Economics 312
Labor & Human Resource Economics
Problem Set 4: Compensating Differentials and Human Capital
1. Consider a competitive economy that has four different jobs that vary by their wage and risk level.
The table below describes each of the four jobs.
Job Risk (r) Wage (w) U
A 0.20 $3 28
B 0.25 $12 28
C 0.33 $23 32.2
D 0.50 $25 29
All workers are equally productive, but workers vary in their preferences. Consider a worker who
values his wage and the risk level according to the following utility function:
u(w, r) = w + 1/ r2
Thus, higher risk (r) results in lower utility.
a. Where does the worker choose to work?
Job C: See utility column in table
b. Suppose the government regulated the work-place and required all jobs to have a risk factor
of 0.20 (that is, all jobs must become A jobs). What wage would the worker now need to earn
in the A job to be equally happy following the regulation?
Solve for w* that makes worker equally happy as Job c, ie U(w*,.2) = w* + 25 = 32.2 =>
w* = 7.2. That is, the worker would need to earn a wage of 7.2 to be equally happy as before
the regulation. In this case the government is making the work place “too safe” from the
standpoint of the worker.
2. Consider Table 5-1 in the text and compare the fatality rates of workers in the mining, construction,
manufacturing, and financial industries.
a. What would the distribution of wages be expected to look like across these four industries if
firms have to pay to compensate workers for risk?
Wages in finance would be lower than in the other industries, because risks of fatalities and
other injuries are lower. (Fatalities are highest in manufacturing suggesting it would have
the highest wages, but injury rates are lower than in mining and construction, so the net
effect on wages is uncertain.)
b. Now look at average hourly earnings in 2006 by industry as reported in Table 614 of the 2008
U. S. Statistical Abstract. Is the actual distribution of wages consistent with your answer to
part a? If not, what might explain the inconsistency?
Average hourly wages in 2006 are Mining: $20.29, Construction: $20.02, Manufacturing:
$16.80, Finance and Insurance: $20.05. No, they are not consistent, because finance wages
are higher than manufacturing and barely below construction and mining, despite much
lower risks in finance. The inconsistency is probably explained by differences in skills or
other characteristics of the jobs. For example, many finance jobs require a college degree
while most construction jobs do not.
3. Suppose a firm must employ 20 workers in order to produce 2,000 units of output that the firm has
contracted to supply to the government for $ 1.4 million. The firm must choose how much to invest in
safety. The firm can choose any level of safety, S, from 0 to 100. The cost of safety is C( S) = 50S2.
Given the firm’s choice of safety, the annual salary paid to workers is determined by Annual salary =
60,000 - 300S. Thus, a firm that chooses S = 30 pays $ 45,000 for this level of safety and pays each
worker $ 51,000. What level of safety will the firm choose, and how much does this cost? How much
will each worker earn? How much profit will the firm earn?
Revenue and output are predetermined; the firm’s problem is to minimize total cost of production by
trading off cost of safety and worker salaries.
Total Cost = C(S) + 20* Annual Salary
= 50S2 + 20*(60,000 – 300S)
dTC/dS = 100S – 6,000 => S* = 60
C(S*) = 50*602 = 180,000
Annual Salary = 60,000 – 300S* = $42,000
Profit = 1,400,000 – (180,000 + 20*42,000) = $380,000
4. U. S. Trucking pays its drivers $ 40,000 per year, while American Trucking pays its drivers $ 38,000
per year. For both firms, truck drivers average 240,000 miles per year. Truck driving jobs are the
same regardless of which firm one works for, except that U. S. Trucking gives each of its trucks a
safety inspection every 50,000 miles, while American Trucking gives each of its trucks a safety
inspection every 36,000 miles. This difference in safety inspection rates results in a different rate of
fatal accidents between the two companies. In particular, one driver for U. S Trucking dies in an
accident every 12 million miles while one driver for American Trucking dies in an accident every 15
million miles. What is the value of a trucker’s life implied by the compensating differential between
the two firms?
The (annual) probability of death for each driver working for US Trucking is 240,000 miles / 12
million miles/death = .02 deaths. Similarly for American Trucking, 240,000 / 15 million miles/death
= .016 deaths. The difference in probability of death ΔPr(Death) = .004. The increased salary is
ΔSalary = $2,000. The implied value of life is ΔSalary / ΔPr(Death) = $2,000/.004 = $500,000.
5. When Plant X closed, Employer Y (which offers no training to its workers) hired many of X’s
employees after they had completed a lengthy, full-time retraining program offered by a local agency.
The city’s Equal Opportunity Commission noticed that the workers Employer Y hired from X were
all young, and it launched an age-discrimination investigation. During this investigation employer Y
claimed that it hired all of the applicants from X who had successfully completed the retraining
program, without regard to age. From what you know of human capital theory, does Y’s claim sound
credible? Explain.
Y’s claim is consistent with human capital theory in two respects. First, its own hiring and training
costs appear to be negligible (we are told that it offers no training on its own, and that its hiring
standards consist of taking successful graduates of another program). Because it makes no major
investments in its workers, it therefore has no reason to prefer younger workers. Second, because the
retraining program to which X’s former employees had access was “lengthy,” it may well be that
only the younger workers from X decided to invest in this retraining. All workers have to decide
whether a human capital investment opportunity will have expected benefits (properly discounted to
the present) that are at least equal to the costs, and a shorter period over which benefits are received
reduces these benefits. Thus, older workers are less likely to have decided to invest in retraining –
with the result that only the younger workers became qualified to apply to Employer Y.
6. Becky works in sales but is considering quitting work for two years to earn an MBA. Her current job
pays $40,000 per year (after taxes), but she could earn $55,000 per year (after taxes) if she had her
MBA. Tuition is $10,000 per year and the cost of an apartment is equal to the $10,000 per year she is
currently paying. Becky’s discount rate is 6 percent per year. She just turned 48 and plans to retire
when she turns 60, whether or not she gets her MBA. Based on this information, should she go to
school and earn her MBA? Explain carefully.
She should go to school if the present value of earning the MBA exceeds the present value of her
earnings stream without the MBA, or if the net present value of the MBA, subtracting off her
opportunity costs, is positive. Since she is 48 and plans to retire at age 60, this implies 12 more years
of working/schooling. Assuming tuition and salary payments are made at the beginning of the year,
the net present value of her earnings stream with the MBA is:
NPVMBA = -[10000+40000] - [10000+40000]/(1.06) + [55000-40000]/(1.06)2 + 15000/(1.06)3 +
15000/(1.06)4 + 15000/(1.06)5 + 15000/(1.06)6 + 15000/(1.06)7 + 15000/(1.06)8 + 15000/(1.06)9 +
15000/(1.06)10 + 15000/(1.06)11
= -50000 –47169.81 + 13349.95 + 12594.29 + 11881.41 + 11208.87 + 10574.41 + 9975.86 +
9411.19 + 8878.48 + 8375.92 + 7901.81
= 6982.38
Thus, her earnings over the rest of her working life will have a present value that is 6982.38 higher if
she goes to school to earn the MBA.
7. Suppose there are smart and dumb people in the world (30% smart). Smart people have a marginal
product of 5 and dumb people have a marginal product of 1. Years of schooling (Y) provides a signal
of intelligence in that it costs smart people Y/4 and dumb people Y dollars to go to school. The firm
will pay people with the signal of intelligence a wage equal to the marginal product of smart people
(5). Assuming that the firm is competitive and the price of the output is 1:
a. find the pooling equilibrium wage under this scenario and;
In the pooling equilibrium, workers get paid the average wage:
.30(5) + .70(1) = 1.5 + .7 = 2.2
b. find the minimum number of years of schooling that the firm must require in order to insure
that dumb people will find it in their best interest not to go to school in a perfectly separating
signaling equilibrium.
Smart people will choose to go to school if the net benefits from attending school exceed the costs:
5 - Y/4 >1
Y/4 < 4
Y < 16
Dumb people will choose not to go to school if the net benefits from attending school do not exceed
the costs:
5-Y<1
Y>4
Thus as long as employers require more than 4 but less than 16 years of schooling, the market will
have a perfectly separating signaling equilibrium.
8. In the paper, "Mortality and Morbidity Risks and Economic Behavior," the author notes on page 1
that "Theory states that a high risk of early mortality or morbidity decreases investment in human
capital. However, empirical investigation of this hypothesis is complicated by various problems…"
(a) Using the human capital model, describe why early risk of mortality would decrease investment
in human capital.
Early risk of mortality reduced the expected period of time in which an individual will earn a
return on their investment (higher earnings), so early mortality reduces the NPV (and IRR) of the
investment.
(b) Explain why the empirical investigation of the hypothesis is complicated. In particular, why can't
researchers just compare the educational attainment of those who die at younger ages (but still old
enough to have completed any educational investments they would make) against those who die
later in life?
Human capital investments depend on the expected return, so the key is when individuals learned
of their disease, rather than when they actually died. Also, length of life may depend on human
capital investment via higher income (reverse causality). Also, human capital investment and
length of life may be correlated because they are jointly caused by a third factor such as
“patience,” which leads people to invest and to take fewer risks. That is, the purpose of the paper
is to ascertain how (expected) length of life affects human capital investment, but observed
correlations may result from reverse causality or spurious correlation.
(c) What is Huntington's disease? How does the author's study of Huntington's disease patients
mitigate the difficulties you described in part (b)?
Huntington’s disease is a fatal genetic disorder that introduces a large and exogenous risk of
early mortality and morbidity. The disease is exogenous, i.e. reverse causality is not a problem.
The incidence of Huntington’s disease is independent of factors like “patience.” “For economic
choices such as the level of educational attainment and fertility, the variance in the age at which
people first learn of their risk status creates a natural control group, as people who learned
about their risk status early in life were able to adjust their educational attainment fully, while
people who learned about their risk status much later were not able to adjust at all.” (p.4)
(d) The paper also investigates the impact of Huntington's on fertility decisions. Describe his findings
and the potential implications of widespread testing for the disease.
The paper finds that fertility is strongly negatively related to learning that one has Huntington’s
disease while in the child-bearing years. Furthermore, “the results suggest that an important
reason for the survival of Huntington’s disease despite the fact that it is genetic is the fact that
people who are at risk for Huntington’s disease simply do not know about it until it is too late. If
over twenty eight percent of people who are at risk elected not to have children at all, and over
twenty six percent of people who are at risk elected to have less children, the number of patients
would quickly decay over time.” p. 20
9. Estimates from regression models of the general form: Ln (Wage) = α + β*(years of college) + other
variables, using cross-sectional data generate an estimate of β of about 0.06.
a. Interpret this estimate as a rate of return
The estimate implies that each year of college is associated with a six percent increase in predicted
earnings.
b. Most economists would argue that the estimate derived from the regression above is likely
too high. Provide an explanation for why.
The most likely reason is ability bias. The cross-section estimates pool together those with high
aptitude ("high ability"), and those with less aptitude ("low ability"). Ceteris paribus, high ability
individuals likely face lower costs of college education (i.e., they can get through more quickly, they
may need to spend less time studying, they are less likely to need to hire tutors, and are less likely to
need additional or remedial courses, etc.), with the implication that they are more likely to attend
college. It is also likely that high ability workers would have had higher earnings than low ability
workers, even if they didn't attend college. Thus, some of the higher earnings of those who attend
college are because of the human capital improvements associated with college itself, and some are
simply because those who would have high earnings anyway choose to attend college. The estimate
above mixes these two effects, and thus overstates the return to college itself.
10. Suppose that a firm is considering training a worker. The worker's MPL is $100 during the training
period, but rises to $200 in the post-training period. The worker's wage is $100 during the training
period, the cost of training is $50 and the discount rate is 10%. What is the most that a profit-
maximizing firm can afford to pay the worker in the second period?
The firm will undertake the training if the discounted net benefits from the post-training period
exceed the net expense from the training period, i.e., if W0 + Z - MP0 < (MP1 - W1)/(1 + r). Plug in
the values to solve for W1 at the breakeven point. $100 + $50 - $100 = ($200 - W1)/1.1, or $50x1.1
= $200 - W1, so W1 = $145. If the post-training wage is less than $145, the firm will make a profit.