Working Paper 205

Human Capital Investment, and the Inefficiency of Compensation Based on Marginal Productivity: The Static Case

Bruce D. Smith

Published August 1, 1982

A simple extension of the traditional analysis of human capital accumulation is considered in a general equilibrium context. When real wages are equated to marginal products in the presence of human capital investment, resulting equilibria are almost never efficient even by very weak criteria. This is true even though labor is not a quasi-fixed factor, and informational asymmetries are excluded from the model. It is shown that human capital investment generates externalities, and has associated with it a “free-rider problem.” This, in turn, explains the common practice of employers requiring minimum levels of human capital accumulation for some employees, and refusing to hire “overqualified” workers for other positions.

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