Growth Theory

Human Capital Accumulation and Growth

Matthew Hoelle
Economics 512
Intermediate Economics II: Macroeconomics
Purdue University
Spring 2014
February 17, 2014
1 Introducing human capital into the model
In this lesson, we will allow the households to endogenously determine their stock of human
capital. We can think of human capital as both schooling and on-the-job training.
The human capital growth is desirable for both the households and the rms, because
(i) human capital enters the production function and allows the rms to produce additional
output and (ii) since rms produce additional output, they can pay higher wages to house-
holds. This is the intuitive reason why students such as yourselves remain in school: higher
future salary.
The production function states that output is produced using three factors of production:
physical capital 1
t
. human capital H
t
. and labor `
t
. The production function , : R
3
+
!R
+
is of the Cobb-Douglas form once again:
, (1
t
. H
t
. `
t
) = (1
t
)

(H
t
)

(`
t
)
1
for o. j 2 (0. 1) . The unit mass of homogeneous households supply labor inelastically. The
total labor supply in equilibrium is `
t
= 1 in all time periods.
The decentralized equilibrium has the following factor prices, which are found by taking
1
the rst order conditions of the rms optimization problem:
1
t
= o (1
t
)
1
(H
t
)

. (1)
~
1
t
= j (1
t
)

(H
t
)
1
.
n
t
= (1 o j) (1
t
)

(H
t
)

.
In all three cases, we have substituted for the aggregate labor supply `
t
= 1. The new rate
of return is
~
1
t
. which is the rate of return on human capital (or the returns from education).
The households receive monetary payouts from their labor market participation. First, they
receive the standard wage rate n
t
based solely upon the number of hours of labor provided.
Second, they receive additional income for every unit of human capital stock that they hold.
As in the previous lesson, the government imposes a tax t on investment. In this model,
that investment is both the physical capital investment and the human capital investment.
Denote the households stock of human capital in the current period as /
t
. Then, the house-
hold budget constraint is given by:
c
t
+ (1 + t) (/
t+1
+ /
t+1
) = 1
t
/
t
+
~
1
t
/
t
+ n
t
.
2 Using no arbitrage
There are two vehicles for savings by the households: investment in physical capital and
investment in human capital. In equilibrium, the returns on these investments must be
identical. Otherwise, there would be an arbitrage opportunity as households would only
invest in the higher return capital. Identical returns is given by:
1
t
=
~
1
t
. (2)
This condition will be referred to as the no arbitrage condition throughout the text.
Lets consider the argument behind no arbitrage in greater detail. Suppose that 1
t

~
1
t
(an arbitrage opportunity exists). Then all households would switch investment from human
capital to physical capital. Given factor price equations (1), this switch would both decrease
1
t
and increase
~
1
t
. This adjustment must continue until the rates of return equilibrate at
1
t
=
~
1
t
.
2
3 Writing the Bellman equation
In equilibrium, the capital inputs for the rm must be equal to the capital stocks held by
the households:
1
t
= /
t
.
H
t
= /
t
.
Using this equilibrium condition and the factor price equations (1), the no arbitrage condition
(2) implies that:
o (/
t
)
1
(/
t
)

= j (/
t
)

(/
t
)
1
.
We can solve for / :
/
t
=
j
o
/
t
.
The budget constraint for the Bellman equation is given by:
c + (1 + t) (/
0
+ /
0
) = 1/ +
~
1/ + n.
Since 1 = 1
0
and / =

/. then we can express the Bellman equation only in terms of the

physical capital stock:
\ (/) = max
c0;k
0
0
ln (c) + ,\ (/
0
)
subject to c + (1 + t)
_
1 +

_
/
0
= 1
_
1 +

_
/ + n
.
4 Solving the model
Lets solve the Bellman equation by using the guess-and-check method as before with \ (/) =
:ln(/) +/ for some coecients : and /. We substitute from the budget constraint into the
utility function, meaning that the Bellman equation is given by:
:ln (/) + / = max
k
0
0
ln
_
1
_
1 +

_
/ + n (1 + t)
_
1 +

_
/
0
_
+ , f:ln (/
0
) + /g
.
Exercise 1 Human capital accumulation and growth
Show that the optimal policy function and consumption function satisfy
q (/) =
(o + j) ,
(1 + t)
_
1 +

_
_
1
_
1 +
j
o
_
/ + n
_
and
c = (1 (o + j) ,)
_
1
_
1 +
j
o
_
/ + n
_
.
3
respectively.
In equilibrium,
1
_
1 +
j
o
_
/ + n = o (/)
1
(/)

_
1 +
j
o
_
/ + (1 o j) (/)

(/)

.
Since / =

/.
1
_
1 +
j
o
_
/ + n = o (/)
+1
_
j
o
_

_
1 +
j
o
_
/ + (1 o j) (/)
+
_
j
o
_

= (/)
+
_
j
o
_

_
o
_
1 +
j
o
_
+ (1 o j)
_
= (/)
+
_
j
o
_

.
5 Steady state
The steady state capital holdings are found to satisfy /
SS
= q (/
SS
) . The algebra is:
/
SS
=
(o + j) ,
(1 + t)
_
1 +

_ (/
SS
)
+
_
j
o
_

/
1(+)
SS
=
(o + j) ,
(1 + t)
_
1 +

_
_
j
o
_

/
SS
=
_
(o + j) ,
(1 + t)
_
1 +

_
_
j
o
_

_ 1
1(+)
.
The aggregate output of the economy (or the GDP) in any time period t is given by:
, (/
t
. /
t
. 1) = (/
t
)
+
_
j
o
_

=
_
(o + j) ,
(1 + t)
_
1 +

_
_
+
1(+)
_
j
o
_
2(+)
1(+)
.
6 Tax analysis
Consider country 1 with a high investment tax (t
1
) and country 2 with a low investment tax
(t
2
). The investment tax is on the combined investment in both physical capital and human
capital. It is not clear what value to use for a tax on human capital, so we will maintain the
4
ratio from the previous lesson as an upper bound:
1 + t
1
1 + t
2
= 1.35.
All other factors (production function , : R
3
+
!R
+
. physical capital share o. human capital
share j. and discount factor ,) are identical. Dene 1
1
(t) as the GDP of country 1 in time
period t and 1
2
(t) as the GDP of country 2 in time period t. Then the ratio of the GDPs in
the two countries is given by:
1
1
(t)
1
2
(t)
=
_
1 + t
2
1 + t
1
_
+
1(+)
for all time periods.
We maintain the value of o =
1
3
for the physical capital share. The labor share is the
remaining fraction 1 o =
2
3
. In this application, the share owed to labor is split between
the share owed for the labor supply and the share owed for the human capital stock. Both
aspects would contribute to the labor share in the data. Empirical work using the returns
on education has been able to approximate the value for j =
1
3
(we trust the value for the
physical capital share much more than this value for the human capital share, but it is a
rst approximation). With the higher investment tax, country 1 has a lower GDP, and the
relative GDP given the relative taxes can be as low as:
1
1
(t)
1
2
(t)
=
_
1 + t
2
1 + t
1
_
+
1(+)
=
_
1
1.35
_2
1
55%.
The model in this lesson is identical to that in the previous lesson, with the lone exception
that human capital is included alongside physical capital. With this change, the negative
eects of a tax on steady state production are exacerbated (from relative steady state GDP
levels equal to 86% to relative steady state GDP levels equal to 55%).
5