Borrowing, Lending and Human Capital

The consumer's motivation to borrow or save is to shift consumption over time. If the consumer wants to consume more now and less later, the consumer borrows. If the consumer wants to consume less now and more later, the consumer saves.

The relative price of consumption now vs. a year from now is the interest rate. If the interest rate is 4 percent per year, then by deferring $100 of purchases today you can have $104 in purchases a year from now.

To make a decision as to how much to spend this year relative to income, a family has to optimize with respect to the relative price, namely the interest rate. You spend until the marginal utility of $1 of spending today is no greater than (1 plus the interest rate) times the marginal utility of spending $1 a year from now.

If the interest rate is high, that means that the cost of moving consumption from the future to the present is high. For most consumers, that means that they will choose to borrow less or save more. A high interest rate means that by putting off a little bit of enjoyment now you can have a lot more later. Just as the relative price of apples and oranges enters into your decision about which fruit to buy, the interest rate affects your decision about how much you want to shift consumption between the present and the future.

In reality, there are many forms of saving. You can have a savings account, a money market fund, a certificate of deposit, or shares of stock, among other vehicles. There also are many forms of borrowing. You can have a mortgage loan on your home, a car loan, or credit card debt, among other instruments.

Consumer Durables

One form of saving is through buying durable consumer goods. For example, suppose that we spend $30,000 on a new car, and we plan to keep the car for ten years. How should we account for that in terms of this year's consumption?

The answer is to treat durable consumer goods (goods that last several years) as capital goods. This year's consumption is equal to the amount of the car that we "use up" in the first year. One way to think of this is to look at the price for which we could sell the car in a year. If that price is $23,000, then the first year's consumption is $7,000. The remaining $23,000 should be counted as saving for future years' consumption.

To see this, imagine two families, each with $30,000 in income. Family A leases a car for $8,000 a year, spends $30,000 on other goods and services, and saves $22,000. Family B also spends $30,000 on other goods and services, but spends the remaining $30,000 on a car.

A year later, suppose that each family must use all its income for other goods and services. Family A has to lease a car for another year, so it has to use some of its cash savings. Family B keeps using the car that it bought the first year. Both families are using savings, with A's savings in the form of cash and B's savings in the form of the car.

Consumer durables create an accounting issue. If you were to add up all of your spending in a year, you probably would include a $30,000 car purchase. However, an economist would treat as consumption only the value of the car that you "use" this year, say, $7,000. On a cash flow basis, you have spent $30,000. On an economic basis, you have consumed $7,000 and saved $23,000.

Human Capital

In addition to financial saving, there is another way that you can forego some consumption in the near term in order to increase your consumption in the long term. That is by investing in human capital. Human capital is the term that we use for education and skill that make you more productive.

For example, consider the decision faced by a college basketball player who might be drafted by the pros at the end of his junior year. Suppose that if he stays in college, his skills will improve so that his salary will be $5 million a year for his first two years as a pro. On the other hand, if he goes pro right now, his salary will be $3 million dollars a year for the next three years. What should he do?

Suppose that the interest rate is 10 percent. The present value of $5 million one year from now is $5/1.1 = $4.55 million. Similarly, we can calculate the present value of the player's salary for the next three years. The results are in the following table, with salaries shown in millions of dollars, comparing the choice to go pro immediately or to defer going pro.

YearImmediate Pro Salary Present Value of Immediate Pro Salary Deferred Pro Salary Present Value of Deferred Pro Salary
Total Present Value--$8.21--$8.68

According to these calculations, it pays for this player to wait until turning pro, because the present value of his future earnings will be slightly higher. Of course, taking into account other factors, such as the risk of injury in college, he might choose to go pro right away.

Another factor that might lead the player to turn pro is the fact that if he turns pro he can start right away to consume at a high level. In theory, he could stay in college and borrow a couple of million dollars, to be repaid after he turns pro. However, in reality this is impossible, for a number of reasons. In fact, it is generally the case that it is difficult or impossible for people to borrow against their human capital. Human capital tends to be illiquid, and that tends to bias people against investing in human capital.

Few of us go to college in order to become better basketball players. However, for many people, education is an investment. Economists generally find that the rate of return for additional years of schooling is high. However, there is controversy over whether the additional investment involved in going to, say, Harvard, pays off compared with the lower tuition of, say, the University of Maryland. When you control for the level of ability at the point of high school graduation, as measured by grades and SAT scores, it is not clear that the incomes of people who go to expensive private colleges are dramatically higher than those of people who attend state universities.

Another example of human capital investment is medical school. To pay for medical school, most students take out large loans. Those loans are paid back out of the returns that you earn as a doctor.

Specific Human Capital

Economists also believe that the concept of human capital applies to on-the-job training. We call this specific human capital, because much of what you learn on a job may apply only at that specific company. One joke is that specific human capital means knowing the location of the bathroom, and general human capital means being able to find it by reading the sign on the door.

When I acquire specific human capital at a company, I learn procedures, terminology, and best practices at that company. If I go to a different company, not everything that I learned at the first company will be transferable. Only my general human capital goes with me everywhere.

If I have a valuable general human capital, such as database programming skills, my employer is forced to pay me a high salary. Otherwise, I will go elsewhere. On the other hand, my knowledge of a particular company's data terminology is not useful elsewhere. That is specific human capital, and my company does not necessarily have to pay me a premium for it.

Although a company need not pay a premium salary to employees with specific human capital, the company will pay for the cost of acquiring that human capital. A company pay to put me through a training program on its data terminology, because the benefit of that training will accrue to the company rather than to me. On the other hand, if the company were to pay for me to get general database expertise, I could then use that expertise to get a higher salary elsewhere.

When a company pays for general training, it may require you to commit to staying with the company a certain number of years. If you do not stay, then you may have to reimburse the company for the cost of the training.

Overall, the decision to invest in specific human capital is made primarily by the firm. The firm also retains most of the benefits. On the other hand, the decision to invest in general human capital is made primarily by the individual. The individual retains most of the benefits.

People who invest in human capital in the form of professional degrees also tend to obtain licenses. It is illegal to practice medicine or law without a license. What role does licensing play in protecting the human capital investments of people who go to law school or medical school?