HUMAN CAPITAL AND THE FUTURE OF TRANSITION ECONOMIES * Michael Spagat Royal Holloway, University of London, CEPR and Davidson Institute.

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1 HUMAN CAPITAL AND THE FUTURE OF TRANSITION ECONOMIES * By Michael Spagat Royal Holloway, Univerity of London, CEPR and Davidon Intitute Abtract Tranition economie have an initial condition of high human capital relative to GDP per capita. But they will not necearily realize their latent high growth potential. In the model, at a good equilibrium a large number of children of well-educated parent take advantage of their family background and invet ubtantially in their own human capital. At a bad equilibrium, pat educational achievement are wated a children fail to build upon their parent achievement. I argue that thi ort of multiple equilibria provide a bai for ditinguihing development economic from tranition economic. JEL Number: P2, O1, O15, I2, D1, J24 Key Word: Tranition, Development, Human Capital, Education, Growth, Multiple Equilibria Addre for Correpondence: Department of Economic, Royal Holloway, Univerity of London, Egham, Surrey, GU21 4QE, United Kingdom M.Spagat@rhul.ac.uk * I wih to thank participant in the ZEI-CEPR Conference Labour Market, Work and Welfare During The Tranition and Integration Proce, Riga, Latvia, 2001 for timulating thi reearch. I alo thank Michael Kaganovich, Michael Mandler and eminar participant at Oxford Univerity.

2 1. Introduction What i pecial about countrie in tranition from communim? They are unuual in many way, but a vital fact i that educational achievement in tranition economie are out of all proportion per capita GDP. Educational level are a high or even higher than in many rich countrie yet the typical tranition economie ha a per capita GDP imilar to that of a middle income developing country. 1 The empirical growth literature [e.g., Barro and Sala-i-Martin (1995)] indicate that education i very important for economic growth o one might uppoe tranition economie are in great hape. Thi i an important inight but not deciive. I argue that human capital in ome tranition economie may fall to meet current living tandard rather than living tandard riing to meet human capital level. In particular, the model below will exhibit multiple equilibria; a good equilibrium can be aociated with rapid growth while a bad equilibrium portend deterioration. There i ome upport for thi idea in a recent EBRD report. Baed on a urvey of foreign invetor and dometic enterprie it conclude that:...firm in tranition economie lag behind advanced indutrialied countrie in term of the quality of their workforce. Such quality gap are larger in the CIS than in CEE. Thi finding qualifie the view that the region ha abundant human capital reource, depite coniderable achievement in formal education. Moreover, the lack of retructuring in the le reformed economie of the region mean that many killed worker are performing job that do not reflect their level of education. Over time, there will be a continuing lo of kill, leading to an even greater gap in quality. (EBRD, 2000, p. vi) The multiple equilibria of thi model are natural for tranition economie but not for typical developing economie. Thi i becaue the reult rely trongly on an initial 1 Gro and Suhrcke (2000) ytematically invetigate thi quetion uing cro-ection regreion on 148 countrie including tranition countrie and find that thee countrie have much higher econdary and tertiary enrollment rate than their per capita GDP would predict. 1

3 condition of high human capital relative to living tandard. So, while tranition economic and development economic urely have much to learn from each other, thi paper provide one plauible bai of eparation between the two field. Alexeev and Kaganovich (1998) i one of the few theoretical paper on human capital and tranition. 2 It ue an advere election argument to how how uncertainty over whether or not a major reform will be implemented can lead more able people, the good guy, to prepare relatively little for the poible change compared to le able people. Thi i becaue the good guy do better in the unreformed ytem then the bad guy. If reform i actually implemented, good guy finih lat due to their lack of preparation. In the preent paper good guy will not finih lat but the two paper hare a general concern about underinvetment in human capital. Fan, Overland and Spagat (1999) (FOS) argue that educational retructuring hould have high priority early in Ruia tranition proce, emphaizing the potential for lo of human capital without uch a policy. Like the preent paper, FOS tudie the dependence of children human capital acquiition deciion on the human capital of their parent. However, FOS focue on Ruia rather than tranition economie in general and it doe not allow for multiple equilibria. On the empirical ide, Münich, Svejnar and Terrell (1999) i a good recent paper howing that the tranition to communim ha brought a ignificant increae in the return to human capital in the Czech Republic. It alo ummarize mot of the earlier empirical work for a variety of tranition countrie that tend to draw imilar concluion. The preent paper relie on the exitence of uch a premium in tranition economie and 2 Roland (2000) i an excellent general urvey of theoretical work on tranition. 2

4 tudie the microeconomic of converting it plu high initial human capital into high human capital for a new generation. Labán and Wolf (1993) and Roland and Verdier (1994) tre critical ma effect in privatization to argue for the poibility of multiple equilibria. The latter paper ugget that giving away a ubtantial amount of property can coordinate agent on the good equilibrium. Johnon, Kaufmann and Shleifer (1998) ha multiple equilibria with tranition economy firm deciding either to pay taxe and benefit from public good or to pay for mafia protection and operate unofficially. There mut be a ufficient number of firm operating officially for the tate to attain the neceary cale to induce firm to reject mafia protection. Roland and Verdier (2000) ha multiple equilibria in a tranition economic etting baed on coordination problem in law enforcement. They argue that their bad equilibrium can be broken by the propect of early entry into the European Union. Certainty that the law will be enforced after entry caue agent to prepare themelve by becoming producer rather than predator even before the entry date. The multiple equilibria in the preent paper operate through very different channel, but there i till complementarity between the different approache ince variou factor can all reinforce a bad equilibrium imultaneouly. Finally, there i now a large modern literature on development trap tarting with Azariadi and Drazen (1990). The preent paper contribute to that literature by identifying a pecific type of development trap that applie broadly to typical tranition economie but not to typical developing economie. 2. The Model There are N familie indexed by i, coniting of a parent and a child. The human capital of parent i i denoted h i0 while hi child human capital i h i1. There i 3

5 intergenerational intellectual continuity, i.e., children of well-educated parent have a better chance of becoming well educated than children of poorly educated parent have. 3 We take a particularly imple formulation. Each child will either choe education or not choe education. 4 The human capital of child i i: h i1 = h ( h ) α i0 if i chooe education otherwie (1) where 0 < α,h < 1. The main notion i that the better i the education of the parent the eaier it will be for children to invet in human capital. There can be many reaon for thi to be true. Well-educated parent might have more money to invet in their children than poorly educated one. Parent with good education might value education more than parent with poor education do. The former group might alo know better how to tranfer education to children than the latter group doe. Thoe who do not make a pecial invetment get h, the baic level of education that i prevalent in the ociety. There are two ector: a killed ector and an unkilled ector. Children who do not invet in education earn a wage of 1 in period 0 and a wage of 1+ k N N u in period 2 for a lifetime income of 2 + k N N u where k u i a contant and N i the number of children who chooe education. Thu, the work of educated people in the killed ector pill over to create technological and organizational improvement that increae the productivity of the unkilled ector. Educated people earn nothing in period 0 when they 3 Many paper have demontrated thi for a wide range of countrie (Heyneman, 1995). 4 Of coure, dividing the population into thoe who do and thoe who do not invet in education i a dratic but ueful implification. 4

6 t are tudying. Educated individual i earn w + ( h ) in period 1 where w and k are contant. Note that killed worker are directly productive a well a creating pillover k N N i1 in both ector. 5 The income of individual i i: I i k N w + N = u k N 2 + N ( h ) α i0 otherwie if i chooe education (2) Thi human capital externality i very imilar to that in Perotti (1993) and imilar in pirit to the human capital pillover in Saint-Paul and Verdier (1993). Thee paper, however, focu on reditribution and political equilibrium. Individual make their educational choice to maximize their income, therefore individual i chooe education if and only if: h i0 u k N 2 + N k N w + N 1 α h c ( N ) (3) that i, a child human capital invetment deciion will depend on whether or not parental human i above a cut-off level that depend on the relative wage of killed and unkilled worker and the parameter α. 5 I can make wage depend on the total quantity of kill rather than the number of killed agent and reproduce all the reult with only a light modification in Propoition 4. 5

7 We aumewk u < 2 k. Thi aumption implie that the kill premium i increaing in the number of killed worker implying, in turn, that the cut-off level of parental human capital, h ( ) c N, i decreaing in the number of killed worker. Thi effect i likely to be large in tranition economie becaue the potential for technological and organizational catch-up with the advanced nation of the world i very large and highly dependent on the availability of killed worker. 1 u 2 + k α 2 α Suppoe further that: h < < < 1. Thi implie that children of w + k w parent with baic education will alway chooe baic education, becaue even with the maximum poible kill premium their family background i too weak to make it worthwhile for them to invet. It alo implie that children of parent with one unit of human capital will alway chooe to invet in human capital, becaue their family background i o good that they will invet even with the wort poible kill premium. We alo aume that the kill premium i necearily poitive, i.e., w > 2 Finally, we define an equilibrium in the model uing the tandard Nah concept. Thi et-up can be viewed a a game in which every player ha two trategie; invet or do not invet. An equilibrium i a profile of trategie, one for each of the N children, uch that each child i maximizing hi own income taking a given what all the other children are doing. Note that for convenience we will aume that any agent who i indifferent between inveting and not inveting will chooe to invet. 3. Analyi 3.1. An Example 1 6

8 In thi ection I compare a tylized tranition economy with a tylized developing economy and argue that multiple equilibria are plauible for the former but not for the latter. An interpretation i that the typical tranition economy ha the potential, but not a guarantee, for rapid growth baed on high human capital while the typical developing economy mut rie gradually over a long period of time. Conider the following illutrative example. At time zero there are three group labeled High, Medium and Low. Each individual in the high group ha parental human capital of 1, while thoe in the Medium and Low group have parental human capital of 2/3 and 1/3 repectively. The ize of the group are 20, 60 and 20 repectively. Table 1 ummarize the initial condition in thi tranition economy. Thi Table 1. Human Capital Ditribution for a Typical Tranition Economy High Medium Low Number Human Capital 1 2/3 1/3 ditribution i meant to reflect the idea that in a typical tranition economy there are many people who have attained a good educational tandard. We contrat the tranition economy with a developing economy at a imilar per capita GDP. The latter tochatically dominate the former. 6 Table 2. Human Capital Ditribution for a comparable non-tranition Economy High Medium Low Number Human Capital 1 2/3 1/3 6 It i reaonable to conider thee economie a experiencing imilar per capita GDP. Much of the human capital in the tranition economy would have low market value, having been acquired under communim when prioritie (the military above all ele) were very different from what they are now. However, it i crucial to note that while a Ruian rocket cientit might earn very low wage, he till can do much to facilitate hi children human capital acquiition. 7

9 Fix the parameter value a in table 3. Table 3. Parameter Value for the Tranition and Developing Economie α w k k u The tranition economy ha two equilibria, a good one and a bad one. In the bad equilibrium only the High group invet in human capital. In the good equilibrium both the High group and the Medium group invet. There i no equilibrium in which the low group invet. 7 There i only one equilibrium in the non-tranition economy. In it, only the High group invet. 8 The example ugget that in the tranition economy cae, in contrat with the developing economy cae, there i much at take. If expectation can be coordinated on a poitive viion of the future, many people will invet in human capital and the economy will take off. Peimim can be lethal General Reult Now conider the general cae, beginning with the following obervation. Propoition 1. At leat one equilibrium alway exit. 7 When only the High group invet we have c 2.2 h = =. 72 o only the High group will want to invet. 2.6 When both High and Medium group invet then c 2.8 h = =. 64 both of thee group but not the low group = 3.8 will want to invet. If all three group invet then c h =. 62 o invetment by the low group will not be utainable. 8 When only the High group invet we have c 2.2 h = =. 72 o only the High group will want to invet. 2.6 When both High and Medium group invet then c 2.5 h = =. 67 o invetment by the Medium group will 3.05 not be utainable. If all three group invet then 3 2 c h = =. 62 o invetment by the low group will not 3.8 be utainable

10 Proof. Conider the trategy profile in which no agent invet. If thi i an equilibrium, the proof i finihed. If not, there i at leat one agent who wihe to invet even when no one ele i inveting. Conider now the profile in which all uch agent invet. If thi i an equilibrium, again the proof i finihed. If not, at leat one agent now wihe to invet. Continue thi procedure until every agent i atified. (Thi might only occur when everyone i inveting.) Propoition 2. Every equilibrium can be characterized by a human capital level, h e, with the property that every child with parental human capital weakly above h e will invet and every child with parental human capital trictly below h e will not invet. Proof. Take any equilibrium and take the child with the lowet parental human capital who i till inveting. Suppoe there i another child with higher parental human capital who i not inveting. That child mut be able to earn at leat a much income by inveting a he currently earn by not inveting o he mut be inveting. The next reult indicate that when there are multiple equilibria only the one with the lowet h e i efficient. Propoition 3. When there are multiple equilibria they are Pareto ranked. More children inveting alway mean more efficiency. Proof. Conider two equilibria with cut-off level h e > h and trictly more children e 1 2 inveting in the econd equilibrium compared to the firt. 9 Then in the econd equilibrium both killed and unkilled worker earn higher wage than their counterpart in the firt equilibrium. Moreover, ome children who are unkilled in the firt equilibrium are killed in the econd equilibrium o they alo earn higher wage in the latter cae than they do in the former cae. 9 We would not conider there to be multiple equilibria ince each child i making the ame deciion in both cae. 9

11 The lat propoition how there i wide cope for increaing human capital in the middle range while maintaining multiple equilibria in the model. Intuitively, increaing the human capital of individual will not upet an equilibrium unle they move from one ide to the other ide of the cut-off point. Propoition 4. Conider an economy with two equilibria characterized by h e > h. e 1 2 Tranform thi economy into another one by increaing the human capital of all parent, e i e e i e i, uch that h h < h while maintaining the inequalitie h h < h. Then in the new economy there will till exit equilibria characterized by the ame h e > h. e 1 2 Proof. Conider the equilibrium in the original economy characterized by h e 1. In thi equilibrium all the children who have different parental human capital in the new economy are not inveting. If they till chooe not to invet in the new economy, wage of both killed and unkilled worker will be the ame in the new economy a they are at the equilibrium characterized by h e 1 in the old economy. Therefore, the choice at thi equilibrium will alo be equilibrium choice in the new economy. A imilar argument how that the equilibrium characterized by h e 2 old economy into the new one. alo urvive the tranformation from the Propoition 4 indicate that the example of ection 3.1 i rather robut. In particular, there i wide latitude to vary the parental human capital of the middle group, including dropping it homogeneity, while maintaining both the good equilibrium and the bad equilibrium. Thi ugget that whether a one tranition economy doe better than another might have little to do with difference in initial human capital ditribution. Two economie can both have the potential for both good outcome and bad outcome with other factor determining which path i followed. 10

12 Propoition 4 doe not how that increaing the bulk of middle range human capital cannot add new equilibria. The above example ha already hown that, tarting from an economy with a ingle equilibrium, increaing the number of children with moderate parental human capital can add a new Pareto-uperior equilibrium Extenion One eay extenion make an important policy point. A temporary inability of an educational ytem to upport large-cale human capital invetment can have a large negative effect on the economy equilibrium. Conider again the above example and uppoe the educational ytem cannot allow human capital invetment beyond the baic level for more than 50% of the population. Then the tranition economy become effectively equivalent to the non-tranition economy. The education contraint break the high-invetment equilibrium, cauing a large lo of human potential. Thi contraint i leveraged o it impact i much greater than might be expected. Reducing the inveting population to 50% decreae the wage premium ufficiently o that another 30% of the population doe not invet, depite the preence of ufficient capacity. In other word, if half the middle group i forced out of educational invetment, the other half drop out voluntarily. In thi ituation there will eem to be inufficient demand for education while potentially there i exce demand. Thi i important becaue one often encounter the view that return to education are generally high in tranition economie and therefore there i no problem with human capital accumulation. But people mut have both the incentive and the opportunity to accumulate human capital if they are to do o. Another obviou extenion i to introduce financing contraint. Then children who would maximize their lifetime income by inveting might till not invet due to 11

13 inufficient reource in the hort run. The effect would be imilar to that of a contraint on educational capacity. Finally, the model can be imbedded in a full overlapping generation model (ee Spagat, 2001 for detail). The main reult i that the population eparate into two clae of dynatie. For one cla, human capital converge to 1. For the other cla it converge to h. The initial time period i vital becaue then it i determined which dynatie rie and which fall 4. Concluion Thi paper i about the long-run future of countrie in tranition from communim. Unfortunately, there ha been very little analytical economic work along thee line. Thee countrie are undergoing major tructural tranformation while creating a large array of new intitution from cratch. Making mitake at the beginning of the tranition proce can caue problem a long time. More poitively, getting thing right now can pay large dividend for decade. Rich countrie have already etablihed workable if not alway optimal intitution and can urvive an overemphai on the hort run. Tranition economie mut think about the future. The communit world treed education, mainly in puruit of military goal. At the beginning of the tranition, human capital tock were highly ditorted from the perpective of the world market economy. Neverthele, thi legacy i omething poitive that can underpin a long period of rapid economic growth. At the ame time, the great human potential of tranition economie can eaily be lot. The model ugget the importance of coordinating agent belief on a highinvetment equilibrium. Roland and Verdier (2000) ugget that a key element might be 12

14 to give many countrie a decent propect of joining the EU within a reaonable period of time. But thi would not guarantee ucce. In addition, people with a willingne to invet mut have ufficient financial reource to do o and education ytem mut provide good opportunitie for people to acquire marketable human capital. With thee element in place, the future could be bright in tranition economie. Bibliography Alexeev, Michael and Michael Kaganovich, Return to Human Capital Under Uncertain Reform: Good Guy Finih Lat, Journal of Economic Behavior and Organization 37, 1:53-70, September Barro, Robert and Xavier Sala-i-Martin, Economic Growth, McGraw-Hill, New York, European Bank for Recontruction and Development, Tranition Report 2000, EBRD, Fan, Chengze Simon, Jody Overland and Michael Spagat, Human Capital, Growth and Inequality in Ruia, Journal of Comparative Economic, 27, Gro, Daniel and Marc Suhrcke, Ten Year After: What i Special About Tranition Countrie, CESifo working paper number 327, Heyneman, Stephen, Economic of Education: Diappointment and Potential. Propect 25, 4: , December Johnon, Simon, Daniel Kaufmann and Andrei Shleifer, The Unofficial Economy in Tranition, Brooking Paper on Economic Activity, 2: , Münich, Daniel, Jan Svejnar and Katherine Terrell, Return to Human Capital Under the Communit Wage Grid and During the Tranition to a Market Economy, CEPR working paper number 2332, Roland, Gérard and Thierry Verdier, Law Enforcement and Tranition, CEPR working paper 2501, Roland, Gérard, Tranition and Economic: Politic, Market and Firm, MIT Pre, Cambridge MA.,

15 Spagat, Michael, Lecture on Human Capital, Growth and Inequality in Tranition Economie, unpublihed manucript,