It is not proposed here to outline in detail the criticisms which have been made of
the human capital approach. The main criticisms relate to whether education and training
2 2
Figure 2.4 The Effect of Cohort Size over Time.
— Ordinary Cohort — Welch large Cohort — Berger large Cohort
Experience
human capital approach with theories from outside economics. Blaug (1976) argued that
" any psychological theory of "learning curves"[or learning by doing], in which
appreciation over time is partly offset by depreciation and obsolescence will likewise
account for concave age-earnings profiles." (p 837)/12)
The screening hypothesis has challenged the human capital model by arguing that
education does not raise productivity but rather acts as a signalling device for pre
existing a b ilities/13) Although education may not be productivity enhancing, if it acts as
an efficient screening device, it may still perform the socially productive role of placing
the right people in the right job. The issue then becomes one of finding the most efficient
screening d e v ic e /14)
While the screening hypothesis offers an explanation of why starting salaries may
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should persist with experience. Employers may select employees on the basis of their
educational qualifications but if these are in fact irrelevant to the individual's
productivity, we would expect older people of similar ability to have more similar
earnings regardless of educational qualifications compared to younger people and for the
effect o f education on earnings to diminish with experience. Layard and Psacharopoulos
(1974) argued that the effects of education on earnings actually rise both proportionately
and absolutely with age (p 992). We shall consider this point in the empirical estimation
reported in the following chapters (see chapter 4 section 3.3).
The growth in the earnings differentials between educational groups may be
explained either by differences in the amount of on-the-job training undertaken by each
group (so the screening hypothesis finds itself reliant on human capital arguments), or as
Layard and Psacharopoulos (1974) suggested
" some would argue that the labour market is like a set of escalators. People are
selected for a given escalator when they join the labor force and cannot thereafter
easily jump from one escalator onto another. People with credentials are selected
for escalators that rise rapidly and others for ones that move more slowly. People
may of course walk at different speeds up their own escalator, but earnings
differences between groups with different credentials are basically determined by
the speeds at which their escalators are traveling."
In terms of our three country comparison, it would be necessary to explain why the
escalators move at different rates in these countries for reasons other than on-the-job
training.
A further argument made against human capital is based on the empirical research
of M edoff and Abraham ((1980) and (1981)) who argued, on the basis of evidence from
three US sets of company personnel records of professional and managerial workers,
that there was no link between earnings within a particular grade and productivity levels.
This result was based on the assumption that job performance ratings done by immediate
supervisors are valid indicators of the relative current productivity of the workers in the
sample. Medoff and Abraham speculated as to the cause of the discrepancy between
productivity and earnings using some of the theories to be outlined in the next section but
did not come to any firm conclusions. Rather the result of their studies is a negative one,
" our findings demonstrate only that productivity-augmenting on-the-job training
should play a substantially smaller role in any new explanation [of the experience-
earnings relationship] than it does under human capital theory." (p 733) (15)
It is a weakness of their argument that Medoff and Abraham offered no definite
explanation as to why a company which constructed the job performance ratings in the
first place, should ignore this information and continue to pay less productive workers
more than the more productive ones.
1.7 Summary
In this section we have outlined the general human capital explanation as to why the
earnings of individuals may differ. We have placed particular emphasis on the reasons
suggested by human capital theory for an upward sloping age earnings profile. While
differences in educational attainment may produce differences in the level of earnings
between individuals, the main source of the upward sloping age earnings profile is on-
the-job training. More training is associated with a steeper slope and a lower starting
wage. Differences between the countries in access to on-the-job training, for example
because of segmented labour markets or the relative size of birth cohorts, may also
influence the shape of the aggregate age earnings profile.
We have also considered some of the general criticisms of human capital theory,
namely the screening hypothesis and the empirical observation that individual pay does
not seem to be closely associated with performance. In the next three sections we shall
consider some alternative explanations o f upward sloping age earnings profiles;
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approaches and finally the role of trade unions and institutional factors in the labour
market.
2. E fficien cy W ag e M odels.
Human capital theory predicts that older workers are paid more than younger ones
because they are more productive. A group of alternative hypotheses, collectively
described as the efficiency wage hypothesis, suggest that the causation does not run
from higher productivity to higher earnings but from higher earnings to higher
productivity. Early modem explanations comes from the development literature where it
was argued that additional wages for those at low levels of nutrition would boost their
food consumption and hence their productivity. (16) Efficiency wage theories have since
been used to explain differences in the level of wages between industries but here we are
concentrating on them as possible explanations of the slope of age earnings p r o f il e s .^ )
Three explanations of efficiency wages have been offered in the literature
"In one case, firms pay higher wages than the workers' reservation wage so that
employees have an incentive not to shirk. In a second version, wages greater than
market-clearing are offered so that workers have an incentive not to quit and
turnover is reduced. In a third version, wages greater than market-clearing are paid
to induce loyalty to the firm." (Akerloff and Yellen (1985) p 829).(1^)
The fact that efficiency wages may not be adopted equally by all firms across all
industries, can be used to explain the effect of industry of employment on earnings. As
Krueger and Summers (1988) noted
"If all firms were identical, one would not expect to see different firms paying
different wages even if efficiency wage considerations were important. But when
there are differences in their ability to bear the costs of turnover, to supervise and
monitor their workers, or to measure labor quality, either because of differences in
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then the optimal wage to pay will vary. Thus efficiency wage models unlike
standard competitive formulations can explain why characteristics of firms that do
not directly affect workers' utility can affect wage rates" (p261).
However, there is a limit to which these hypotheses can be thought of as contributing
additional understanding of industry differentials to those already proposed by standard
competitive theory. Rather than attributing earnings differences to unobserved
characteristics of individuals, the efficiency wage interpretation attributes the differences
to unobserved characteristics of an industry.
Most of the models consider why earnings for apparently similar individuals
should differ between firms and industries for all workers and do not consider reasons
for an upward sloping age earnings profile. Shapiro and Stiglitz (1984) and Bulow and
Summers (1986) however, do discuss the possibility of an upward sloping age earnings
profile as an alternative method to an efficiency wage for reducing shirking. In both
these models workers are paid above their alternative wage in order to reduce shirking
where monitoring costs are high. The higher wage encourages the worker not to shirk
for fear of losing his job and returning to alternative employment at a lower wage.
Alternatives to an efficiency wage which would also reduce shirking include the workers
posting a performance bond or the adoption of an upward sloping age earnings profile.
As these authors note, there are problems associated with either of these solutions. The
firm has an incentive to renege on the contract and claim inaccurately that the worker
shirked (a point to be discussed in more detail below). In addition, enforcement of such
contracts, for example in a court of law, is likely to be expensive because objective
measures o f effort are difficult to find. Both these papers rely on the theory developed by
Lazear (1981) to explain a rising age earnings profile. This is not an efficiency wage
model so we shall present a fuller discussion in the following section.
In summary, efficiency wage models offer an alternative explanation of earnings
version of the human capital approach. In the efficiency wage models surveyed,
however, there were no specific developments of the basic model in order to explain
rising age earnings profiles. Rather where rising age earnings profiles were considered
they were seen as an alternative to an efficiency wage.
It is difficult to explain the other facts about earnings within the context of these
efficiency wage models, basically because they were not formulated with these questions
in mind. If the theory were going to explain why the more educated earned more than the
less educated, it could be argued that the more educated tend to be in occupations or
industries where monitoring costs or the cost of labour turnover is highest. The wages of
the less skilled may be set at the competitive level while employers adopt an efficiency
wage above the market clearing rate for the more highly educated. As the efficiency wage
models surveyed did not include an upward sloping age earnings profile, they offered no
explanation as to why earnings of the more educated peaked later than for the less
educated.