The Economic Rationale for Investing in Children: A Focus on Child Care. Human Capital Rationales

12/01/2001

Economists look at certain types of human activities as analogous to the creation of physical capital. Physical capital  such as plant and equipment  contrasts with other productive inputs. Other productive inputs, such as labor and materials, are immediately transformed in a short time period into products or services. Physical capital, in contrast, requires a large investment at the outset and then produces returns over long periods of time. Human activities which take the form of investment at an early period and yield returns over long periods of time are referred to as human capital. The most common example is education. Education usually requires the bulk of resources at an early period  the investment  and yields benefits over long periods of time, e.g., greater productivity through the working years. In the economists' most common model, those benefits take the form of increased productivity of the individual and are reflected in higher earnings over the period following the initial investment in education.

There are of course other types of activities which have been called human capital, such as investment in better health, e.g., immunizations, or better eating and exercise activities, in that they yield benefits over longer periods of time. And there are benefits other than just increased productivity in a work activity that can accrue from human capital investments.

The major rationale given for employment creation and training activities is that they create human capital and the expectation is that the payoff from the investments in employment creation and training activities will be increased productivity. The above-cited economist's query is: if these are such good investments why doesn't the free operation of private markets provide the optimal amount of such investment and at the lowest cost in resources used?

To attempt to answer this query one examines the theory of the behavior of the two potential private market sources of investment in employment creation and training: the individual and the firm.

Individual Human Capital Investment

In the economist's model, rational individuals consider all the alternative uses of the set of resources they control and what benefits will accrue from each use of resources. With respect to education and training, they assess the investment required  in terms of direct costs (tuition, fees, materials) and the indirect cost (earnings foregone while engaged in the education or training activity). Then they calculate the benefits which will accrue, e.g., higher earnings paid for deploying the learned skill, over the useable lifetime of that investment  how long they expect to be able to use that skill and earn a premium for exercising it. (There is an added element of the calculus. The potential investor discounts to get present values of the future benefits. I won't go into this here except to say that benefits obtained far in the future have a present value which is far less than the value of the same magnitude of benefit obtained in the near future). If the benefits exceed the costs, the rational individual makes the human capital investment. In this basic model, all human capital investments that yield benefits greater than costs would be freely undertaken through the market mechanism.

What factors have been cited which limit the reach of this model and lead to an argument for intervention beyond the free markets?

Poor Information

The rational person model assumes that for individuals there is good information available about both the costs and the benefits of the investment and that individuals are in possession of that information. Particularly, in this case, the information about the long term pattern of benefits and costs is important for the decision calculus. Where individuals do not, or cannot, access the relevant information, the market will fail to provide optimal outcomes with respect to human capital investments.

In the case of employment and training there are a variety of circumstances which could give rise to a lack of good information on the part of individuals, several of which I will return to below. For now, however, I will leave it that information failures may provide a rationale for the public sector to intervene in employment and training markets.

Externalities Are Ignored by Individuals

The term externalities embraces a wide variety of situations which may be cited as causes of market failures. The usual example given of externalities is a situation involving pollution. Pollution imposes a cost, e.g., bad air or bad water, on individuals exposed to it. The polluter can ignore these costs to others that his actions cause because the market does not measure it as a cost. The costs the polluter takes into account are only those he pays for in producing his good or service where as the social costs are those costs the polluter pays plus the costs to others imposed by his pollution. Externalities cause social costs and benefits to diverge from those costs and benefits the individual takes into account in making decisions.

For employment and training activities there are again a wide variety of externalities which can arise and cause social costs or benefits to diverge from those which affect the individual engaged in these activities. Again, I will return to a number of these in discussion of other categories of rationales below. Just one relevant example: suppose there is a critical skill needed for a given production process and the productivity of other workers is directly affected by the presence or absence of that skill. The individual deciding whether to invest in that skill may undervalue it, from society's point of view, because she herself will not capture the enhanced returns from providing that skill which will accrue to the other workers or to the firm because the critical bottleneck has been avoided. The public sector, taking the wider societal perspective, may intervene to foster the investment.

Individual Inability to Finance the Investment

While the individual may correctly assess the benefits and costs of a given human capital investment they may lack control over sufficient resources to make the investment. With respect to investments in physical capital, the investor can often borrow funds for the investment, pledging a return on the basis of future earnings. However, since the outlawing of slavery, rights to human labor are not an alienable asset. A contract in which an individual pledges the future earnings as collateral would not be enforceable in court if the contractor sought to collect the collateral. This is often referred to as "an imperfection in capital markets". The inadequacy of markets for borrowing against human capital is a rationale often given for market failure, especially as applied to liquidity constrained individuals. Here again, the public sector may intervene to offset the failure of the market and either facilitate borrowing or engage in direct production of the human capital at lower cost to the individual.

Application of Individual Human Capital Rationales to Child Care

All of the rationales suggested in this section for public sector investment in employment and training would appear to carry over to a rationale for public sector investment in child care. As I go through these arguments I will, for the most part, stress potential positive benefits deriving from child care. It should be recognized, however, that there are also potentially negative effects emerging from individual parents' choices regarding child care; indeed there has been a long-running debate in some segments of the research community as to whether child care by other than the mother has negative effects on child development.

Poor Information. Surely individual parents will have difficulty assessing what the long term benefits (or costs) will be from having their child in a particular type of care situation. As I perceive it, assessments of what those benefits or costs might be over the long term remain disputed even among experts in the child care field(1). At a minimum, the public sector should continue to invest in developing better knowledge of what long term effects of alternative child care settings may be. A public supported effort at dissemination of such information as exists at present would also seem justified. Public regulatory structures are generally advocated as a protection against lack of information by consumers and thus regulation of child care is a public sector intervention meant to offset consumer lack of information.

The poor information rationale would apply both to arguments for public investments which increase the quantity of child care and to arguments to increase the public investment in the quality of child care. A particularly important public service would be to provide parents with better information about how various types of quality in child care are likely to affect long term outcomes.

Externalities Ignored By Individuals. As has been the case with public education for a long time, there is a widespread belief that the wider community benefits from healthier, more intelligent, participatory individual citizens. To the extent that particular child care settings can be shown to help increase the number of such individual citizens, they are creating externalities that may be ignored by the parents. Calculation of social, as opposed to private, benefits would include such community gains. Of course, there are more specific forms of this "better citizen" externality that could be counted: lower crime, less substance abuse, lower school dropout rates, etc. While individual parents might take such benefits into account with respect to their child's well-being, there are broader costs in the community  incarceration, substance abuse treatment  which could, due to better child care, be avoided. The avoided-community-costs might not enter the parents' benefit calculus.

Recently, there has been a rash of research studies by economists regarding "peer effects". Some clever work has been done  using the fact that at some colleges roommates are essentially randomly assigned  to get presumably unbiased estimates of the relationships between the behavior of roommate pairs, a form of "peer effect."(2). Also, as part of the debate over the benefits of small class size, it has been suggested that a major influence on classroom learning of a given student is the degree of concentration of disruptive children in her classroom(3). Thus better classroom behavior generated by specific child care settings for a given child could generate external benefits to that child's peers in the classroom. These external peer effects might not enter in to the calculus of individual parents.

Individual Inability to Finance the Investment. Clearly many types of child care are high cost. The costs are high relative to the incomes of families with only low skilled earners. This is particularly true for many low income single parents. Further, it is noteworthy that usually parents will have to be making investments in child care when they are at the early stages of their working careers and their current earnings are low relative to what their average earnings over their working years are likely to be. It is evident that many worthwhile investments in child care, from both a private benefit-cost perspective and from a social benefit-cost perspective, are likely not to be made because of parental inability to finance the investment. This would apply both to arguments for the quantity of child care and to those for the quality of child care.

Human Capital Investment by Firms

Firms are purchasers of the skills created through human capital investments and they are also producers of skills. When, or why, won't the free market operations of firms lead to optimal and efficient human capital investments?

In his classic work, Becker made the distinction between specific human capital and general human capital. Specific human capital is a set of skills that increase productivity of workers in a narrow context  in particular, as applied to the production process and/or organizational structures of a given firm. The term general human capital refers to skills whose productivity is widely transferable across different production processes and organizational settings. This distinction is critical for assessing possible sources of human capital market failure due to the actions, or inaction, of firms.

General and Specific Skill Investments

The usual starting point is the argument that firms will invest in skill development only to the extent they can capture the full returns on their investment in worker training. The major way they capture the return is to increase the wage of the newly skilled worker by less than her productivity has increased. Where general skills are involved firms might make an investment in skill improvement of a given worker but, shortly after she is trained, a rival firm recognizes a now more highly skilled worker and offers her a higher wage. The rival does not incur the training costs and does not have to recapture them through a wage/productivity differential so can offer a higher wage than the firm that trained her. This phenomenon is often referred to as "poaching". Recognizing this potential scenario at the outset, the firm will not invest in providing the training in general skills. This problem is thought not to arise with specific skills because the greater productivity these skills engender does not transfer to another firm. Therefore, the training firm can capture the return on their training costs by increasing wages by less than productivity increases.

The point about firms underinvesting in general skills usually leads to the argument that, since the general skills can be redeployed at another firm and higher wages obtained, the individual worker should be willing to pay for training in general skills. This argument clearly interacts with those in the previous section dealing with the inability of individuals to finance human capital investments; they may be unable to borrow to make the investment. The next question usually posed is: Why can't the worker finance it by taking a lower wage during the training period, a "training wage"- the mechanism traditionally used in "apprenticeships"? Some answer: very low skilled workers may have inadequate resources to sustain themselves and their families during the "training wage" period, and there is too much uncertainty about the marketability of the skill they are investing in through acceptance of lower wages. Further, what guarantee is there that the employer who is paying them a "training wage" (less than their actual productivity) and thereby gaining benefits will, in fact, pay them a sufficiently higher wage later or that their "general skill" will indeed be recognized in the market or that there will be demand for it?(4)

Several types of public sector interventions  suggested or carried out  to offset this under-investment by firms in general training have been undertaken. One is promotion of more industry-wide apprenticeship systems; the prime example cited is the extensive German apprenticeship systems. Another form of "internalizing the externality" is to institute sectoral training taxes on a "play or pay" basis. Firms are taxed to provide general funds to underwrite training. If the firm "plays", by itself providing approved training at at least the minimum level specified, the tax is reimbursed (or they are exempted). If they don't train themselves their tax goes to a central fund to subsidize training by other firms or by a public sector created and administered program. Another step that is sometimes thought to offset the uncertainty by individuals about the recognition of and payment of higher wages for their learned skill, is the creation of government-sponsored skill certification programs. And, of course, the public sector can, and does, provide general skills training directly, either fully financed by the public sector, or, in a few cases, with partial payment of costs by the trainee.

Asymmetric Information

I already noted above some of the information problems which could lead to a failure of the market to generate an optimal degree of investment in human capital. A literature has now grown up around the applications to employment and training investments of economic models involving asymmetric information.

The asymmetry in information can arise between the worker and the firm, or among firms. The relevant information in this case is information about workers' abilities and the degree to which they receive training. Further there is a possible interaction of abilities and training; workers may differ in their "trainability" so a given amount of training may increase the productivity of some workers more than others.

There are several ways in which these asymmetries could work either to decrease or increase the degree of training provided by firms. I will not try to reproduce the full array of models. To give just the flavor of how these work: I noted above that traditional theory suggested that firms will under-invest in general human capital because they risk losing their investment when competing firms bid away the trained worker. However, if the competing firm cannot determine the degree of training, or the degree to which the abilities of the given worker interact with the training investment, the asymmetry of knowledge will allow the firm that trains the worker to pay him somewhat less than his after-training marginal product  since the competing firm does not have complete knowledge of the degree to which training has increased that individual's productivity and therefore will not offer a competing wage that reflects that post-training productivity. Thus, here the firm giving the training can recapture its costs by paying a wage lower than the worker's post-training productivity.

In an interesting application of this type of model, an author (Autor 2000) has sought to explain a puzzling phenomenon: some temporary help supply firms provide computer skills training to workers. This training is general training and the above noted traditional model would suggest that temporary help firms would be the least likely to provide any general skills training since the workers they supply are effectively employed by others, the extreme form of "poaching". The author argues that the temporary help firms are providing not only workers to firms but also better information about the quality of those workers. Thus success in computer training can signal a more capable worker and this information is valuable to the firm.

It can be argued that government intervention could be structured to alleviate the impact of these asymmetric information problems. For example, the public sector can, and in some places does, subsidize temporary help agencies both to place and to train workers. Alternatively, through public training and certification programs, the public sector can provide information to firms about workers' abilities, trainability and productivity.

"Efficiency Wages"

In recent years there has been considerable attention paid in a variety of situations to the concept of what is called "efficiency wages." Again there is a wide variety of models of firm and worker behavior to which the label of "efficiency wages" has been applied and, in most cases, a root problem is asymmetric information.

In most "efficiency wage" models, it is suggested that some firms may pay wages that are higher than what other firms would pay for workers with given characteristics (often referred to as "the market wage"). The primary motivation suggested is to lower the costs of turnover (losing some workers and having to hire their replacements) in the firm by making workers see this particular job as more valuable than others they might obtain in the market. The workers therefore have a substantially lower probability of quitting.

A related feature is the problem of monitoring effort made by workers. In situations in which the supervisory span is wide, it may be difficult for the firm to assure that workers are not "shirking" on the job. The higher, "efficiency wage" is thought to make workers feel that they have more to lose if they are caught "shirking" and fired.

Since the "efficiency wage firms" are paying above the "market wage" they will employ fewer workers than if they paid the lower "market wage". Thus "efficiency wage" behavior may increase unemployment  both because these firms hire fewer workers and because they may induce "wait unemployment"(5). The existence of both types of unemployment serves, it is argued, to heighten the motivational force of the "efficiency wage", as the potential for losing the "efficiency wage job" through being replaced by someone from the ranks of the unemployed is that much more palpable.

While there are some discussions of how "efficiency wages" affect the allocation between general and specific training and who pays for it, these do not seem to lead directly to arguments for public sector intervention in training. For our purposes here, however, the "efficiency wage" focus on the desire of firms to reduce their workforce turnover and to elicit maximum effort can carry over to our discussion of rationales for public investment in child care.

Applications to Child Care of Rationales Related to Human Capital Investment by Firms

General and Specific Skill Investments. This distinction does not seem to me to have any carry over to the child care outcomes. "Training" is provided by the child care institution, which is a producer of whatever human capital results from a given type of child care. But unlike the firm, it is not also a utilizer of the skills (embodied in the children) it is helping to produce; all such skills it produces are general, not specific skills. The "poaching issue" does not arise in this context.

On the other hand, the issues about ability to finance the investment in human capital do have some carry over in the case of the liquidity constrained family. This is a slight variant on the argument above about individual inability to finance human capital investment. Because it is not possible for the family to borrow against the higher future earning of the child which may emerge as a result of the impact of the particular type of child care, there is again a "capital market imperfection." This may result in under-investment in human capital producing child care and an argument can be made, on those grounds, for public intervention to subsidize child care investments. The under investment would apply to both quantity and quality of child care. The fact that quality child care is likely to be somewhat higher cost would imply that relieving the liquidity constraint on families would be particularly important to encourage higher quality child care.

Asymmetric Information. Here we would simply repeat the arguments made above with respect to the effects of poor information on the part of individuals, but the force of the emphasis on asymmetry is much less in this case. Much as in the case where there is an asymmetry between the worker and the firm as to what training is most productivity enhancing, there may be an asymmetry between the parents and the child care institution or child development experts about what type of child care is most "productivity" enhancing for the child. Thus, again, a rationale for government interventions is to reduce the information asymmetry.

Perhaps a closer analogy might arise with respect to asymmetry of information between the education system as a utilizer of the child's human capital from child care in its next stage of production of further human capital. The asymmetry could go in either direction. The parents may know more about the abilities of the child engendered by its child care experiences than do the education authorities. Or the education authorities may be more knowledgeable than the parents about the relevant skills engendered by a given type of child care experience, and how their subsequent human capital process should be adjusted in light of those abilities. Again, a case for further public sector intervention to offset the effects of the information asymmetry can be made.

"Efficiency Wages." Here we might pick up on the concerns that are said to lead to the payment of "efficiency wages," i.e., to reduce turnover at a firm by better binding workers to the firm or to induce greater effort on the job. Creating stability in employment and advancement in the job ladder for low skilled workers is often a stated objective of public policies. Though the connection may be loose, public intervention to support child care might help to meet some of the concerns which are theorized to lead to "efficiency wages"; they may enhance job stability and increase worker effort.

Provision of child care for the children of workers is one form in which an "efficiency wage" could be paid. It could be through subsidization of child care, either as provided by the employer at the place of work or close to the worker's home so the trip to work does not require a long diversion to leave kids off at child care and pick them up. Good attendance is said to be an important ingredient for enhancing chances of advancement up the job ladder and ease of movement to child care can enhance attendance. We also hear a good deal about child illness as a cause of irregular attendance that can lead to dismissal. In addition, the problems of child care for those engaged in shift work are often mentioned. Public intervention to provide child care in these situations could be justified as contributing to the "efficiency wage" goals of greater stability of employment and reduced "shirking."

The basic issue is that public sector subsidization of child care could enhance stability in employment. It is not clear, however, whether just promoting any child care assistance by the firm is sufficient or whether clearly higher quality child care made available through the firm would make workers even more "loyal to the firm".