reasons? Is it human capital, or ability and opportunities, and
intelligence quotient (IQ), and/or emotional quotient (EQ)? How do lifetime earnings behave over time?
Those with high skills witness higher growth in income or at least slower retardation in income growth than
those with low skill employees. It was found that ‘the higher the occupational rank, the higher the level of
earnings, the steeper the life-path earnings’. Intra-occupational di erences result from experience. But
bona de conceptualizations could be traced centuries ago to Adam Smith (1776/1976), John Stuart Mill
(1926) and Alfred Marshall (1890/1920) (Sweetland 1996: 343–4). However, the idea of investment in man
can be attributed to the mercantilists who emphasized the importance of ‘art and ingenuity’ or skilled
manpower (Bowman 1966: 103). However, Adam Smith (1776/1976) was the rst to characterize
expenditure on education as investment expenditure by drawing analogies between men and machines
which would contribute to the enhancement of skill and productivity of individuals and hence for the
1
economy as a whole. Marshall referred to the socio-economics of ‘talent wastage’ but not explicitly to
investment in man and Keynes’s General Theory made labour passive rather than an active agent (Bowman
2
1966: 108). As an illustration of an early awareness, we can see in Adam Smith (1776/1976: 118):
A man educated at the expense of much labour and time to any of those employments which
require extraordinary dexterity and skill, may be compared to [an] expensive machin[e]. The work
which he learns to perform, it must be expected, over and above the usual wages of common
labour, will replace to him the whole expense of his education, with at least the ordinary pro ts of
an equally valuable capital.
p. 21 Alfred Marshall in his Principles of Economics (1890/1920: 564) echoes a similar understanding of
education: ‘The most valuable of all capital is that invested in human beings.’
The enrichment of the theory of human capital has been made possible because of the contributions made
from labour economics, public sector economics, welfare economics, growth theory, and development
economics. Possibly because the theory concerns people and people are at the centre stage of any economic
theory and developmental agenda, education deserves more attention in both academic and policy discourse
today than what it has received as a sub-discipline of economics. The human capital research programme
witnessed a very rapid growth in the 1960s and 1970s. As mentioned in Blaug (1976a: 827), that a
comprehensive annotated bibliography was rst published in 1966 recorded 800 entries; the second edition
published in 1970 had 1350 items; and the third edition published in 1976 had nearly 2000 items (Blaug
1976b). The growth in research publications was not sustained and the economics of education as a sub-
discipline of Economics withered, or at least it can be argued, it did not ourish despite having many
linkages with various branches of economics. However, in recent years, there has been a surge in
publications in the area of economics of education. Dearden et al. (2011) argue that the papers related to
education in mainstream economics journals were only 2.5 during the 1980s, which went up to 5.2 and 9.7
during the 1990s and 2000s, respectively. There are a number of edited volumes in this area such as The
Economics of Schooling and School Quality (Hanushek 2003), Modern Classics in the Economics of Education
(Bel eld 2003), International Handbook of Economics of Education (Johnes and Johnes 2007), and Economics of
Education (Brewer and McEwan 2010).
The Human Capital Approach

The emergence of the economics of education as a sub-discipline of neo-classical economics and its
p. 22 relevance even today in policymaking can be attributed to the concept of human capital. Recognition of
the area also came in the form of two Nobel prizes to those who contributed to the advancement of the
concept of human capital and its salience in the economy as mentioned earlier. The connectivity between
human capital theory and the Nobel prize for Economics is perhaps more impressive (Sweetland 1996).
Theodore Schultz (1961, 1963) and Gary Becker (1964) are the two most prominent scholars who
3
contributed to the development of the human capital theory. Arguably, there were notable contributions
from Friedman and Kuznets (1945) as well. The growth models developed in the 1980s helped to identify
relatedness of education to the aggregate production function (through endogenous growth theory) and
growth. Even, Sen (2000), the Nobel Laureate in Economics assigned special role to education in his
capability approach to the study of ‘development as freedom’.
Becker and Chiswick (1966) applied neo-classical economic theory of optimization to understand various
aspects of household decisions and the most prominent of those remain that of investing resources for
education. Education expenditure is considered to be investment expenditure as it involves sacri ce of
resources for presumably no present bene ts but with an expectation of future gains in the form of higher
remunerations accruing to an individual than what would have been otherwise with a lower level of
4
education. At the national level, education and in particular human capital formation gained more
importance to spur growth with knowledge assuming dominance in policy discourse. Empirical studies were
undertaken to ascertain the contribution of human capital in growth which are be discussed in Chapter 3.
Defining Human Capital
The rationale behind introducing the concept of human capital and its de nition comes out clearly but only
in few words in Schultz (1960):
I propose to treat education as an investment in man and to treat its consequences as a form of
p. 23 capital. Since education becomes a part of the person receiving it, I shall refer to as Human
Capital … it is a form of capital if it renders productive service value to the economy…
Human capital is an outcome of learning which remains embodied in an individual and manifests in the
form of augmentation of productivity of the individual. Schultz (1960) argued why acquiring skills and
knowledge constitute a form of capital, a part of deliberate investment which was found to be rising at a
much faster rate than physical capital. During 1900–56, while assessing the contribution of the factors of
production to growth in national income, the estimated stock of education as embodied in the workforce
was estimated to have grown at nearly twice the rate of reproducible capital.
The human capital theory suggests that individuals and society gain substantial economic bene ts from
investments in people. The hard core of the theory as Blaug (1976a) would argue is that individuals spend on
themselves with the purpose of future gains, pecuniary and non-pecuniary, and not for the sake of present
enjoyments. An educated population is a productive, creative, and innovative resource for not only growth
but also for achieving broad based growth. This means that human capital formation involves both formal
and informal education, on-the-job training, and ‘learning by doing’ as all of these contribute to the
enhancement of economic capabilities of people. To be precise, Schultz (1960) listed ve major categories of
investment which would lead to improved human capabilities: (i) health facilities and services including
stamina, vigour, and vitality; (ii) on-the-job training including old style apprenticeship; (iii) formally
organized education at the three levels, primary, secondary, and higher education (HE); (iv) study
programmes for adults (extension programmes including agriculture), and (v) migration of individuals and

families to adjust to changing job opportunities. In addition, individuals spend time in searching for jobs or
spend to gather information about job opportunities (Blaug 1976a: 829).
In fact, education could be treated both as a consumer good as well as a capital good. As a consumer good, it
p. 24 yields satisfaction to say a student as she goes through the process of learning in the sense of
socialization in the school campus, participation in extra-curricular activities, and even simply enjoying the
exposure to the new vistas of knowledge and classroom experiences. But more importantly as per the
human capital theory, education is an input to the production of goods and services through the agency of
labour. Not only does working with the machines require skill and dexterity acquired in the process of
schooling and training but the very production of physical capital today with higher and higher
productivities is largely an outcome of new ideas, innovative thinking, and research. So in the sense of the
production function, both capital and labour undergo transformation through education and training and
the consequent skill development. Further, it can bring about both economic and social transformation. It is
in fact a pre-requisite for not only narrowly de ned economic growth but also for a broad based notion of
development. Bene ts may accrue in terms of health and nutrition, a control on population growth,
improvement in the overall quality of life, enlightened citizenry to participate in democratic and legal
processes, rational decision-making at the level of the community as a concerned member of the society,
pursuing values such as equality, fraternity, and liberty at both private and social levels, and lower levels of
corruption. Human resources constitute the ultimate basis of wealth of nations and educated citizenry are
its active agents.
Becker’s (1964) contribution to the theory of human capital (HC) has been a path breaking one. He provided
a theoretical and empirical analysis of human capital formation with special reference to education by
invoking calculational rationality of human agents. As portrayed in the neo-classical theory, the humans
are driven by the primary instinct to compete in order to maximize their opportunities in a rational choice
model. The basic argument relating to human capital and growth in earnings can be put in the form of a
sequence.
Human capital: (1) Education and training increase individuals’ cognitive capacity, (2) which, in turn,
p. 25 increases their productivity; (3) productivity tends to increase the earnings of educated and skilled
individuals and (4) this, becomes a measure of human capital. In short, education becomes a measure of
human capital as:
education 〉 cognitive capacity 〉 higher productivity 〉 earnings 〉 a measure of HC
The major arguments of the human capital approach to education can be put in the form of three
propositions as succinctly put forward by Majumdar (1983).
A. Concept of human capital, a counterpart to the notion of physical capital formation.

B. Spending resources on education is an act of investment:
i. investment decision-makers in education are analogous to investors in the capital market,
ii. alternative opportunities in education are at par with alternative investment channels, and
iii. ‘choice rule’ is similar to returns’ maximization as in the normal capital market.
C. Education or the learning process is similar to production carried out by a rm: input–output
analysis.
While A and B are taken up for discussion in this chapter, Chapter 4 is devoted to C only, arguably the second
paradigm in the economics of education. Chapter 3 seeks to add to the discussion of A as well.

Human Capital and the Rate of Return
If expenditure on education is treated as an investment and students are rational in the sense of assessing
the costs and bene ts of education before they decide whether to pursue studies, students’ (and/or parents)
decision to spend on education is an act of investment, and hence, it is an act of investment similar to an act
of investment in the capital market. Therefore, it is a natural corollary that rate of return from investment
p. 26 in education would be a guiding factor for decision-making. Not only so, it is a guiding factor for
investment decisions at the macro or national level or a new social investment criterion (Blaug 1976a). We
present next the rate of return approach as widely used in empirical studies; a substantial critique of this
follows in Chapter 5.
Estimating the Rate of Return

Rate of return on a project is a summary statistic describing the relationship between costs and bene ts
associated with the project. This equates net discounted bene ts to zero.
Let us take the example of assessing the rate of return from doing higher studies beyond the masters level,
say joining a PhD programme. Say the research scholar after completion of her PhD programme intends to
nd out, based on her estimation of cost and expected pay packages, what the rate of return from investing
in her PhD programme would be. Assume she is of 22 years of age and would enter the job market after 5
years to remain employed for 38 years or so to retire at the age of 65 years. She would incur an explicit cost
(out of pocket expenses) of say, CP, costs of doing her PhD, for 5 years. In addition, she would also incur an
implicit cost in the form of opportunity cost as she could join the job market and earn WM, a pay package
with a masters degree for the 5 year period. Looking forward to the future, she expects her remuneration to
be WP, a pay package with a PhD degree. Her MB for pursuing PhD is the extra pay she expects to earn when
she joins the job market. Since she is expected to join the job market after completing her PhD, her future
pay di erences are to be discounted to the present time when she is contemplating joining a university.
Therefore, costs to be incurred in the next 5 years are to be valued at the present time. Equating costs and
bene ts, rate of return r which is called the internal rate of return, can be calculated at the point of entry to
the job market as:
−t −t
∑ (C P + W M )(1 + r) = ∑ (W P − W M )(1 + r)
t=1 to 5 t=6 to 38
(2.1)
p. 27 In general, if Ch is the resource cost of schooling incurred to achieve a higher level h from a lower level l, Wl,t
captures the foregone earnings of a student while the student is engaged in studying, and (Wh−Wl) is the
di erence in earning attributable to the two di erent levels of education, high and low, ‘s’ is the years of
schooling and let R be the retirement age, and the estimation of costs and bene ts being carried out at the
entry point to the high level of schooling, then:
s R
−t −t
∑ (C h + W l,t )(1 + r) = ∑ (W h,t + W l,t )(1 + r)
t=1 t=s+1
(2.2)
The internal rate of return rule entails its estimation by equating present value (PV) of bene ts with the PV

of costs. Investment decisions can be argued to be justi ed or rational if the internal rate of return is greater
than the chosen rate of interest or rate of discount which should re ect the opportunity cost of the
investment expenditure. And the second investment criterion is to rank alternatives according to their
internal rate of return (Vaizey et al. 1972).
Ignoring Ch and dividing by W l

′
s W l,t R W l,t W h,t

−t −t
∑ (1 + r) = ∑ ( − 1)(1 + r)
t=1 ′ t=s+1 ′ W l,t
W W
l l
(2.3)
Let us assume that equation 2.4:
R
′
W = ∑ W l,t
l
t=s+1
(2.4)
is the sum of non-discounted lifetime earnings of a worker with a lower skill or an unskilled labourer.
′
W
l
= pt , is the proportion of the unskilled labourer’s lifetime earnings earned in year t. The set of p’s
′
W l,t /W
l
where pi = 1,…,R gives the shape of the lifetime age-earning pro le for the unskilled labourer in the form of
a distribution function. From the rst order conditions for cost minimization, marginal productivities of
p. 28 factors be equal to factor prices under the standard assumptions of a perfectly competitive market. Cost
minimization requires that (Wh,t/Wl,t) equals MRSt of low skilled for skilled labourer in period t.
If we substitute p and MRS we obtain the following (2.5):
s R
−t −t
∑ p t (1 + r) = ∑ p t (M RS t − 1)(1 + r)
t=1 t=s+1
(2.5)
The internal rate of schooling can be regarded as a function of three categories of variables: (1) marginal
rate of substitution through time between labourers with di erent skills, (2) the shape of age-income
pro le, and (3) the state of the arts in the production of skill.
s
r = r [M RS (t), p (t), ]
R
(2.6)
The other way of doing it is to nd out whether net discounted present value (NDPV) of bene t is greater
than zero with a pre-determined rate of discount:
Annual net benef its rule: (PV of Benef its − PV of cost) = 0
(2.7)
The investment criteria would be: (i) it makes sense to invest as long as NDPV is positive, and (ii) rank
alternatives according to NDPV. The choice of the appropriate discount rate would be informed by the rate of
interest, ‘i’, and the discount rate.

A Comparison of the Criteria
Vaizey et al. (1972) argue that if the two methods yield di erent estimates, NDPV is ‘conceptually the correct
one’. In Figure 2.1, NDPV is plotted against the di erent discount rates. There are two NDPVs with the same
cost.
Figure 2.1 Choice of Discount Rate
The curves intersect as the time pro les of the returns from the two investments di er. At higher rates of
p. 29 discount as we move further right along the X axis, curve B o ers higher NDPV as curve A intersects the X
axis before curve B does. If we go by the maximization of the internal rate of return, curve B would be
chosen as D2 is the highest which is achievable (as curve A touches the X axis before curve B does). However,
at D1, A would be the right choice. Since at higher rates of discount, B has the higher NDPV, B yields greater
returns in the near future. As Vaizey et al. (1972) argue, A must be the right choice because it adds more to
the resources of the investor.
Besides these conceptual clari cations, it needs to be remembered that certain adjustments are required to
get closer to reality. The following adjustments are suggested in literature.
Adjustments in the Estimation of Rate of Return

Earnings standardization: earnings di erentials are not entirely dependent on education. Ability, social
class, gender, motivation, parental education, region, schooling, and medium of instruction are all
pertinent. In the human capital approach, the causal link between education and earnings is established
through an enhancement in the cognitive capacity and its impact on productivity. There are two ways of
addressing this important issue.
p. 30 Generally an adjustment factor to education, α ‘alpha coe cient’ suggested by Blaug (1976a) can be used to
account for factors like innate ability other than education. This means, that αΔW will have to be used in the
regression exercise rather than ΔW. For example, if α = 0.4, 60 per cent of the change in wage re ects the
importance of factors other than education and skill embodied in an individual. It was argued that to the
extent of two-thirds of the di erences in earnings could be explained by education and training.
Regression method can be used by including the possible variables which could have an impact on earnings
in the regression to apportion the variability in wage in terms of education and all other factors in order to
assess the relative contributions of the explanatory variables. The following regression equation can be
estimated:

Wage = f (education/skill, gender, ability, motivation, etc.)
(2.8)
Unemployment: The bene t pro le needs downward adjustment because of the perennial problem of
uncertainty in the job market and a mismatch between demand and supply resulting in underemployment
and unemployment. The wage has to be adjusted by the probability of unemployment as follows: UstWst
where 0 〈 Ust 〈1. The other way to look at it would be to consider labour force participation: if the labour force
participation rate is Pma, expected earnings are equal to Pma*Wma which is typical of women’s education.
Probability of survival: The probability that the worker will survive is greater than zero but less than one.
*
Hence, the wage pro le is adjusted by multiplying the wage by the survival rate, that is, S t W t where St is
the survival rate which depends on the mortality and morbidity rates for a person of age t. This is similar to
what Becker (1975, 71–2) said about the possible length of the period of the activity the individual is willing
to invest in because it raises the rate of return. Even if we ignore that young people have a comparative
p. 31 advantage in learning, unencumbered by responsibilities and tensions, the incentive to invest would rise
simply because of the fact that they would reap the bene ts from their investment over a longer period of
time.
Productivity growth: In the rate of return calculation, we assumed that the wage pro le to remain constant
for the rest of the working life as the di erence in wage remained the same for the entire working period.
This needs to be modi ed as wage would generally grow because of the rising productivity of a worker
owing to experience and other intrinsic factors or even independent of them. We need to multiply the given
t
wage pro le with (1+g) where t is the working life of the individual. Else, we can add g to the expected rate
of return.
Consumption bene ts arising out of education are crucial for determining the rate of return. As discussed
earlier, the process of learning can be an enjoyable experience thereby yielding consumption bene ts not
only for the period of study but for the entire lifetime in terms of appreciation of life, culture, arts, and
literature resulting in a higher and more satisfactory standard of living. We need to add another stream to
income to capture the additional bene ts or a percentage of the cost laid aside. For the economy as a whole,
non-economic bene ts are generally de ned to be externalities or external bene ts which are not valued in
the realm of the market. For estimating a wide social rate of return, sources of positive externalities are to
be identi ed, quanti ed, and incorporated (Psacharopoulos and Patrinos 2004).
Risk and uncertainty: Since the future is always uncertain, estimating future bene ts in terms of expected
wages is always fraught with uncertainty. A comparison of standard deviations of incomes received by an
age-education survey with the mean, would give an idea of the extent of uncertainty faced by a student
while taking the decision. A rational investor would make sure before investing that the expected rate of
return was greater than the sum of rate of return from risk-less assets plus a term to account for liquidity
and risk premiums associated with the investment. In comparison to physical capital, human capital is not
p. 32 saleable, or to put it di erently human capital is an illiquid asset. The uncertainty in the rate of return on
human capital arises due to the di erential abilities of individuals and various unforeseen events. The
prevailing situation would form the basis of knowledge about the emerging macro situation.
It is often argued that imperfections in the capital market for investing in education may be one good reason
for explaining underinvestment in education and training. This arises because of an absence of collateral
due to the unique character of human capital.
Becker provides deep insights into the funding aspects of education such as educational loans as compared
to individual sources of funds. Young people on the verge of entering higher studies tend to underestimate
their abilities and the investment opportunities available. Investment in education unlike physical capital is

di cult to postpone as the earlier one acquires knowledge, the better returns one reaps. Hence investment
is often made with less knowledge and without a proper assessment of alternative opportunities as delay in
investing may prove costly (Becker 1975: 80).
Private versus Social Rate of Return

Assessing costs and bene ts can be done at two di erent levels, at the individual level (micro) and at the
societal level (macro). The rate of return estimated earlier can therefore be calculated from the point of view
of an individual and society. When resources are used, it has implications for allocation of resources for the
society as a whole. The bene ts generated do not accrue to an individual only in the form of pecuniary
bene ts but to society as a whole in the form of non-pecuniary returns. Similarly, from investments in
school education, society gains in term of lower crime rates, better functioning of democratic institutions,
spreading of health awareness, and inculcation of responsible citizenship. Costs and bene ts pertaining to
investment in education therefore have important social implications. In view of this, both costs and
bene ts need to be reassessed. In view of the subsidization of education, social costs should include the
p. 33 extent of subsidization as this re ects the resources dedicated to the provision of education by the
government on behalf of society in addition to the costs incurred by individuals. Similarly, bene ts arising
out of education accrue not only to the individuals engaged in higher education but to the entire society in
the form of various externalities as mentioned earlier. When social costs and social bene ts are taken into
consideration, we obtain the social rate of return.
The private rate of return is estimated when the cost of education is what is incurred by individuals pursuing
higher education and the bene ts of education as realized by the same individual as obtained earlier.
Social costs would have to be rede ned as C P′ hD = C P hD + S U niv
SUniv = amount of resources devoted to a student by the university or per capita subsidy. If the bene t
calculation remains the same as that of an individual, that is, only in the form of a higher stream of
earnings, rate of return thus obtained is de ned as a narrow social rate of return (Psacharopoulos and
Patrinos 2004). If the calculation of bene ts includes externalities, the bene ts are to be rede ned as:
′ ′
W = W M A + T M A and W = W P hD + T P hD
MA P hD
(2.9)
where TMA = externalities accruing to society emanating from an individual with a masters degree whereas
TPhD refers to the positive externalities accruing to society arising out of an individual who obtained her PhD
degree.
The rate of return thus calculated after incorporating the externalities is called the wide social rate of return.
Social rate of return (narrow) would be less than the private rate of return because it includes the cost of
subsidization whereas the estimation of bene ts remains the same in the form of higher remunerations
accruing to an individual due to a higher level of education. However, for a wide social rate of return, the
estimation of bene ts is revised upward by the extent of the externalities. It is possible therefore that
p. 34 depending on the valuation of externalities that education generates, it is possible that the wide social
rate of return would be greater than the private rate of return despite in ation of costs due to subsidization
of education. It is unfair to ignore social bene ts arising out of education also in view of endogenous growth
theoretic literature which supports spill-over e ects or externalities (Lucas 1988, discussed in Chapter 3).
The nature and estimation of social bene ts would depend on the level of education, its quality, and
composition.

It follows therefore:
5
social rate of return narrow 〈 private rate of return 〈 social rate of return wide
We need to distinguish between marginal rate of return and average rate of return. What we have calculated
is a marginal rate of return for the PhD cycle (or from a lower level to a higher level). Whereas, average rate
of return pertains to the entire period, say of rate of return of schooling. There can also be a distinction
between ex-post rate of return and ex-ante rate of return. The ex-post rate of return is in the historical
sense as it has been recorded in the past or estimated based on real life data from the past, near and far. Ex-
ante rate of return on the other hand is good for behavioural analysis and relevant for making decisions
both by an individual and by institutions, public and private. In practice, rate of return are neither ex-ante
nor ex-post. Based on today’s cross-sectional data, rate of return estimates are either extrapolated
backward or forward.
Becker (1975) compared the social returns of investment in business with that of investment in education in
terms of the relative contributions of business capital and human capital to national income (Becker 1975:
197). Becker used Denison’s residual growth to estimate (to be discussed in the next chapter) to arrive at
estimates of social rates on college education compared to that of business capital depending on whether
residual growth which was argued to be a proxy for ‘advancement in knowledge’ could be attributable to
education or business capital or some combination of the two. If advancement in knowledge was due to
p. 35 education alone, social rates of investment in education might double. The same could happen to social
return to business capital as well if the residual was made attributable to business capital. Becker admits
that a comprehensive social rate of return should include e ects arising out of cultural advancement and
deepening of democracy. What determines whether to go to college or not is private rate of return. However,
Becker concludes that ‘… private real rate of return has apparently been higher on college education than on
physical capital’ (Becker 1975: 200). However, monetary and psychic costs should be considered while
calculating the private rates of return.
Policy Implications of Rate of Return Approach to Education
As Blaug (1976a) argued, the rate of return calculation has an important implication for guiding resource
allocation at the macro level because one could come up with new social investment criterion. Resources are
to be allocated to the di erent levels of education and to the di erent years of schooling to ensure that the
marginal social rate of return across the various avenues are equalized (Blaug 1976a: 830). Rate of return
estimated for education is treated at par with rate of return for any other sector in policymaking when it is
argued that the equalized rate of return from investment in education should not be lower than the yield on
alternative investment opportunities. Though there is indeed a vast literature on the estimation of rate of
return for understanding career choices and evaluation of decision-making both at an individual as well as
at an institutional level, implications for policymaking are often very tenuous. The basic question is whether

rate of return should be used at all for guiding decision-making? What is the use of a private rate of return
calculation for schooling? Education can be argued to be so fundamental to a digni ed existence, treating it
at par with other sectors is tantamount to saying education is no di erent from power and irrigation, for
example. Power and irrigation are no doubt important and so are education and health for the
p. 36
government to invest in. For the education sector as a whole, can we use estimates of rate of return to
determine level of investment at the three levels—primary, secondary, and tertiary? For example, can we
compare the rate of return for college education with that for school education, or compare the rate of
return for higher education with other sectors such as power, irrigation, and transport? Education creates
externalities, quanti cation of which would always remain problematic. It does not really matter how large
or small the rate of return are. Therefore, both intra-sectoral as well inter-sectoral allocations are not
meaningful if they are based on rate of return estimations. Since estimation of externalities and non-
pecuniary bene ts remains a formidable challenge, estimates vary and so with it, the optimal strategy for
investment (Blaug 1976a: 831).
Therefore, the pertinent issue is whether investment decisions should be guided by estimates of rate of
return for at di erent levels of education and for di erent sectors. Or, how much resources are to be devoted
in aggregate for education as a whole? How to mitigate the mismatch between the demand for and supply of
skill? How does quality matter and by how much? How to subsidize education and how much would be the
extent of the subsidization?
Without specifying how the government expands education facilities, it is di cult to estimate the demand
for the schooling function as a supply function is also involved in the process. There lies the possibility that
both the supply and demand functions would have to be estimated in the process.
The General Earnings Function: Becker and Mincer
Investment in education or human capital could be one of the major factors to explain di erences in income
over time and also among persons and families, both within a region or across di erent regions. The talent
required for gaining economic success should encompass some particular kind of personality, persistence,
p. 37 and intelligence. Since ability and di erences in education would a ect incomes, the di culty lies in
separating out the e ect of ability from that of education. Becker (1975: 84) suggests one way of capturing
the impact of ability on earnings when all other possible variables are held constant. As shown, gross
earnings would include returns on human capital (r) as well as amount invested (C) plus that of earnings
which is independent of education (X):
Y = X + r ⋅ C
(2.10)
The distribution in Y would be determined by distribution in r and C given that X remains more or less
unchanged for all. Ability would be measured by only the average rate of return (r) on human capital when C
is held constant if we ignore distribution of X because the same level of C would generate di erent levels of Y
ceteris paribus. Hence di erences in r thus estimated will capture di erences in abilities intrinsic to the
individual’s characteristics. But the new dimension Becker adds is the interdependence between r and C.
Individuals with higher ability would have a greater tendency to invest more on education compared to
others if they perceive a higher marginal rate of return keeping all other personal sources of variations

being held constant. So, ability as indicated by average r and investment in education are positively
correlated. Thus, even if ability and investment are symmetrically distributed, their product would be
skewed. Therefore a strong positively skewed distribution in earnings can be reconciled with, presumably, a
symmetrical distribution of abilities.
It is also generally observed that earning distribution of the skilled and older people would be more skewed
than that of younger people. In the last equation, the investment cost was ignored. But at a younger age, the
cost of investment would be higher. Net earnings would be given by:
j−1
Yj = X0 + ∑ r i C i + (−C j )
i=0
(2.11)
Let Y j refer to the net earnings and C j to the investment cost at an younger age j. Let C i measure
p. 38 investment cost at the age of i and r i the rate of return on C i. As is seen, the distribution of (−C j) would
impact the distribution in Y j as C j tends to be larger at the earlier stages of an individual engaged in
studies. So the skewness would rise over time. The impact of X tends to dominate at younger than at older
ages. In addition, the negative correlation between (−Cj) and ΣriCi would negate the positive correlation
between r and C resulting in a more skewed distribution in earnings at older ages and among the skilled
persons with higher rC than X. Becker (1975) adds a new dimension to the debate on income distribution
with the incorporation of the argument that investment in human capital can shed light on (inequity in)
income distribution purely in the realm of economics.
The Mincerian Approach to the Determination of Wage and Rate of
Return
Mincer (1958, 1970) identi ed education as one key determinant of income or wage in his empirical
investigation of factors responsible for di erentials in earnings. He took years of schooling in the earnings
function to estimate rate of return on education for a cross-section of workers. Mincer assumed the
opportunity cost of student’s time as the only cost of an additional year of schooling and further, it is
assumed that a proportional increase in earnings attributable to education remains the same over the years.
It was shown that the logarithm (log in brief) of earnings would be linearly related to an individual’s years
of schooling. The regression coe cient could be interpreted as the rate of return on investment in

schooling. The model was augmented to include a quadratic term for work experience to allow for returns
for on-the-job training. Assume that the total cost C to an individual investing in a year of schooling is the
opportunity cost of not joining the job market, or annual earnings foregone to pursue education in that year.
Let Wt be the annual earning after t years of schooling be equal to the annual earnings with t – 1 years of
schooling plus the cost of education (Ct = W t−1) times the rate of return on investment in education:
W t = W t−1 + rW t−1
(2.12)
p. 39 Following the rule of mathematical induction, it follows that earnings after ‘s’ years of schooling are given
by:
s
Wt = W0 ∏ (1 + r t )
t=1
(2.13)
If we take natural logarithms and apply the approximations that for small values of r, ln(1 + r) ≈ r, (2.13)
yields:
s
ln W t = ln W 0 + ∑ rt
t=1
(2.14)
For r = rt being constant across the levels of schooling, this is equal to:
ln W s = ln W 0 + rs
(2.15)
Or equation 2.18 could also be written as:
s
W t = W 0 (1 + r)
(2.16)
Equation 2.15 is also the logarithmic version of equation 2.16. The relationship between earnings and
investment in education measured in monetary units is converted to the relation as in equation 2.12 where
natural logarithms of earnings and investment in education measured are in time units. Logarithm of
earnings is a linear function of years of schooling. The interpretation that each additional year of schooling
raises earnings by r per cent is made possible by the log linear formulation of the wage function.
Mincer (1958, 1970) estimated the rate of return across countries by controlling for work experience of the
individuals. It spawned many empirical studies only to recon rm the faith reposed in the Mincerian wage
equation. Since Ct equals W t−1, there is no scope for direct costs such as tuition, school fees, books, and
other stationeries. As indicated earlier, the age earnings pro le (Wössmann 2003) are assumed to be
constant for di erent levels of education otherwise the regression coe cient would be a biased estimate of
the rate of return on investment in education.
However, there are problems associated with the treatment of average years of schooling as a proxy of
p. 40 human capital other than the data related problem including a problem with recording average years of

schooling. There could be two major criticisms (Wössmann 2003: 249, 265). An increase in the years of
schooling by one year would not necessarily lead to an augmentation of the stock of human capital
irrespective of the level of schooling. What this means is that di erent years of schooling contribute to the
enhancement of the human capital stock by di erent degrees. And secondly, quality of education matters.
Merely by saying that the average years of schooling have gone up by one year means very little, unless the
education imparted was of good quality. This is a typical problem with education that focusing on the
number of years would not be able to capture what education essentially is and what it does to an individual.
To refer to the rst criticism, assigning the same weight to any year of schooling to quantify human capital
by average years of schooling implies productivity di erentials among the workers are assumed to be
proportional to their years of schooling. But empirical studies which are micro-econometric in nature show
that there are decreasing returns to schooling (Psacharapoulos 1994). Ideally a year of schooling should be
weighted depending on how many years of schooling the individual has acquired.
The familiar Mincerian wage equation for i can be written as:
2
ln W i = β 0 + β 1 S i + β 2 exp i + β 3 exp + ∈ i
t
(2.17)
where ln W i is the natural logarithm of individual i’s, earning Si is the number of years of schooling, ‘exp’ is
2
the experience in years and exp is the squared of experience and ε is the error term. The coe cient of
schooling is the rate of return obtained as the discount rate obtained by equating two PVs of earnings of cost
and bene ts. The estimate of β 1 ranges from 0.05 to 0.15. The usefulness of the Mincerian equation is that
the semi-log formulation captures the relevant data in countries with sharp di erences in socio-economic
conditions (Krueger and Lindahl 2001: 1104, 1108). Wage is assumed to rise with a gain in experience but
with a decreasing rate.
p. 41 The issue is whether the coe cient re ects unobserved ability and other variables which are correlated with
education or the ‘true reward that the labour market places on education?’ (Krueger and Lindahl 2001:
1104). There can be two ways to interpret this. Either it is a signal for ability (Spence 1973) or it is a measure
of increases in productive capabilities (Becker 1964), and in all probability it is a blend of the two. Further,
would all the individuals gain equally in their earnings or would these vary systematically with individual
characteristics? Evidence suggests that education is more than a proxy for unobserved ability.
From 2.15, it follows:
2 2 2 2 2 2 2
σ (ln W t ) = r σ (s) + s σ (r) + σ (s)σ (r)
¯
¯
(2.18)
The inequality in earnings is large when σ(r) and the average level of schooling s are large other than the
contributory factors r and σ(s). Other than r, which is a proxy for individual ability, and variances in the level
of schooling, that is, σ(s) contributing to the larger inequalities in earnings, variances in ability, that is, σ(r)
and the average level of schooling would also cause larger inequalities in earnings. To be more precise, we
can make the following observations based on (2.18): (a) for a given level of schooling (s), invidual
di erences in ability would cause larger realitive and absolute di erences in earning at higher levels of
schooling and (b) for a given level of r, larger di erences in schooling would generate larger di erences in
earnings at higher levels of ability (Mincer 1970:10).
Beckerʼs Approach to Human Capital and Income Distribution

Becker (1975: 94) proposed a model which essentially captures the centrality of human capital in
determining income distribution, but in a somewhat broader framework incorporating various other non-
economic aspects, individual cognitive capabilities, and family environment other than the economic
p. 42 factors such as nancing of education. Becker (1975) made his intention clear in the beginning that the
objective was to advance a comprehensive explanation of the factors behind personal income distribution,
particularly focusing on why a representative individual undertakes di erent levels of investment in
education which he analysed within a framework traditionally used to deal with investment in physical
capital. Becker sought to explain actual income di erences across regions, countries, and time periods with
the help of a comprehensive economic model. The key to understanding personal income distribution was to
address the basic question of why the rate of return and investments vary substantially among persons.
Rate of return is viewed as the outcome of two forces, demand and supply, which though have di erent
connotations in the present context. The demand curve shows MB or rate of return for di erent levels of
investment whereas the SS curve shows the MC of nancing to her or simply the rate of interest (Figure 2.2).
So both the demand and the supply curves pertain to the same individual who mobilizes her nances to
invest in education with the purpose of gaining in the form of a marginal rate of return akin to MB
obtainable from the consumption of a good. In Figure 2.2, we depict human capital along the X axis
measured in rupees and marginal rate of return or cost along the Y axis. The equilibrium at the intersection
between the demand and the supply curve ensures equality between rate of return and rate of interest for
nancing education. Given the di erences in the underlying factors generating the demand and supply
curves, it is an imperative that we deliberate on the factors responsible behind the two curves.
Figure 2.2 Equilibrium Levels of Investment in Human Capital
Source: Becker (1975).

Generally, the demand curve slopes downward but in the present context the reasons behind this are
di erent. One particular aspect of the distinctions between human capital and physical capital is crucial
here. In the case of human capital, capital is embedded in the person investing. Since memory capacity,
physical size, etc., are limited, as the person keeps on investing, eventually diminishing returns would set
p. 43 in. Indispensability of time and the universal time constraint faced by an individual contributes further to
the negativity of the curve. As Becker argued, the factors contributing to the formation of human capital are
not a single entity but constitute indispensable elements like time which are xed for all individuals. In the
case of an upward sloping supply curve, MC rises for producing a rupee of returns as cost of nancing goes
up. A large part of human capital is the own time of a person investing which is equal to foregone earnings.
Optimal combinations of inputs over an optimal investment period to maximize PV of bene ts may justify
spreading out of capital in view of the fact that time as an input for human capital accumulation is both

essential and expensive. However, it can only partially mitigate the decline in the MB as the MB curve
continues to be negatively sloped. The value of own time increases and time is spread out but essentially
time remains an important ingredient, as without it, the relevance of all other factors cease to matter. In the
long run, there exists an optimal combination of such inputs to human capital formation which would
maximize PV of future streams of earnings.
p. 44 So, the later investments become less and less pro table because of high mortality, and a decline in the PV
as it is similar to a postponement of an investment decision. The capital accumulated becomes increasingly
valuable and so does a person’s time associated with increasing risk aversion at the margin. The supply
curve re ects an MC of nancing which is equal to the rate of interest of borrowing funds or the opportunity
cost if own funds constitute the source of funds.
This can also be explained as the annual repayment on an additional rupee borrowed for funding investment
in education. In reality, the capital market for funding education is segmented. Local subsidies, borrowings,
transaction costs, imperfections in the education loans market, and rationing of funds may all lead to a rise
in the cost of nancing education. In fact, the higher the segmentation, the higher is the cost as one’s
intention to invest rises. Subsidy is in e ect zero cost to the borrower in the form of cheap loans, subsidized
loans, commercial loans, etc. But accumulation of time matters. The longer the time period, the costlier are
the loans.
At equilibrium, a rational decision entails choice of a path that maximizes the PV of pro ts. As per
convention, the question is how do we ensure uniqueness and independence of the DD and the SS curves?
Becker assumes that own time and hired inputs are used in a xed proportion. Time has a xed cost and has
got a maximum limit. At equilibrium, MB = MC.
The model implies that the total amount invested di ers because of di erences in either demand or supply
conditions. Therefore, the model provides an explanation of why di erent individuals invest di erent
amounts in themselves, thereby causing incomes to change with the variation in the rate of return. A higher
demand curve in the form of a rightward movement of the DD curve and lower supply curves in the sense of
a rightward movement lead to greater investment than others. Given the supply curves one can nd out that
the higher the demand curves, the higher are the returns. If the underlying conditions determining the cost
p. 45 of education remain the same, some individuals would invest more and some would invest less
depending on their rate of return. Similarly, given the demand curves, as the supply curves shift rightward,
returns from investment fall. This happens because with a rightward movement of the supply curves, as
formation of human capital takes place, rate of return fall along the downward sloping DD curve. As we can
see both the demand and the supply conditions are possible factors to explain the di erences in earnings.
We will now focus on one aspect at a time.
Egalitarian Approach
Becker (1975) distinguishes between the two approaches based on the demand and the supply curves to
explain the rate of return based on the DD and SS curves. In the egalitarian approach, as Becker (p. 106)
de nes it, ‘Demand conditions are the same for everybody and that only cause of inequality is di erences in
supply conditions’. Same demand conditions imply that everyone has the same capacity to bene t from
investment in human capital but opportunities di er amongst all to invest in human capital and so there
would be di erent supply curves for di erent nancing conditions. To bring equality in the distribution of
incomes, the policy should target eliminating the di erences mostly in terms of availability of funds. Given
the segmentation in the capital market, cost of nancing is likely to go up. Availability of subsidies may also
6
di er for di erent individuals and with respect to di erent state policies.

Investors may be from wealthy families which will enable people with favourable conditions to invest large
amounts and the SS curve will be lower implying cheaper sources of nancing. So the underlying di erences
in the supply conditions explain why the supply curves vary among individuals. As shown earlier, one can
write:
E = r avg *C
(2.19)
If demand curve was negatively sloped, as it has been argued to be so, the impact on E due to a change in C
p. 46 will get muted. E will now be more equally distributed compared to C because E will change by a smaller
percentage in response to any change in C as average rate of return (ravg) and c move in the opposite
direction. However, if the demand curve was more elastic, both E and C would be more unequally
distributed. Thus, the students with favourable supply conditions would be encouraged to invest more in
response to higher ravg, whereas the students with unfavourable supply conditions would be willing to
invest even less in response to lower ravg.
ʻEliteʼ Approach
The ‘elite’ approach also portrays the analysis to be an extreme one for the purpose of contrast. As de ned
by Becker (1975: 109–110), ‘Supply conditions are identical and the demand conditions alone vary among
the individuals.’ The underlying assumption is that earnings di er primarily because of di erences in the
capacity to bene t from investment in human capital in di erent individuals: some persons are able to do
this more and would form an elite group. To reiterate, opportunities are measured by the SS curves and
capacities are by the DD curves. The DD curves can be higher only if more units of capital are produced for a
given expenditure which implies that the human capital formed has more capacity and ability to gain from a
given investment as re ected in a higher rate of return. Ability is measured by earnings received when the
investment in human capital is held constant as discussed earlier.
There can be two de nitions of ability: (i) in terms of IQ, personality, and motivation, without regard to
earnings (attention to form and not to results), and (ii) in terms of earnings without regard to opportunities
(confounding in the process ‘nature’ and ‘nurture’). Becker’s approach emphasizes on the relationship
between ability or capacity as perceived by the student as an investor in education and expected earnings
given the underlying supply of nances as indicated by the given SS curve.
As is evident from Figure 2.2, if the cost rises, the rate of return rises as we move up the common supply
p. 47 curve and along the higher demand curves. With the same cost, rate of return rises as DD shifts up. If we
combine these two, earnings would tend to be more unequally distributed and skewed than investments as
the rate of return rises with a rise in investment along the positively sloped supply curve.
In the egalitarian approach, marginal rate of return is lower, the larger is the amount invested in human
capital as the DD curve is negatively sloped. Whereas in the elite approach, marginal rate of return is higher,
greater is the investment in human capital as the SS curve is upward rising.
Inequality in earnings tends to be less than that in supply conditions and greater than that in demand
conditions because the former implies a negative and the latter a positive correlation between rate of return
and investment. In the egalitarian approach, inequality in earnings is more serious because it indicates a
larger extent of underlying inequities. This has relevance for the present debate in India. Therefore, a
skewed distribution of income with a presumed symmetrical distribution of abilities can now be explained.

A More General Approach to the Rate of Return
Investment in education and the return earned therefrom constitutes the core of the model which seeks to
explain income di erentials among individuals. In line with the neo-classical approach to resource
allocation in terms of demand and supply, Becker in an ingenuous way provided a sound rationale for
looking at the determination of the rate of return in a supply–demand framework by focusing on the same
individual but from two di erent perspectives—funding education by linking interest costs and the amount
borrowed for investment and return from investment in education. How to explain the variability in
earnings among the people who invested the same amount in human capital? Neither the special case, nor
variations in DD nor SS alone are su cient to provide an explanation. There is a new parameter other than
p. 48 distribution of cost and earnings and the elasticity of DD and SS curves.
A Comparison between the Egalitarian and Elite Approaches

In the egalitarian approach, as the SS curves move rightward, marginal rate of return falls with an increase
in investments, whereas in the elite approach, higher the investments, greater is the marginal rate of return
as the DD curve shifts rightward. In the former approach, the variations in earnings would be less than that
of inequities in the supply conditions because of the negative correlation between the rate of return and
investments made in education. In the elite approach, because of the positive correlation between r and C,
the inequities in capabilities get exacerbated in earnings. This model can help explain why a symmetrical
distribution of capabilities would result in a positively skewed distribution of income under constant
elasticity of supply and constant and identical elasticities of demand curves. As opposed to the egalitarian
approach, the elite approach is better enabled to explain income inequities as it takes di erences in
capacities into account. This is interesting because the supply curve is amenable to the funding policy of the
government. The government through subsidization, cheaper education loans, and ‘scholarships to the
needy’, can bring about equality in the SS side but variations in the demand conditions are intrinsic and
person speci c, di erences in intelligence, and other factors not amenable to direct policy interventions.
Focusing on supply conditions would also e ect better allocation of resources to human capital. So the
inequities would remain ‘even’ if the supply curves are made almost horizontal by policy interventions.
Unlike the conventional DD and SS analysis, there exists a correlation between the DD and SS curves.
Individual represents the DD curve as an investor in human capital in response to the rate of return and at
the same time the individual would constitute the SS curve as someone, who is faced with the locus of
marginal cost of nancing and availability of funds to nance her decision to study: (i) Abler persons are
more likely to receive scholarships or grants from public and private schools, shifting the SS rightward, (ii)
children from higher income families on an average are more intelligent and receive greater psychic
p. 49 bene ts from human capital, and (iii) government measures to tackle poverty lowering the SS curves. If
the rst two dominate, we would get a positive correlation between the SS and the DD curves. It increases
the skewness further by increasing earnings and investment of persons who would have high earnings and
investment anyway.
Becker uses the same framework to discuss the important issue of an e ciency–equity trade-o .
Equalization of a marginal social rate of return across all the persons would ensure e cient allocation of the
total investment in human capital if attitudes towards risk are ignored. If we assume that marginal social to
private rate of return are equal, the equality of the social rate of return would also ensure equality among
the private rate of return.
Nature versus Nurture Debate

Though in the human capital theory it is the levels of education which determine earnings, the role of ability
is clearly brought out in the demand and supply framework as discussed earlier. However, the relative
impact of ability on return is not really apportionable in empirical literature. Even conceptually
distinguishing the relative contribution of attributes and schooling is di cult. We again engage in this
debate in Chapter 5 after we conclude our discussion on the theory of screening.
Generally it is believed that the human capital approach undermines the impact of pre-school factors on
lifetime earnings whether it is in the form of native ability or time spent by the family or the family
background. The impact of these factors like native ability, family background, and schooling cannot be
added to gauge their total impact as in that case we would ignore the interaction e ect. The combined e ect
would be greater than the sum of the impact of individual factors. Strictly speaking, as argued by Blaug
(1976a: 843) the human capital theory does not deny the interaction but emphasizes more on the additive
e ect. It is of course a matter of concern that it is di cult to get reliable data on pre-school factors and
family backgrounds. The unconvincing empirical results can emanate from three factors: the identi cation
problem, problem related to proxy variables, and data related problems.
p. 50 Since earnings depend on wage which is market determined, an earning function could be considered as a
reduced form equation in which the estimated coe cients are biased as the simultaneous equation model is
7
not speci ed and therefore estimated.
The impact of home environment can be in the form of parental education, income, parental occupation,
both before school or during schooling or post-school in uences, or may be because of attitudinal changes
or aspirations and encouragement. For measuringnative ability, the use of IQ is often contested. Instead
achievement motivation may be a better proxy. It can be argued that schooling does exercise a strong impact
and in a way it mediates the family background and pre-school cognitive ability, which on their own would
not mean much to an individual in the skilled segment of the job market. Not only is it schooling, but quality
schooling which transforms family backgrounds and cognitive abilities into marketable assets. It follows
therefore that schooling by itself would not su ce to equalize income without adequate attention given to
family support and pre-school development. Otherwise a school would be a strati er instead of being an
8
equalizing force.
Valuation of Human Capital
If valuation of physical capital remains problematic, valuation of human capital has also been a formidable
exercise. However, economists have not shied away from its valuation because it is a rst step towards
conceptualizing human capital and subjecting it to the rate of return analysis. The general criticism levelled
against even valuation of physical capital remains valid for human capital to a large extent. The
measurement of human capital is highly sensitive to the rate of discount applied. As argued by Wössmann
(2003) adult literacy rates, school enrolment ratios, and average years of schooling of the working-age
population are all poor proxies for human capital. The concept of obsolescence is not important as it is for
physical capital, but mortality rates need to be considered. Further, the relation between earnings and
productivity is central to the measurement of net human capital. There are two problems associated with

p. 51 it. One, the entire rise in earnings cannot be attributed to contributions from human capital as innate
ability, race, sex, and other socio-economic factors do count. Two, investment in human capital is
constrained by various socio-economic factors. It remains debatable whether quanti cation of human
capital should tilt more towards an earnings-based approach or a cost-based approach. Further, the
consumption-investment apportionment of expenditure on education complicates the process. The
delineation of the future pro le of earnings and cost is based on the assumption that steady state or steady
growth equilibrium persists in the long run (Vaizey et al. 1972) which is, realistically speaking, untenable.
Evolution of Human Capital Theory
The human capital theory has evolved over time. There have been changes in methodological issues, focus,
and their subsequent impact on the practice of policymaking. Marginson (1997: 221–2) traced the evolution
of the human capital theory in three phases. This chapter dealt basically with the rst phase (during the
1960s) with focus on education augmenting productivity and therefore income. For policymaking, the
emphasis was on ensuring equal access to education with the social rate of return being regarded as a
measure of investment on economic growth in a broader sense. In the second phase during the 1980s, the
linkage between education and growth was re-envisaged with technological change being considered as the
mediating factor. The focus then was on how education could be an enabling factor in the development,
generation, and dissemination of knowledge as embodied in technology to spur income growth (discussed
in Chapter 3). Shrinkage in the size of the government against the backdrop of the structural adjustment
policies underpinned the approach to education reform. With the coming of the third wave by the early
1990s, termed as the ‘market liberal human capital theory’ (Marginson 1997), the economic logic of free
p. 52 market gained importance which became a compelling reason to undertake reform in education. For a
change in focus, the importance of social rate of return waned even though the private rate of return
emerged as a guiding factor for individualized investment in education. The role of the government was to
facilitate private investment with the aggregate leading to the optimum level of social investment. However,
all three waves share one core element, expenditure on education is investment in human capital, but they
di ered in terms of their methodological approaches and in di erent ways they informed policy practices in
education.
Concluding Remarks
This chapter dealt with the concept of human capital and the rate of return approach to investment in
education. The development of human capital constitutes the core of economics of education and it is a
critical concept in the theory of growth and broad based participatory development. The theory has had
in uence over government policies with regard to skill development in the West. Expenditure for the
purpose of acquisition of skills and knowledge is argued to be no di erent from investment in physical
capital. The advocates of human capital theory have also argued that the choice of investing in education
should be guided by the same principle applied in the case of investment in physical capital. The concept of
the rate of return was developed in the case of education and this idea was broadened to include other
relevant factors determining earnings. At the micro level, the Mincerian equation posits a relationship

between wage and a set of independent variables including education and work experience. The human
capital approach can be argued to be located within the mainline economics of ‘methodological
individualism’. So the criticisms levelled against this approach question the very foundation of this theory
which is based on the methodology of neo-classical economics. Fitzsimons and Peters (1994) quote Fred
p. 53 Block (1990) to point out two fundamental building blocks of neo-classical economics. One, the economy
is analytically separate from society. But an economy is indeed in uenced by politics, society, and culture.
Two, individuals act rationally to maximize their utilities. However, individuals do behave di erently but in
order to lay bare the dynamics of the core of the economy, other behaviours are relegated from the analysis.
Fitzsimons and Peters (1994: 252) say that ‘These assumptions are cast in universal and ahistorical terms’.
The neo-classical perspective simpli es the entire gamut of social events that are signi cant in education
and quanti es all qualitatively di erent aspects of social, cultural, and historical phenomena. Though this is
indeed the approach of this dominant paradigm, the human capital theory has been very well supported by
empirical studies. Sometimes, in order to understand the core, a lot many aspects, even though they are
important, have to be relegated otherwise an analysis of the entire system becomes almost unmanageable.
We have seen in Becker’s model how other socio-psychological factors could be recognized and made part
of the demand–supply model to determine the rate of return from investment in human capital. In order to
probe in to the relationship between education and earnings, the model developed by Becker, as discussed
earlier, seeks to explain income di erences in terms of demand and supply factors.
Blaug (1976a: 828) in his review of the human capital approach raised a fundamental question which has
remained valid even today. He says, ‘Has it progressed, in the sense of grappling ever more deeply and
profoundly with the problems to which it was addressed, or are there signs of stagnation and malaise?’
Though the human capital approach has led to the emergence of many new areas of research in many
branches of economics, but in terms of empirical support, Blaug argues that the theory ‘… is not very well
corroborated.’ (Blaug 1976a: 833). While concluding, Blaug quotes Oulton (1974) to make a point which
questions the very root of the demand and supply approach. Accumulated human capital in the earnings
p. 54 function is supposed to be determined by two exogenously determined distributions, ‘abilities’ and
‘opportunities’. But these two are mere re ections of early cognitive ability and family background. These
two are actually:
… endogenously determined variables in any intergenerational view of the process of human-

capital formation. Thus, at best, the schooling model is incomplete and, at worst, it is misleading
(Blaug 1976a: 845).
Linking education with income earnings requires a study of the role of education in the process of selection
in the job market which remains outside the ambit of the human capital approach. Education may act as a
signalling device for employers to segregate job applicants as potentially more productive from the low
potential ones which opens up a new channel to explain the positive correlation between education and
productivity and/or earnings.
The importance of education has to transcend its mere role in enhancing income. Education by itself is
intrinsically important to a person irrespective of its positive impact on income earning capacities. This
aspect of education that it empowers an individual to participate in the larger socio-political context and
overcome constraints to live life with more freedom and dignity have been stressed by Sen (2000) in his
capability approach.
From a Marxian perspective, the human capital approach scores points but falls short of giving a fuller
analysis of socio-economic dynamics. It extends the notion held by classical economists like Ricardo and
Marx that labour is a produced means of production as distinct from labour being treated as a mere
commodity. Labour is heterogeneous and di erentiated as it embodies di erent levels of skills. An analysis
of the process of production of education requires social institutions, schooling, and family to be put

together rather than relegating family to the background of the analysis. But the notion of schooling needs
to be deconstructed along with an attempt to understand and trace out the implications of education
imparted within a social context in a typical capitalist order.
The focus on individuals as decision-making agents in education ignores the other agents (government and
p. 55 the private sector) in decision-making, thereby ignoring their roles in capacity creation for delivery of
education and policymaking. Choice making from society’s perspective is often insightful and meaningful
as argued by Majumdar (1983). An overall critique of the human capital approach located within the neo-
classical theory entails a much broader canvass to appreciate how education has been dealt with by
economic theory and various other theoretical perspectives over the years. Some of these points are taken
up for a detailed discussion in Chapter 5, which revisits the contributions of human capital theory from four
di erent perspectives—education as a screening device, Sen’s approach to education in his approach to
development, Majumdar’s critique of the human capital approach from the social choice perspective, and
the Marxian critique.
Notes
1. Because of Adam Smithʼs emphasis on division of labour, economic progress would reduce rather than raise supply and
demand for human skills. Malthus like Smith treated education for the betterment of man and not for the creation of
human resources (Bowen 1963: 104).
2. Sustained investment in physical capital was necessary to sustain the demand for labour as aggregate demand
determines output and hence employment.
3. Specifically, Schultz was awarded in 1979 and Becker was awarded in 1992.
4. To the extent acquisition of skill and knowledge and being a part of an institution gives satisfaction to the individual in the
form of socialization and realization of oneʼs potential, expenditure on education would better be classified as
consumption expenditure.
5. It is assumed that while estimating the social rate of return, the valuation of the externalities as a proxy for social benefits
would be large enough to outweigh the social costs.
6. If scholarships are given on the basis of merit or income, only those who fulfill the defined criteria become eligible for the
scholarships. The supply curve will also vary from individual to individual depending on the familyʼs income and wealth
conditions.
7. This issue appears in the discussion in the context of a critique advanced by Majumdar (1983) in Chapter 5. He argues that
the human capital approach focuses only on one domain of investment—the individual domain—and there may arise
di erences between micro and macro estimates. Both these put together show that supply responses in the education
sector matter for realization of returns as wages are essentially market determined.
8. Blaug (1976a: 844–5) quotes Fägerlind (1975) to drive home the point that schooling a er all does matter.

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Education and Economics: Disciplinary Evolution and Policy Discourse

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https://doi.org/10.1093/acprof:oso/9780198082255.003.0002 Pages 17–55

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The Human Capital Approach

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Defining Human Capital

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education 〉 cognitive capacity 〉 higher productivity 〉 earnings 〉 a measure of HC

A. Concept of human capital, a counterpart to the notion of physical capital formation.

i. investment decision-makers in education are analogous to investors in the capital market,

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Estimating the Rate of Return

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Ignoring Ch and dividing by W l

s W l,t R W l,t W h,t

Let us assume that equation 2.4:

If we substitute p and MRS we obtain the following (2.5):

Annual net benef its rule: (PV of Benef its − PV of cost) = 0

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Figure 2.1 Choice of Discount Rate

Adjustments in the Estimation of Rate of Return

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Private versus Social Rate of Return

Social costs would have to be rede ned as C P′ hD = C P hD + S U niv

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The General Earnings Function: Becker and Mincer

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Or equation 2.18 could also be written as:

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The familiar Mincerian wage equation for i can be written as:

From 2.15, it follows:

Beckerʼs Approach to Human Capital and Income Distribution

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Figure 2.2 Equilibrium Levels of Investment in Human Capital

Source: Becker (1975).

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A Comparison between the Egalitarian and Elite Approaches

Nature versus Nurture Debate

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Evolution of Human Capital Theory

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… endogenously determined variables in any intergenerational view of the process of human-

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