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The Option Value of Human Capital

  • Yongseok Shin

    (Washington University in St. Louis)

  • Sang Yoon Lee

    (University of Mannheim)

  • Donghoon Lee

    (Federal Reserve Bank of New York)

We study human capital investment decisions in the face of risk. Human capital is an important source of uninsurable idiosyncratic risk. However, the few studies that focus on the effect of risk on human capital investment typically treat human capital like any other risky asset, without taking into consideration its unique features. Unlike most assets, human capital investments are irreversible, so that it cannot be decumulated or sold off even if it may be desirable to do so. Furthermore, it has an option-like payoff structure. For example, when hit by a large negative wage shock, an individual can choose an outside option---such as leisure or home production---rather than work for a low wage. Similarly, a college graduate may take a job that does not require a college degree. In contrast to a standard risky asset, this implies that an individual has an incentive to increase human capital investment in response to a mean-preserving spread in wages, because they are protected from the downside risk in current and future periods. As a result, an increase in wage volatility may lead to an increase in human capital investment. This may in turn translate into increased labor supply, as higher human capital, holding other things equal, leads to more labor supply ex post. We characterize conditions under which this "optionality" of human capital dominates the standard risk aversion considerations, and individuals increase human capital investment in the face of larger risk.

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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 1033.

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Date of creation: 2012
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Handle: RePEc:red:sed012:1033
Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
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Web page: http://www.EconomicDynamics.org/society.htm
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  1. James Heckman & Pedro Carneiro & Flavio Cunha, 2004. "The Technology of Skill Formation," 2004 Meeting Papers 681, Society for Economic Dynamics.
  2. Stacey H. Chen, 2008. "Estimating the Variance of Wages in the Presence of Selection and Unobserved Heterogeneity," The Review of Economics and Statistics, MIT Press, vol. 90(2), pages 275-289, May.
  3. Fatih Guvenen, 2005. "Learning Your Earning: Are Labor Income Shocks Really Very Persistent?," Macroeconomics 0507004, EconWPA.
  4. James Heckman & Lance Lochner & Christopher Taber, 1998. "Explaining Rising Wage Inequality: Explanations With A Dynamic General Equilibrium Model of Labor Earnings With Heterogeneous Agents," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 1(1), pages 1-58, January.
  5. Todd Stinebrickner & Ralph Stinebrickner, 2012. "Learning about Academic Ability and the College Dropout Decision," Journal of Labor Economics, University of Chicago Press, vol. 30(4), pages 707 - 748.
  6. Lance J. Lochner & Alexander Monge-Naranjo, 2011. "The Nature of Credit Constraints and Human Capital," American Economic Review, American Economic Association, vol. 101(6), pages 2487-2529, October.
  7. Claudia Goldin & Lawrence F. Katz, 2007. "The Race between Education and Technology: The Evolution of U.S. Educational Wage Differentials, 1890 to 2005," NBER Working Papers 12984, National Bureau of Economic Research, Inc.
  8. Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2008. "The Macroeconomic Implications of Rising Wage Inequality in the United States," NBER Working Papers 14052, National Bureau of Economic Research, Inc.
  9. Joseph G. Altonji & Prashant Bharadwaj & Fabian Lange, 2008. "Changes in the Characteristics of American Youth: Implications for Adult Outcomes," NBER Working Papers 13883, National Bureau of Economic Research, Inc.
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