The Human Capital Premium Puzzle

TLDR: In this paper, the authors study the relationship between consumption and human capital investment and find that the riskiness of human capital investments alone cannot possibly justify the return premium that is observed on human capital assets relative to the return on the riskless asset.

Abstract: This paper studies the dynamic relationship between consumption and human capital investments. We find that the riskiness of human capital investments alone cannot possibly justify the return premium that is observed on human capital assets relative to the return on the riskless asset. Using a stochastic discount factor methodology, we then study the extent to which different frictions in human capital markets such as short-sale constraints and irreversibility, borrowing and solvency constraints, and psychic costs of investment help to explain the size of the risk-adjusted premium. We find that some of these frictions allow the models to satisfy the basic restrictions that human capital returns impose on the variability of the intertemporal marginal rate of substitution under feasible preferences parameters. This is particularly the case for short-sale and irreversibility constraints, and for preference specifications that include various non-separabilities in consumption. We also find that frictions in human capital markets are quite different across demographic groups, decreasing with education, age, and experience. On average the size of frictions for the different demographic groups is from 4 to 14 times greater than in financial markets.