Methods of HC estimation: an evaluation

5. Methods of HC estimation: an evaluation

The two main approaches of HC estimation, i.e. the prospective and the retrospective methods, drawn inspiration from actuarial mathematics and from economics, respectively. The retrospective approach, first proposed and applied by Engel 1883, is an inappropriate analogy with the economic method of estimating the cost of goods and services, i.e. the price determination at factors cost. It is an inappropriate analogy because of the existence of incommensurable components entering into the production of HC. In effect, the cost of production of goods and services has clear and well identifiable inputs and prices for the raw materials, the intermediate inputs, the certain value added wage, interest, and rent of the factors of production, in the sense of Cantillon 1755, see also Dagum 1999 and the imputed profit according to Cantillon, the uncertain remuneration to arrive at an accurate price estimation at factors cost. Besides, given the technology and the input standards applied in the process of production, the goods or services of a given produced brand are indistinguishable. None of these features is present in the HC estimation as a cost of production. In effect, maternity costs, the cost of rearing a child, the cost of formal and informal education, the parents’ health, the health care choice, recreation and mobility cost, are important and not standard inputs of HC output. Besides, the cost of production approach completely ignores the genetic endowment, the home and the environment contributions to the stock of personal HC. It has to make also a meaningful imputation of public investment in education, health, recreation, mobility, information, and very specially, in research and development RD. The sociopolitical impacts of these public investments intro- duce a substantial distinction between the private and the social rates of return. Besides, the cost of education fulfills a multidimensional scope, contributing to a more civilized way of living, including a convinced tolerance and acceptance of what is different, such as religion, ideology, and race, making a decisive contribu- tion to a more efficient working of democratic societies and of economic processes. Engel’s approach cannot be construed as a human capital estimation. However, it provides a useful and important information about the economic cost of rearing a child since hisher conception until heshe enters into the labor market. It can consider different types of family’s socioeconomic backgrounds, hence, presenting the cost equation as a function of its corresponding levels of income, wealth, social environment, and educational levels of the child parents. Engel advanced a critique of the prospective method which is overcome by the approach presented in Section 4. He argued about the impossibility of finding the proper weights and the lack of knowledge about the future earnings of outstanding outliers such as Goethe, Newton, and Benjamin Franklin. This is, indeed, a powerful argument against Engel’s own approach as a method of HC estimation; it should be retained only as a method of estimating the cost of rearing a child. Besides, Engel’s approach, very often, would give the undesirable and inaccurate estimation of an HC of a less talented child as being greater than the HC of a more talented one because of the former having less intelligence, ability, drive, effort, and determination than the latter, therefore, incurring in a larger cost taking more years of study andor hiring a private tutor to complete the same professional career, contradicting the fact that, compared with the latter, the former will have a smaller HC, defined as the power to generate a flow of income. The prospective method as developed by Farr 1853 and adopted by Dublin and Lotka 1930 is theoretically rigorous. Accurate and timely mortality tables are available, the choice of a discount rate is not a serious problem eventually, HC can be estimate for several levels of it and the unemployment rate by age and years of schooling, although so far not available, can be calculated from a redesigning of the quarterly labor force and the consumer finance surveys. This method provides, indeed, the HC estimation at market price, since the labor market takes into account the economic unit attributes such as ability, intelligence, effort, drive, determination, and professional qualifications, as well as the institutional and technological structures of the economy in an interactive framework of HC supply and demand. The main drawback of this method, as applied by Farr, and Dublin and Lotka, is the lack of information and the inaccurate factual assumption about the flow of future earnings. One extreme and unacceptable assumption is the one advanced by Mincer 1970 when he assumed that the flow of earnings of a person with s years of schooling is constant throughout hisher working life. An ingenious approach to overcome the limitations of the former assumptions about the flow of earnings was introduced by Jorgenson and Fraumeni 1989. They assumed that the earnings that a person of age x will receive at age x + t will be equal to the earnings of a person at age x + t with a similar profile sex and education adjusted for increases in real income, and weighted by the probability of survival. This approach is more rigorous, however, it is still insufficient because of the large variations of personal endowment introduced by nature and nurture, among persons of the same sex and education, introducing severe biases and inaccuracies in the process of imputing the expected future earnings. Macklem 1997 approach introduces also biases and inaccuracies in his HC estimation throughout the specification and estimation of a bivariate vector autore- gressive model. The biases and inaccuracies are already present in the data on real interest rate and the growth rate of labor income net of government expenditures and on the corresponding data on labor income. Section 3.3 presented the contribu- tions that use a measure of educational enrollment, or an index number of educational stock, to represent the stock of HC of the working age population or of the labor force. The authors adopting this approach bypass the quantitative measurement of HC and retain only an important indicator, the educational stock of a population. This is a follow-up of Mincers’s classical contribution. While Mincer derived a microeconomic earnings function, these authors provided either a macroeconomic index number time series or cross-section averages of the educa- tional stock of the working age population as a qualitative indicator of the stock of HC. A new approach to estimate the microeconomic levels of HC for each economic unit, and its size distribution, is presented in this study Section 4. It combines the microeconomic estimation of HC as a latent variable HC is indeed a full-fledged latent variable, with the macroeconomic estimation of the average HC of a population of economic units. This combination offers a robust statistical support to the estimation of HC. The main objection to the prospective approach does not apply to our approach because it works with average earnings by age. These averages allow an accurate representation of the capacity or power of the average economic unit by age to produce a flow of earnings because, under general conditions of stochastic regularity, the law of large numbers applies. The applica- tion of the prospective method to the smoothed values of the average earnings by age allows the estimation of the weighted average of HC, i.e. the average HC of the population. Besides, this average becomes our scaling or benchmarking factor to pass from the transformed latent variable estimation to the monetary values and the size personal distribution of HC.

6. A case study: the 1983 U.S. human capital