Robert T. Michael

English

Research Papers in Economics

This PDF is a selection from an out-of-print volume from the National
Bureau of Economic Research
Volume Title: The Effect of Education on Efficiency in Consumption
Volume Author/Editor: Robert T. Michael
Volume Publisher: UMI
Volume ISBN: 0-87014-242-9
Volume URL: http://www.nber.org/books/mich72-1
Publication Date: 1972
Chapter Title: Human Capital and Consumption: The Theoretical Framework
Chapter Author: Robert T. Michael
Chapter URL: http://www.nber.org/chapters/c3514
Chapter pages in book: (p. 7 - 13)1
HumanCapital and Consumption:
The Theoretical Framework
THIS CHAPTER PRESENTS a conceptual framework in which the
effects of human capital on nonmarket or consumption efficiency can
be analyzed. The model is developed in the context of a general human
capital variable, H, with the household as the unit of analysis. The
effect of H on the productivity of the various production functions, on
the relative prices of commodities, and on real full income is discussed
in the first part of the chapter. The second part suggests some implica-
tions regarding the demand for commodities, for factors of production,
and, briefly, for H itself.
THE ROLE OF AN ENVIRONMENTAL VARIABLE
Suppose the household has some utility function
U =u(Zi,Z2, , (1.1)
where the Z's are various commodities produced by the household ac-
cording to the production functions
=(xi,H). (1.2)
Theis a vector of market goods,isthe household's own time input
in the production of commodity i, and H represents the household's
available quantity of some environmental variable. The household has
some money income
=Wtw +V= (1.3)8 Effect of Education on Efficiency in Consumption
where w is its wage rate in the labor market,is the time spent in
-thelabor market, and V is its nonwage income for the period.' Given
an appropriately inclusive definition of market goods, the money in-
come is equal to the total money expenditure. The household also has
some fixed amount of time at its disposal, t, which it uses in the pro-
duction of the commodities and in the labor market:
t
= + (1.4)
Equations (1.3) and (1.4) can be combined into one full income
constraint on the household's utility maximization:2
Y =wt+ V (1.5)
In this framework the household is viewed as a small firm producing
many products, called commodities, from which it derives utility. The
environmental variable, H, affects production by influencing the con-
ditions in which production takes place, the nature of the productive
processes, or the effective quantities of the direct inputs of time and
market goods. The environmental variable is distinguished from the
direct inputs by the fact that production of a commodity uses up some
of the household's available time and market goods but does not, in
general, affect the quantity of the environmental variable.3
The variable H was defined as a human capital variable, but it
may be interpreted more broadly to encompass any factor affecting the
household's nonmarket productivity, excluding the direct factors of
production themselves. Certain environmental variables—for example,
the degree of political stability, the level of hygiene and sanitation, the
rate of literacy, the climate—might affect all households in a particular
geographical location in a similar manner, and their effects would be
studied in interregional or international comparisons. On the other hand,
the influence of variables like the family's size, its age structure, and
its stock of some form of human capital (such as formal schooling
While the wage earnings of each family member might be treated separately,
for simplicity's sake this will not be done here.
2Inorder to make this chapter more readable, the mathematical proofs of
most of the statements are relegated to an appendix. Consequently, Appendix
A roughly parallels the development in this chapter, but includes verylittle
verbal description of the material.
While the opportunity cost of using the environmental variable in producingHuman Capital and Consumption 9
or the level of health), which affect each household individually, would
be observed in an interhousehold comparison. While the model is
developed here with the latter comparison in mind, the general frame-
work is clearly applicable to interregional differences as well.
To analyze the effect of H on the production of a given commodity,
we differentiate the production function with respect to H, holding the
levels ofandconstant, which yields the marginal product of H
in the production ofAssuming the production function to be homo-
geneous of the first degree in the direct factorsand
I= + (1.6)
or, using the convention that a tilde indicates a percentage change per
unit change in H,
=WX.MPX.+ (1.7)
where the weights are the production shares and the sum of the weights
is unity. Equation (1.7) states that the environmental variable's mar-
ginal product in the production of Z, is a weighted average of its effect
on the productivity of the direct inputs. Since in general the effect on
the marginal products of the factors may be positive or negative, so, too,
may ; that is, the environmental variable may increase or decrease
the productivity of the factors.
As a complement to (1.7), one might ask what effect H has on the
price of the commodity Definingas the average price of the
effect of H on evaluated at a fixed level of is simply
—MPI, (1.8)
which suggests, for example, that a 3 per cent increase in the produc-
tivity of a linear homogeneous production function lowers the price
of the commodity by 3 per cent.
While the analysis is developed in terms of the commodity the
environmental variable H may affect the production of each Z in the
household's commodity basket. If H has different.effects on the various
production functions, it will affect the relative prices of the commodities.
any commodity may be zero, this does not imply that changing the level of H
is costless. Determining the optimal level of the environmental variable is dis-
cussed at the end of this chapter.10 Effect of Education on Efficiency in Consumption
In the most general case, H may have a different effect on each factor's
marginal product in each production function, and these may differ
in sign as well as in magnitude. Even if all the absolute price changes
have the same sign, relative prices may be affected.4
In order to analyze these relative price effects more explicitly, define
a price level as
II = 11282,..•, (1.9)
where s1 is the expenditure share on commodity i and the sum of the
shares equals Unity.5 Then the aggregate effect of an increase in H
can be expressed as
ii =E s.ff1=—E (1.10)
That is, the percentage change in the price level is a weighted average
of the productivity effects of H on the various production functions,
with the direction of the effect reversed. Since the relative price of is
ilL/Fl, the change in the relative price resulting from an increase in H
would be
= —ii. (1.11)
There is an alternative method of evaluating the effect of the environ-
mental variablethat involves computing the value of the marginal
'This can be illustrated with a very simple case. Suppose that for all com-
modities —MP,, = thatis, H hasthe same percentage
effect on the productivity of time used in all activities and also a different but
equal effect on the productivity of all goods used inallactivities.Suppose,
furthermore, that H affects the productivity of the time input more than the
productivity of the goods input, i.e., > In such a case the effect of H
on the productivity of the function i or onthe price ofwould be greater the
more time-intensive the production of Z1. Since is simply a weighted average
of the inputs' productivity effects and the weights are production shares, under
these assumed conditions the ranking of thewould be exactly the same as
the ranking ofthetimeintensitiesifthesubstitutiOnelasticitiesdidnot
differ greatly. The relative prices of those commodities that were relatively
time-intensive would fall (if the MP were positive) and the relative prices of
commodities that were relatively goods-intensive would rise.
A geometric or logarithmic mean is used since our interest is in averaging
percentage changes in these prices. Although (1.9)is called a price level,it
uses fixed weights, and a price index would simply be the ratio of II in one
period or one situation to 110, the base period's price level.Human Capital and Consumption 11
product of H in each productive activity and summing these
Intuitively, the sum of these dollar values is a measure of H's effect
on real income. Let
= =
then, summing over all commodities,
=E =E (1.12)
willbe called the "change in consumption income." is the
value of the additional units of 1, resulting from a unit increase in H;
the sum of the is then the total value of H's effect. expresses
this total value as a percentage of full income. The term abstracts
completely from any effects of H on market earnings, but incorporates
the nonmarket effects. From equations (1.10) and (1.12)
=E =—II. (1.13)
Thus, a change in H which affects nonmarket productivity may be
evaluated as either a reduction in the cost of achieving a given output
or as an increase in the output of commodities, holding the levels of
the factors of production constant.
The household's full income, Y, defined by equation (1.5), combines
price level, H, reflects its capacity to convert these time and money re-
its time and money resources into a single constraint. The household's
sources into commodities. Reductions in market prices of goods or
increases in the efficiency with which commodities are produced lower
-thehousehold's price level. The household's "real full income" may be
defined as (Y/H), which indicates its resource constraint expressed in
real terms. So, for example, if H adversely affects nonmarket pro-
ductivity, households with higher levels of H will have a higher price
level and a lower real full income. Since the probable direction of H's
effect depends upon the nature of the environmental variable, no hy-
pothesis h,as been formulated as yet. The model simply suggests a
framework in which the influence of an environmental variable on the
household's real income may be analyzed.
THE IMPLIED EFFECTS ON THE HOUSEHOLD'S DEMAND
Through its effect on the marginal products of the direct inputs, H
can change the relative prices of the commodities and can alter the real12 Effect of Education on Efficiency in Consumption
income of the household. Thus, the usual analysis would suggest that
H would create substitution and income effects on the demand for
the commodities; that is, H would alter the optimal basket of com-
modities. If we write the demand function for commodityas
=d (1.14)
where the arguments are real income and the relative price ofH's
effect on abstracting from its effects on money income, would be°
= +H, —H) (1.15)
where= andandarethe commodity's income
and own price elasticity. The first term in (1.15) is the income effect,
which will be positive for any "normal" good if H's nonmarket effect
on real income is positive; the second term is the substitution effect—
if H is biased toward > H and its relative price falls, and
since<0, the effect onis positive. If the productivity effects on
is equal to the average productivity effect, U and the substitu-
tion term drops out.
Similarly, if an increase in H affects the optimal quantity of the
commodities, it would be expected to affect the derived demand for
the factorsand tj.Fromproduction function (1.2), the percentage
change in the demand for factorper unit change in H would be
= —MP;)+ —ti), (1.16)
where Wtisthe production share. If the production function is homo-
geneous, and H is assumed not to affect the ratio of factor prices,
Pz/Pt, then the evaluation of —t)in equilibrium gives
=(Z1d — MP1)+ — (1.17)
where o•isthe elasticity of substitution in production (o￿0); sub-
stituting (1.15) and rearranging,
= —+ —H)+ — (1.18)
The first term on the right indicates the gross increase in the demand
See section 5 of Appendix A for the derivations of equations (1.15) through
(1.18).Human Capital and Consumption 13
forresulting from the effect of H on real income; the second repre-
sents the• change in the production of Z, from the initial quantities
of the inputs, and the third represents the influence of commodity bias.
The sum of these three terms indicates the net change in de-
manded—a demand which is met by altering the quantities of the
factors of production. The final term shows the effect of factor bias—
if H enhances productivity and is biased toward x, 0,
and the final term is positive.
The human capital variable H has been viewed as an exogenous
variable throughout this chapter. The model indicates the effects of 11
on utility maximization without developing the implications for the
optimal stock of H. To the extent productivity in nonmarket activities
is altered by H, the return on an investment in H isalso affected.
Ceteris paribus, if consumption efficiency is enhanced by human capi-
tal, the return will be larger, and if the marginal return is increased,
the household will be induced to increase its stock of H.
Clearly, the human capital variable could be incorporated in the
analysis as an endogenous variable, with consumption income treated
as a return on the investment in H. In this way the effect of human
capital on consumption—on the activities associated with nonmarket
time—would be included in the evaluation of H as an investment
prospect. In addition to investigating the return through earnings in
the market sector, one would alsoinvestigate the return through
productivity in the nonmarket sector. The sum of these pecuniary and
consumption effects isa more adequate reflection of the full return
on the investment. It is these consumption income effects that are the
focus of this study.

The Effect of Education on Efficiency in Consumption

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