Labor market flexibility and investment in human capital

Abstract

We consider the effect of labor market rigidities on human capital accumulation and economic growth when some human capital is difficult to observe prior to employment. We distinguish between two types of human capital, those that formal schooling and test scores can measure (``knowledge") and those that can be observed by employers only after a period of employment (``creativity"). We build a simple model to show when employers have limited discretion to set wages or terminate employment they favor the more reliable signals of ``knowledge'', such as years of schooling and class rank, at the expense ``creativity'', which stands for non-testable skills. Individuals in rigid labor markets will therefore favor greater acquisition of knowledge at the expense of creativity, which results in distorted accumulation of human capital and lower growth. We explore the implications of our model for the relevant debates in the empirical growth literature, returns to education literature, and education policy. Our model suggests a possible reason why the social return to education appears low in cross country regressions. These regressions treat years of schooling in countries with more and less flexible labor markets as the same. We show that distinguishing empirically between countries with rigid and flexible labor markets can help reveal the greater productivity of schooling in the latter. Schooling in the latter is correlated with greater investment in non-observable skills.Labor Market flexibility, investment in human capital, schooling, cognitive and non-cognitive skills, cross country regressions