The Effect of Wages on Human Capital and its Virtuous Dynamic Cycle

Abstract

This paper provides economic theory with a dynamic structural model that mathematically proves both a positive effect of wages on the workers’ human capital intertemporal investment decisions and the existence of a virtuous dynamic cycle between wages and human capital.Among the desired characteristics of the proposed model is that it has an analytical solution, permitting the  achievement of an optimal decision rule for each choice variable and the calibration of its parameters using observed data; this favors an easy implementation by policymakers and researchers. The constructed statistics and the results of the empirical application of the model, to the Mexican developing economy, support the  mathematical conclusions. The model predicts two  benchmark human capital gross returns and their  corresponding wages, by levels of education. Below the  second one, human capital coming from formal education  vanishes over time, due to investment not being enough to  offset its depreciation; below the first one, workers stop  investing in education. Unfortunately, around 40%  and 20% of Mexican workers are located below them,  respectively.