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Economic feasibility of on-the-job training
Economics o f Education Review V O L . 2, no. 2 (Spring 1 9 8 2 ) : 1 5 7 - 1 7 3
Economic Feasibility of On-the-Job Training David Stem
I n v e s t i n g in o n - t h e - j o b t r a i n i n g (OJT) is risky b e c a u s e t h e
value of specific human capital is lost if a permanent separation occurs between the employer and employee. An efficient contract between the two parties can reduce but not eliminate the risk. In theory, some form of "training insurance" could further reduce the risk or eliminate it entirely by pooling risk among employees or employers. The merits of this idea in practice could be determined by field tests, as could the value of ideas for improving the actual process of OJT. What d e t e r m i n e s the a m o u n t o f on-the-job training (OJT) is basic to u n d e r s t a n d i n g h o w earnings are d i s t r i b u t e d a m o n g individuals and over the life cycle. T h e l o n g - t e r m effectiveness o f public policies aimed at redistributing e m p l o y m e n t - s u c h as, in the U n i t e d States, affirmative a c t i o n laws and programs to r e d u c e structural u n e m p l o y m e n t - d e p e n d s in p a r t o n w h e t h e r i n t e n d e d beneficiaries are given o p p o r t u n i t i e s for c o n t i n u i n g OJT. E c o n o m i c analysis has s h o w n that some i n v e s t m e n t in O J T is risky. This article provides a simple algebraic m o d e l o f O J T in w h i c h the risk is m a d e explicit. A l t h o u g h n o one has y e t devised a m o d e l o f the labor m a r k e t in which wages, e m p l o y m e n t , and risky O J T are all j o i n t l y d e t e r m i n e d , H a s h i m o t o and Yu (1980) have s h o w n h o w e f f i c i e n t c o n t r a c t s b e t w e e n an e m p l o y e e and an e m p l o y e r can reduce the risk o f OJT. This article e x t e n d s the analysis b y showing h o w the risk c o u l d be f u r t h e r r e d u c e d , or e n t i r e l y eliminated, b y some f o r m o f " t r a i n i n g i n s u r a n c e " t h a t w o u l d p o o l risks a m o n g emp l o y e e s or e m p l o y e r s . T h e c o n c e r n here is e c o n o m i c , n o t political, feasibility. In practice, a g r e e m e n t s t h a t w o u l d be p r o f i t a b l e for b o t h the e m p l o y e r and e m p l o y e e m a y be p r e c l u d e d b y m i n i m u m wage laws. This is m a d e explicit in the c o u r s e o f the analysis. It is also possible, in practice, to The author is Associate Professor of Education, University of California, Berkeley. Work on this paper was supported by the Institute for Research on Educational Finance and Governance, Stanford University. [Manuscript received January 30, 1981; revision accepted June 23, 1981.]
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Economics of Education Review circumvent minimum wage laws by means of wage s u b s i d i e s - f o r example, Targeted Jobs Tax Credits--which preserve the principle that no employee should receive less than the minimum, by splitting the wage cost between the employer and the taxpayers. If taxpayers are willing, such programs may be efficient; however, the following analysis does not include such a possibility. It is concerned exclusively with contracts between employers and employees. BENEFITS AND COSTS
Economic analysis of costs and benefits from OJT continues to make use of Becker's (1964) original distinction between specific and general training. If working for a particular employer makes an employee more productive not only in the service of that employer but also, and equally as much, if employed by someone else, then that employee is said to receive completely general training. If experience gained with the present employer makes the employee more productive for this employer than for other employers, then the experience is said to include specific training. Sometimes training may be specific not to a single employer but to a group of employers, as in a particular industry or geographic region. The distinction between specific and general training is important because it is profitable for employers to invest in specific but not general training. Employers may offer general training, but only if employees are willing to pay for it on a current basis through reduced compensation. It is not profitable to pay employees any more than what they are presently worth to the organization while they are receiving general training because after they are trained they will have to be paid no less than what they are then w o r t h - o t h e r w i s e they will quit for the higher pay they can obtain elsewhere. In contrast, employees who have had specific training will be worth more to the employer who trained them than to other employers. The employer who trained them will therefore be able to pay these specifically trained workers something less than they are worth but more than they can earn elsewhere. This possibility of profit for the employer who provides specific trianing may justify paying the employees more than they are worth during the training period. So while only the employees themselves will find it profitable to invest in general OJT, both employees and employers may invest in specific OJT. B ecker (1964) constructed algebraic models of purely specific and completely general training. He recognized, however, that much on158
Economic Feasibility of On-The-Job Training the-job training in reality is neither completely specific nor completely general. Recent empirical studies have confirmed that employees with more years of work experience generally receive higher pay, b u t the additional pay per year of experience on average is greater if more of the experience has been acquired with the present employer (Chapman and Tan 1980; Duncan and Hoffman 1979). If amount of learning is assumed to be positively related to duration of experience, then these empirical results are consistent with the hypothesis that the monetary p a y o f f from what is learned by working for a particular employer is usually greater if one continues to work for that employer than if one goes to work elsewhere.1 There are exceptions: the existence of professional "head-hunters" depends on the fact that employers, by offering more compensation, sometimes lure e m p l o y e e s - e s p e c i a l l y top managers or technicians who possess some rare and valuable k n o w l e d g e - a w a y from other employers. Exceptionally tight labor markets, as in the late 1960s, also offer unusually large numbers of employees an opportunity to quit and earn more m o n e y with another employer. But evidence from the 1970s shows that even workers who voluntarily quit and go to work for another employer usually receive less pay than those who keep working for the same employer (Black 1980). And workers who are fired or permanently laid off do even worse than those who quit voluntarily. The evidence on h o w earnings are related to work experience and j o b mobility is therefore consistent with the idea that learning on the j o b ordinarily has both specific and general value. Some interesting implications of this idea can be derived from a simple algebraic model, in which time is divided into two periods, present and future. Suppose there is one market interest rate, r, at which anyone can b o r r o w or lend. Let the following denote constant-dollar earnings of a particular individual in different possible jobs: !
w0
= p r e s e n t o r f u t u r e e a r n i n g s i n a j o b w h e r e t h e r e is n o t h i n g f o r a n employee to learn;
w0
= present earnings during the training 2 phase of a job where the e m p l o y e e is e x p e c t e d t o l e a r n s o m e t h i n g ;
1. The observed association between changing employers and lower pay is also consistent with the hypothesis that less successful employees are usually the ones who move (Jovanovic 1979). These two hypotheses are not mutually exclusive. 2. Training m a y consist of pure learning-by-doing, coaching, simulations, formal instruction, or any c o m b i n a t i o n of these. For a discussion of formal and n o n f o r m a l training in manufacturing, see Benson and Lohnes (1959). For an estimate of the extent of formal instruction sponsored by employers, see Smith (1980).
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w I = future earnings on the job where the employee has gone through the training phase and continues working for the same employer; w~ = future earnings if the employee has gone through the training phase but then goes to work for a different employer; and p = probability of staying with the same employer where the training occurred. In this two-period model, all training would be in the present because there would be no time to obtain any p a y o f f from training undertaken in the future. The choice confronting the individual is whether or not to enter a training phase now. If not, then constant-dollar earnings would be the same in the two time periods, and the discounted present value of " l i f e t i m e " earnings would be wo + wo / (1 + r). If training is undertaken now, the expected value of future earnings will be p w 1 + (1 - p ) w ' 1 , because the individual has probability p of staying with the same employer, and probability (1 - p) of going to work for someone else (assumed to be the next highest bidder). The decision to stay or leave may be up to the individual or the employer; this point will be discussed further below. In any event, the present value of lifetime earnings if the person receives training is w 0 + { p w I + ( l - p ) w ~ } / ( 1 + r). The expected net present value of training is therefore: w0 +{pwl = P(wl -
+
t
t
(1-p)w~ } /(1 + r ) - w O - w 0 /(1 +r) t
I
t
w ' a ) / ( l + r ) + (w 1 - W o ) / ( 1 + r ) - ( w O - w O )
= specific payoff + general p a y o f f - cost. The expected net present value of training for the employee consists of three additive components. First is the specific payoff. It is the discounted difference between future earnings obtainable from the employer where training was received and earnings offered by the next highest bidder, multiplied by the probability of staying with the former employer. The second component of the p a y o f f from training is the general component, which is paid to the employee whether the person stays with the same employer or not. This is simply the discounted difference between future earnings obtainable from another employer after training and future earnings after no training. Finally, the third component of the net present value of training is the cost to the trainee, which is w o - w o . This is subtracted from the p a y o f f to the trainee. Direct extension of Becker's argument gives the conditions under which training would be profitable for the employer as well as the 160
Economic
Feasibility of On-The-Job
Training
employee. Let q o stand for the trainee's productivity in the present period, and ql denote future productivity if the trainee continues to work for the same employer. Then the employer's investment in training is w o - q o , and this must be no less than the discounted present value of the employer's expected payoff, which is p ( q l w 1 ) / (1 + r). That is, the employer will offer training only if: wo-qo
< p(q, -wl)/(l
+r)
or, w0 < q O + p ( q l
-Wl)/(l+r).
The employee, similarly, will participate in training only if the expected net present value of training is positive; that is, + ( w 'l - w
w 0' - w 0 < { p ( w , - w x ) '
or,
,
w0 - { P ( w l
-wl)
,
,
(wl
+
o)) / ( l + r )
,
-Wo)}/(l+r)
< w0 •
Putting these two conditions together implies that training will take place only if: LO5 - {/9 (W 1 -Z/J; )+ (ZJ1 - W ; ) } /(1 + r ) ~ ZOo ~ q o + P ( q l -7"01 )/(1 + r).
The expression on the left represents the smallest amount of compensation a trainee would accept in the present period, and the expression on the right is the largest amount the employer will pay during training. There exists some level of compensation for the trainee that makes training worthwhile for both parties only if: w0 -
{
, , p(wa-wl)+(wt-w;)
)
/(1 +r) < q o + p ( q l - W l ) / ( l + r ) .
This condition can be simplified to: (1 + r ) ( w ; - q o
t
) < P ( q l - w ' l ) + (w'l-Wo).
Neither w I nor w o appears in this condition, because this is the necessary and sufficient condition for training to be potentially profitable for both parties. Whether this potential profit exists is a separate question from h o w it is to be shared, which is determined by w o and w I . The statement of the condition for collective profita? bility has a straightforward interpretation: If w o and w'l represent the value of the trainee's time in alternative employments (or in unemployment), then (1 + r) ( w g - q o ) is the minimum desired value in the future of the p a y o f f from the value of time invested in training, w o - q o . The actual p a y o f f has a general component, w'l - w~), and a specific component, p (ql - w~ ). If the actual p a y o f f is at least 161
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as great as the m i n i m u m desired p a y o f f , t h e n there will be some a m o u n t s o f p r e s e n t and f u t u r e c o m p e n s a t i o n , w o and w~, that w o u l d m a k e training p r o f i t a b l e for b o t h e m p l o y e r and e m p l o y e e . It is quite possible, in reality, for training to be p o t e n t i a l l y profitable for b o t h parties, b u t for m i n i m u m wage laws to p r e v e n t the t r a n s a c t i o n f r o m o c c u r r i n g because the e m p l o y e r c a n n o t p r o f i t f r o m the training if the trainee m u s t be paid t o o high a wage. H o w m a n y O J T c o n t r a c t s are in fact p r e c l u d e d b y m i n i m u m wage constraints, even t h o u g h t h e y w o u l d be p r o f i t a b l e to b o t h sides, is an empirical question. M A R K E T - C L E A R I N G AND G L O B A L E F F I C I E N C Y So far, this m o d e l contains no explicit m e c h a n i s m for equating supply and d e m a n d . Is it possible to imagine a m a r k e t - c l e a r i n g m e c h a n i s m t h a t w o u l d p r o d u c e a P a r e t o - o p t i m a l allocation of training? Using Becker's c o n c e p t s , Rosen ( 1 9 7 2 b ) f o r m u l a t e d a m o d e l of the labor m a r k e t in which wage a d j u s t m e n t p r o d u c e d an efficient allocation of resources to training. H o w e v e r , in that m o d e l all O J T was assumed to be p e r f e c t l y general. E m p l o y e r s t h e r e f o r e have a clear incentive to " s e l l " training to e m p l o y e e s . An interesting result is t h e n o b t a i n e d f r o m the fact that e m p l o y e e s t e n d to " b u y " less training w h e n t h e y are older, " s i n c e there is less time available to capitalize f u t u r e returns as r e t i r e m e n t a p p r o a c h e s " ( R o s e n 1972b: 329). C o n s e q u e n t l y . . . an important implication of the analysis is that workers progress through a "hierarchy" of jobs with lesser learning content (and higher pay) over time and as their skill accumulates (p. 333). Some workers will progress through the entire sequence within the firm. If more workers are hired at entry-type jobs than there are spaces for further up the hierarchy, some workers will not be promoted and will seek jobs offering their desired level of (pay and further training) elsewhere (p. 336). In this m o d e l , m o v e m e n t of workers f r o m one firm to a n o t h e r does n o t penalize e m p l o y e r s because e m p l o y e e s have paid the full cost of training. M o b i l i t y also does n o t penalize the e m p l o y e e s because their training is assumed to be p e r f e c t l y general. B u t w h a t if training is specific? R o s e n (1972a) has also f o r m u l a t e d a d y n a m i c m o d e l of a firm in which there is l e a r n i n g - b y - d o i n g . In this m o d e l , the value of on-the-job learning is assumed to be c o m p l e t e l y specific to the firm. If this learning is e m b o d i e d in the era162
Economic Feasibility of On- The-Job Training ployees, as oppose d to the owners, Rosen asserts that " i t is Paretooptimal for all parties, to act as if labor cost is the alternative wage [i.e., the wage employees could obtain elsewhere] in making investment decisions, for such policies provide the largest surplus to be divided among t h e m " (p. 376, note 5, emphasis in original). Rosen does not indicate what the employees should or would actually be paid. But, as Becker pointed out in his original discussion and Rosen acknowledges, the question of how much to pay employees who have received specific training is important because it relates to the risk of turnover and consequent capital losses. The question becomes more complicated when we consider the hypothesis of Baily (1974), Azariadis (1975), and others who have argued that employees accept implicit contracts which expose them to the risk of layoff at times when demand for their labor decreases, but which protect those who remain employed against the risk of wage reductions in low-demand periods. Hashimoto (1975, 1979) has pointed out that employees who have invested in specific training actually should prefer some reduction in wages to being laid off, especially if l a y o f f is permanent. No one has yet produced an analysis of the labor market that shows how these competing desires can be accommodated efficiently. Hall (1980) has recapitulated and refined some of the separate arguments, but he concludes: Much remains to be understood about the failure of macroefficiency in an economy in which individual agents try hard to achieve micro-efficiency in their own employment arrangements (p. 93). Similarly, we must conclude that at present we lack a complete, consistent model to explain how wages, employment, and training could be determined when workers want predictable wages, when the suitability of a person for a particular job may be revealed only after some time (see f o o t n o t e 2), and when OJT has a specific component. Lacking such a model, we cannot tell whether the outcome would be Pareto-optimal in theory, or whether the model itself is consistent with what we observe in reality.
MAKING OJT MORE EFFICIENT Stopped, at least for now, from making global assertions about the efficiency of OJT, we may nevertheless approach the question locally. A n y change that makes training more profitable for some set of employees or employers, or both, without increasing any costs to 163
Economics o f Education Review others, could be considered an improvement in efficiency. The conditions under which OJT will be profitable for employees and employers were stated above. As mentioned earlier, these show the variables that might be altered in a given setting. OJT will become more profitable for employers or employees, or both, if any of the following can be achieved: 1 The productivity of employees during training, qo , is increased. This obviously reduces the real cost of training. 2 The productivity of employees after they are trained, q a , increases. This means a bigger specific p a y o f f from training. 3 The market rate of interest, r, is reduced, thus reducing the opportunity cost of training. 4 The productivity in alternative emph)yment where there is no OJT, Wo, is lower. This "also implies lower opportunity cost of training. 5 The productivity" of employ'ees who are trained but go to work elsewhere, w'l, is increased. This represents a bigger general p a y o f f from OJT. 6 The probability that a trainee will continue to work for the same employer, p, is increased. This improves the specific p a y o f f from training. This last variable may require some further explanation. Why is p ever less than one? The first reason is that some trainees may: not succeed in learning to perform at a satisfactory level in the time available. (In the model here, those who " t ] u n k " the training have to settle for w~ , which gives them credit for having learned at least something. In reality, the result could be worse, as shown in Rosenbaum [1979]). For those who do succeed in learning how to do the work, the second risk is that there may not be enough jobs, due to unexpected slowdowns in business activity, or because an unexpectedly high proportion of trainees completed the training successfully, or because the employer deliberately trained some extra people in order to be able to select the best or to avoid any risk of a shortage of trained people. For any of these reasons or possibly for other reasons, it could turn out that the actual productivity of the employee after training, q l , is less than the agreed-upon post-training wage, w l . Unless this wage can be reduced (see below), the profitseeking employer will dismiss the employee. It is also possible that an employee who successfully completes the training, and whom the employer wants to retain, will become aware of alternative employment that is, unexpectedly, more desir164
E c o n o m i c Feasibility o f O n - T h e - J o b Training
able. The rational employee would then quit and take the more desirable alternative. In short, at the time the training decision is made, the expectation is that q l > Wl > w[. But after the training is done, it may turn out that q l < w l or w 1 < w i , so that either the employer or the employee, respectively, decides to separate.
Efficient Contracting Separation is the collectively rational outcome if ql is so much less than expected, or w~ is so much more than expected, that q l < w~. The employee's time is simply more valuable in a firm other than the one in which he or she was specifically trained. But separation P will be rational for the employer if w 1 > ql > wa, or for the employee if ql > w~ > Wl, even though ql > W~ means the employee is still more productive where he or she is than in the alternative employment. Such separations are n o t collectively rational. Hashimoto and Yu (1980) have provided a careful analysis of conditions under which unilateral, non-optimal separations will occur when expectations are not met. They show that the risk of nonoptimal separations can be reduced ex a n t e by appropriate division of the quasi-rent to the specific human capital (agreement on w o and zo1 ); by prior agreement to use tamper-proof economic indicators to measure productivities after training (that is, objective indicators of ql and w~ ; see also Hall and Lilien [1979]); and by choosing among alternative rules to limit quitting or dismissal (ranging from tenure to indenture). These provisions would make e m p l o y m e n t contracts more efficient by protecting the employer's and employee's shared interest in specific h u m a n capital. But even the most efficient contracts cannot always completely eliminate the risk of non-optimal separation. And there is always the chance that a particular training decision will turn out to have been a mistake, in which case separation becomes the best resolution for both parties.
Training Insurance Therefore, in spite of efficient contracting, there is still some risk of separation after training, so that p < 1, and the present value of the expected gross p a y o f f for the employer who provides training is P ( q l - W l ) / ( 1 + r). But if the employer is averse to risk, then this expected p a y o f f would be considered less valuable than a certain p a y o f f of the same amount. The expected p a y o f f p ( q ~ - w1)/(1 + r) would be considered equally valuable as a riskless p a y o f f of P ( q l w~)/(1 + r) - D R ( p ) , where D R (p) > O is the employer's discount for risk, which is inversely related to p (at least for .5 <_ p < 1). 165
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Similarly, if an employee is risk-averse, the expected p a y o f f from training, { p ( w , - w ; ) + (w; - w o ) } / (1 + r), would be considered equally valuable as a certain p a y o f f of only { p ( w 1 - w'l) + (w; w~) )}/ (1 + r) - De (p), where DE (p) >_ 0 is the employee's discount for risk. Therefore, even if it were true that t
wO - { p ( w l
I
!
t
- W l ) + (Wl - % ) } / ( 1 + r ) < qo +P(ql - w l ) / ( l + r ) ,
it may not be true that 4-
[{p(w, -w',)+ (w; -w;)} /(l + r ) - DE (p)] <_ qo q-/)(ql -Wl)/ (1 + r ) - DR(p).
In other words, even if, on average, the employer and employee could both expect to benefit from training, they might be unwilling to incur the necessary risk. In theory, the risk of training could be further reduced for individuals by pooling risk among trainees, or among employers, or both. There could be a kind of "training insurance," through which winners indemnify losers. Among trainees, losers would be wholly indemnified if, upon leaving the employer who trained them, and having to settle for w[ instead of w l , they were paid an insurance benefit equal to their loss in pay, w I - w [ . If these benefits were financed by collecting a premium of (1 - p ) ( w I - w[)/(1 + r ) f r o m every trainee at the start of training, then all trainees would pay the same premium and obtain the same future earnings. The discounted present value of these future earnings, net of the insurance premium, would be {pw~ + ( 1 - p ) w[}/(1 + r), the same as the discounted present value of expected post-training earnings in the absence of an insurance plan. In other words, a risky investment would become a riskless one with the same expected value, so that risk-averse employees would not be deterred from making an investment from which they can expect to profit. Complete indemnification could also reduce trainees' incentive to work hard since they would have nothing to lose if they flunked the training. To preserve an incentive for trainees, the insurance benefit could be only some fraction of the difference between winners' and losers' earnings, c(w I - w[), where 0 < c < 1. Then actuarial balance would imply a premium of c(1 - p) (w I - w[)/(1 + r) to be collected from all trainees at the start of training. This would leave some risk since winners would again earn more in the future than losers. 166
Economic Feasibility of On-The-Job Training To get a rough idea of how this idea would translate into actual dollars, suppose it takes two years for the average new person on a particular job to become fully proficient. If the annual pay were $10,000 at the outset, suppose it rises to $11,000 (in constant dollars) after the two years of training. But if the employee for some reason had to change employers at the end of the two-year period, the highest annual pay he or she could obtain would be $10,300. These numbers are based on the averages reported by Duncan and H o f f m a n (1979) from the 1976 Panel Study of Income Dynamics. The $700 annual difference, discounted at a real interest rate of 0.05 for the remainder of the employee's working life, has a present value on the order of $10,000. At a real discount rate of 0.1 (more than most households can hope to receive as a return on investment), the loss in pay has a present value on the order of $5,000. Suppose for every employee who left after the two-year period there were three who stayed to reap the benefits of specific training (that is, p = 0.75). For simplicity, also suppose that employees either leave after two years or stay for the rest of their working lives. Then to make every mover just as well off financially as every stayer would require each employee to pay an insurance premium on the order of $600 to $1,200 each year during the two-year training period. Obviously, if movers were only partially compensated, the premium would be correspondingly less. A higher ratio of stayers to movers also implies a lower premium. For instance, if there were nine stayers for every mover (p = 0.9), then the premium required to fully compensate the mover would be $250 to $500 from each trainee each year during the two-year training period. Although these premium payments would reduce the net gain from training for those who stay, the expected value of training, calculated at the start of the two-year period, would be same as in the absence of insurance, because in return for the premium p a y m e n t the risk of moving is reduced or eliminated. Implementation of such a plan would require identification of groups of employees who face similar risk. Presumably, p a y m e n t of insurance benefits to an employee would require the employer to certify that he or she had been terminated. Possibilities for collusion between emi~loyer and employee to defraud the insurance fund, as well as other kinds of moral hazard, would have to be anticipated. The insurance fund would also have to be insulated against cyclical demands; otherwise a severe recession could destroy it. The purpose of training insurance is to compensate employees who are permanently separated from the employers who trained them, not to pro167
Economics of Education Review tect against temporary unemployment. Workers who are laid off subject to recall should n o t be eligible for training insurance benefits. Training insurance could also make it safer for employers to finance some of the cost of specific training. 3 Here implementation would require identifying groups of employers who face similar risks, and presumably benefits would be paid only if an employee certified that he or she had w)luntarily quit. Again problems of collusion and moral hazard would have to be anticipated.
Reducing Losses Due to Temporary Layoffs Training insurance would protect employers or employees against the risk of losing their investment in specific training as a result of permanent separation. Training insurance benefits should not be payable if a layoff is only temporary. But a large proportion of temporary layoffs do become permanent separations (Summers 1980:137). This is the efficient o u t c o m e if the employee continues to be more productive in the new j o b than in the j o b from which that person was laid off. But if the temporary layoff was caused by a temporary reduction in demand, and if the employee would be more productive when recalled to the old j o b than in any alternative job, then permanent separation is not efficient. Although the minority of workers who receive supplemental unemployment benefits to keep their incomes at normal levels while on temporary layoff would not be forced to make an inefficient separation just to meet their current living expenses, many other employees might be forced to do so, and in so doing they would forfeit their investment in specific human capital. One way to prevent this would be to create the option for an employee on temporary layoff to receive training under the employer's auspices, and possibly on the employer's premises, while the employee receives u n e m p l o y m e n t benefits. 4 The training would be designed to enhance the employee's performance when recalled, or even to enhance the employee's prospects for advancement. This would help protect existing investments in specific human capital against temporary reductions in demand. Another way to do this may be job-sharing financed by unemployment insurance. In California, for example, it is now possible for an employer to reduce hours of work for a larger group of employees instead of laying off a 3. Under the East German Ausbildungsplatzfoerderungsgesetz (" Law Fostering Apprenticeship") of 1976, employers in certain industries have set up funds which appear to have a very similar intent (Sadowski 1980). 4. This is similar to the Swedish " 2 5 - k r o n o r system" (Ericsson 1979).
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Economic Feasibility of On-The-Job Training smaller n u m b e r - a n d the employees whose hours are reduced receive u n e m p l o y m e n t benefits. Allowing u n e m p l o y m e n t benefits to be paid to employees who are still working, or who are at the work site as trainees, may tempt employers to use u n e m p l o y m e n t benefits to pay regular wages and salaries. If the experience-rating provisions of une m p l o y m e n t insurance did not provide enough disincentive to deter this, some additional deterrent would have to be created. Implementing these proposals for reducing risk of specific training might produce major efficiency gains or very little. The problems of enforcement and administration might be tremendous or trivial. The most straightforward way to find out would be to conduct field tests. Different models could be tested in different localities. Arguably, the possible social benefit of demonstrating how to achieve efficiency gains would justify allocating some tax revenues to pay for such field tests. Improving the Technology of OJT Direct experimentation would also be required to develop and test improvements in the technology of OJT itself. The lack of recorded, systematic knowledge about general questions like how best to combine formal instruction, simulation, coaching, and pure learning-bydoing makes it apparent that the " t e c h n o l o g y " of OJT has not been developed in any rigorous, purposive way. According to one recent review (Goldstein 1980), there has been virtually no consideration of systems which examine the total job and provide information on which activities should be learned in [off-the-job] training and which activities should be learned on the job. Similarly, no established procedures exist that empirically establish the content validity of a training program based upon a match of relevant tasks on the job and in the training program (p. 234). One current development that might lead to more knowledge in this area is the increasing number of college degree programs that are offering courses where people work, and in some instances are awarding credit for work that is part of the job (Business Week, August 4, 1980). Another development which is providing opportunities to learn more about efficient combinations of on-line and off-line training is the creation of productive enterprises based in schools. Traditionally, such enterprises have been used in vocational education to provide realistic experience for students (Harter 1980). More recently, school-based enterprises have been sponsored by federal programs for e m p l o y m e n t and training of young workers (Corporation 169
Economics of Education Review for Public/Private Ventures 1979). Both school-based enterprises and degree programs in the workplace represent hybrids of educational and productive organization. As such, both are possible sites for research on how to combine formal instruct.ion with on-the-job experience for efficient acquisition of work-related knowledge and skill. More generally, researchers in organizational behavior have begun to map out an ambitious program of research on learning in and by organizations (Staw 1979). Although OJT is usually conceived as a process of acquiring a limited set of skills and knowledge required for c o m p e t e n t performance in a particular job, it can also be conceived as an open-ended process of continual learning, resulting in continually improved performance. On-the-job learning can therefore encompass not only what other people already k n o w - t h e usual meaning of " t r a i n i n g " - b u t also new ideas, techniques, and "tricks" that others may not have discovered. Such open-ended learning is the objective of organizational devices like "quality circles" and Scanlon plans. The idea is to p r o m o t e on-the-job research, aimed at continual improvement in productivity. Whether and how OJT in the narrow sense is, can be, or should be combined with OJT in the broader sense, is a question well b e y o n d the scope of this article. The point here is that opportunities and incentives for on-the-job learning are conditioned b y the structure and ethos of the whole employing organization. What appears as a marginal change in the context of the whole labor market may be a global transformation for a particular employer. CONCLUSION Investment in specific human capital is risky because its value will be lost if a permanent separation occurs between the employer and the specifically trained employee. Recent work by Hashimoto and others has shown h o w an efficient agreement between employer and employee can reduce the risk. This article has suggested how the risk can be further reduced or even eliminated b y some form of training insurance which would pool risks among employees or employers. The net advantage of such arrangements in practice could be measured only b y actual field tests. Actual field studies will also be required if we are ever to see what really goes on inside the "black b o x " of OJT. Much work remains to be done to understand and improve the process of education in workplaces. 170
Economic Feasibility of On-The-Job Training REFERENCES Azariadis, Costas/1975 IMPLICIT CONTRACTS AND U N D E R - E M P L O Y M E N T EQUILIBRIA. Journal o f PoliticalEconomy 83, no. 6 (December): 1 1 8 3 - 1 2 0 2 . Baily, Martin Neil/1974 WAGES AND EMPLOYMENT U N D E R U N C E R T A I N DEMAND. Review of Economic Studies 41, no. 1 or no. 125 ( J a n u a r y ) : 3 7 - 5 0 . Becker, Gary S.[1964 HUMAN CAPITAL. New York: National Bureau of Economic Research. Benson, Charles S., and Paul R. Lohnes]1959 SKILL REQUIREMENTS AND I N D U S T R I A L T R A I N I N G IN D U R A B L E GOODS MANUF A C T U R I N G . Industrial and Labor Releations Review 12, no. 4 (July): 5 4 0 - 5 5 3 . Black, Matthew]1980 PECUNIARY IMPLICATIONS OF ON-TIlE-JOB SEARCH AND QUIT ACTIVITY. Review of Economics and Statistics 62, no. 2 ( M a y ) : 2 2 2 - 2 2 9 . Bowman, Mary J e a n / 1 9 7 9 O U T - O F - S C H O O L F O R M A T I O N OF HUMAN RESOURCES. In Economic Dimensions o f Education, edited by Douglas M. Windham. Washington, D.C.: National A c a d e m y of Education. E A R N I N G AN U N D E R G R A D U A T E DEGREE AT THE PLANT]1980 Business Week (August 4): 7 6 - 7 7 . Chapman, Bruce J., and Hong W. T a n / 1 9 8 0 SPECIFIC T R A I N I N G AND I N T E R - I N D U S T R Y WAGE D I F F E R E N T I A L S IN U.S. MANU F A C T U R I N G . Review o f Economics and Statistics 62, no. 3: 3 7 1 - 3 7 8 . Corporation for Public] Private Ventures (CP] PV) ] 1979 A D I R E C T O R Y OF T R A I N I N G AND EMPLOYMENT PROGRAMS IN THE PRIVATE SECTOR. Philadelphia. Duncan, G r e g J . , and Saul H o f f m a n / 1 9 7 9 O N - T H E - J O B T R A I N I N G AND EARNINGS D I F F E R E N C E S BY RACE AND SEX. Review of Economics and Statistics 61, no. 4 (November): 5 9 4 - 6 0 3 . Ericsson, Bo A./1979 THE EMPLOYMENT SITUATION IN SWEDEN: SOME MAIN ISSUES LOOKING AHEAD TO THE 1980S. Swedish Information Service: Election Year "79, no. 2 (June). New York: Swedish Consulate General. Gay, Robert S., and Michael Borus]1980 V A L I D A T I N G P E R F O R M A N C E INDICATORS FOR EMPLOYMENT AND T R A I N I N G PROGRAMS. Journal o f Human Resources 15, no. 1: 2 9 - 4 7 . Goldstein, Irwin L./1980 T R A I N I N G IN WORK O R G A N I Z A T I O N S . Annual Reviews o f Psychology 31: 2 2 9 - 2 7 2 .
171
Economics of Education Review G u s t m a n , Alan L., and T h o m a s L. Steinmeier/1980 L A B O R MARKETS AND E V A L U A T I O N OF V O C A T I O N A L T R A I N I N G PROGRAMS IN THE PUBLIC HIGH S C H O O L S - - T O W A R D A F R A M E W O R K FOR ANALYSIS. Hanover, N.H.: D a r t m o u t h College. Hall, Robert E./1980 EMPLOYMENT F L U C T U A T I O N S AND WAGE RIGIDITY. Brookings Papers on EconomicActivity, no. 1 : 9 1 - 1 2 3 . Hall, Robert E., and David M. Lilien/1979 EFFICIENT WAGE BARGAINS U N D E R U N C E R T A I N SUPPLY AND DEMAND. American Economic Review 69, no. 5: 8 6 8 - 8 7 9 . Harter, J o h n , David Stern, and T h o m a s Strano/1980 ENTERPRISES F O R LEARNING. Albany, CA.
Hashimoto, Masanori/1975 WAGE REDUCTION, UNEMPLOYMENT AND SPECIFIC HUMAN CAPITAL. Economic Inquiry 13, no. 4 ( D e c e m b e r ) : 4 8 5 - 5 0 4 . Hashimoto, Masanori/1979 BONUS PAYMENTS, ON-THE JOB TRAINING, AND LIFETIME EMPLOYMENT IN JAPAN. Journal of Political Economy 87, no. 5, part 1 (October): 1 0 8 6 - 1 1 0 4 . Hashimoto Masanori, and B. T. Yu]1980 SPECIFIC CAPITAL, EMPLOYMENT CONTRACTS, AND WAGE RIGIDITY. Bell Journal of Economics 11, no. 2 : 5 3 6 - 5 4 9 . Jovanovic, Boyan/1979 J O B MATCHING AND THE T H E O R Y OF T U R N O V E R . Journal of Political Economy 87, no. 5, part 1 ( O c t o b e r ) : 9 7 2 - 9 9 0 . Mincer, J a c o b / 1 9 5 8 INVESTMENTS IN HUMAN CAPITAL AND PERSONAL INCOME DISTRIBUTION. Journal of Political Economy 66 (August) : 281- 302. Mincer, J a c o b / 1 9 6 2 ON-THE-JOB-TRAINING: COSTS, RETURNS, AND SOME IMPLICATIONS. Journal of Political Economy 70, no. 5 (Supplement, part 2) (October): 5 0 - 7 9 . Mincer, Jacob] 1974 SCHOOLING, EXPERIENCE, n o m i c Research.
AND EARNINGS. New York: National Bureau of Eco-
Mincer, J a c o b / 1 9 7 9 HUMAN CAPITAL AND EARNINGS. In Economic Dimensions of Education, edited by Douglas M. Windham. Washington, D.C.: National A c a d e m y of Education. Parsons, Donald O.]1972 SPECIFIC HUMAN CAPITAL: AN APPLICATION TO QUIT RATES AND L A Y O F F RATES. Journal of Political Economy 80, no. 6 (November/December) : 1 1 2 0 - 1 1 4 3 . Rosen, Sherwin/1972a LEARNING AND EXPERIENCE 1N THE L A B O R MARKET. Journal of Human Resources 7, no. 3 (Summer): 3 2 6 - 3 4 2 .
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Economic Feasibility of On-The-Job Training Rosen, Sherwin/1972b L E A R N I N G BY EXPERIENCE AS J O I N T PRODUCTION. Quarterly Journal of Economics 86, no. 3. ( A u g u s t ) : 3 6 6 - 3 8 2 . R o s e n b a u m , James] 1979 T O U R N A M E N T MOBILITY: C A R E E R PATTERNS IN A CORPORATION. Administrative Sciences Quarterly 24 (June): 2 2 0 - 2 4 1 . Sadowski, Dieter/1980 FINANCE AND G O V E R N A N C E OF THE GERMAN APPRENTICESHIP SYSTEM: SOME CONSIDERATIONS ON M A R K E T F A I L U R E AND ITS EFFICIENT CORRECTIONS. Stanford University: Institute for Research on Educational Finance and Governance. Smith, G. G.]1980 E M P L O Y E R - S P O N S O R E D R E C U R R E N T EDUCATION IN THE UNITED STATES: A R E P O R T ON RECENT INQUIRIES INTO ITS S T R U C T U R E . Washington, D.C.: National Institute for Work and Learning. Staw, Barry M., ed./1979 R E S E A R C H IN O R G A N I Z A T I O N A L BEHAVIOR. Greenwish, CT: JAI Press. Summers, Lawrence H./1980 COMMENTS ON H A L L Brookings Papers on Economic Activity, no. 1: 1 3 3 - 1 3 9 . T h u r o w , Lester]1975 G E N E R A T I N G INEQUALITY. New York: Basic Books.
173
Economic Feasibility of On-the-Job Training David Stem
I n v e s t i n g in o n - t h e - j o b t r a i n i n g (OJT) is risky b e c a u s e t h e
value of specific human capital is lost if a permanent separation occurs between the employer and employee. An efficient contract between the two parties can reduce but not eliminate the risk. In theory, some form of "training insurance" could further reduce the risk or eliminate it entirely by pooling risk among employees or employers. The merits of this idea in practice could be determined by field tests, as could the value of ideas for improving the actual process of OJT. What d e t e r m i n e s the a m o u n t o f on-the-job training (OJT) is basic to u n d e r s t a n d i n g h o w earnings are d i s t r i b u t e d a m o n g individuals and over the life cycle. T h e l o n g - t e r m effectiveness o f public policies aimed at redistributing e m p l o y m e n t - s u c h as, in the U n i t e d States, affirmative a c t i o n laws and programs to r e d u c e structural u n e m p l o y m e n t - d e p e n d s in p a r t o n w h e t h e r i n t e n d e d beneficiaries are given o p p o r t u n i t i e s for c o n t i n u i n g OJT. E c o n o m i c analysis has s h o w n that some i n v e s t m e n t in O J T is risky. This article provides a simple algebraic m o d e l o f O J T in w h i c h the risk is m a d e explicit. A l t h o u g h n o one has y e t devised a m o d e l o f the labor m a r k e t in which wages, e m p l o y m e n t , and risky O J T are all j o i n t l y d e t e r m i n e d , H a s h i m o t o and Yu (1980) have s h o w n h o w e f f i c i e n t c o n t r a c t s b e t w e e n an e m p l o y e e and an e m p l o y e r can reduce the risk o f OJT. This article e x t e n d s the analysis b y showing h o w the risk c o u l d be f u r t h e r r e d u c e d , or e n t i r e l y eliminated, b y some f o r m o f " t r a i n i n g i n s u r a n c e " t h a t w o u l d p o o l risks a m o n g emp l o y e e s or e m p l o y e r s . T h e c o n c e r n here is e c o n o m i c , n o t political, feasibility. In practice, a g r e e m e n t s t h a t w o u l d be p r o f i t a b l e for b o t h the e m p l o y e r and e m p l o y e e m a y be p r e c l u d e d b y m i n i m u m wage laws. This is m a d e explicit in the c o u r s e o f the analysis. It is also possible, in practice, to The author is Associate Professor of Education, University of California, Berkeley. Work on this paper was supported by the Institute for Research on Educational Finance and Governance, Stanford University. [Manuscript received January 30, 1981; revision accepted June 23, 1981.]
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Economics of Education Review circumvent minimum wage laws by means of wage s u b s i d i e s - f o r example, Targeted Jobs Tax Credits--which preserve the principle that no employee should receive less than the minimum, by splitting the wage cost between the employer and the taxpayers. If taxpayers are willing, such programs may be efficient; however, the following analysis does not include such a possibility. It is concerned exclusively with contracts between employers and employees. BENEFITS AND COSTS
Economic analysis of costs and benefits from OJT continues to make use of Becker's (1964) original distinction between specific and general training. If working for a particular employer makes an employee more productive not only in the service of that employer but also, and equally as much, if employed by someone else, then that employee is said to receive completely general training. If experience gained with the present employer makes the employee more productive for this employer than for other employers, then the experience is said to include specific training. Sometimes training may be specific not to a single employer but to a group of employers, as in a particular industry or geographic region. The distinction between specific and general training is important because it is profitable for employers to invest in specific but not general training. Employers may offer general training, but only if employees are willing to pay for it on a current basis through reduced compensation. It is not profitable to pay employees any more than what they are presently worth to the organization while they are receiving general training because after they are trained they will have to be paid no less than what they are then w o r t h - o t h e r w i s e they will quit for the higher pay they can obtain elsewhere. In contrast, employees who have had specific training will be worth more to the employer who trained them than to other employers. The employer who trained them will therefore be able to pay these specifically trained workers something less than they are worth but more than they can earn elsewhere. This possibility of profit for the employer who provides specific trianing may justify paying the employees more than they are worth during the training period. So while only the employees themselves will find it profitable to invest in general OJT, both employees and employers may invest in specific OJT. B ecker (1964) constructed algebraic models of purely specific and completely general training. He recognized, however, that much on158
Economic Feasibility of On-The-Job Training the-job training in reality is neither completely specific nor completely general. Recent empirical studies have confirmed that employees with more years of work experience generally receive higher pay, b u t the additional pay per year of experience on average is greater if more of the experience has been acquired with the present employer (Chapman and Tan 1980; Duncan and Hoffman 1979). If amount of learning is assumed to be positively related to duration of experience, then these empirical results are consistent with the hypothesis that the monetary p a y o f f from what is learned by working for a particular employer is usually greater if one continues to work for that employer than if one goes to work elsewhere.1 There are exceptions: the existence of professional "head-hunters" depends on the fact that employers, by offering more compensation, sometimes lure e m p l o y e e s - e s p e c i a l l y top managers or technicians who possess some rare and valuable k n o w l e d g e - a w a y from other employers. Exceptionally tight labor markets, as in the late 1960s, also offer unusually large numbers of employees an opportunity to quit and earn more m o n e y with another employer. But evidence from the 1970s shows that even workers who voluntarily quit and go to work for another employer usually receive less pay than those who keep working for the same employer (Black 1980). And workers who are fired or permanently laid off do even worse than those who quit voluntarily. The evidence on h o w earnings are related to work experience and j o b mobility is therefore consistent with the idea that learning on the j o b ordinarily has both specific and general value. Some interesting implications of this idea can be derived from a simple algebraic model, in which time is divided into two periods, present and future. Suppose there is one market interest rate, r, at which anyone can b o r r o w or lend. Let the following denote constant-dollar earnings of a particular individual in different possible jobs: !
w0
= p r e s e n t o r f u t u r e e a r n i n g s i n a j o b w h e r e t h e r e is n o t h i n g f o r a n employee to learn;
w0
= present earnings during the training 2 phase of a job where the e m p l o y e e is e x p e c t e d t o l e a r n s o m e t h i n g ;
1. The observed association between changing employers and lower pay is also consistent with the hypothesis that less successful employees are usually the ones who move (Jovanovic 1979). These two hypotheses are not mutually exclusive. 2. Training m a y consist of pure learning-by-doing, coaching, simulations, formal instruction, or any c o m b i n a t i o n of these. For a discussion of formal and n o n f o r m a l training in manufacturing, see Benson and Lohnes (1959). For an estimate of the extent of formal instruction sponsored by employers, see Smith (1980).
159
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of Education
Review
w I = future earnings on the job where the employee has gone through the training phase and continues working for the same employer; w~ = future earnings if the employee has gone through the training phase but then goes to work for a different employer; and p = probability of staying with the same employer where the training occurred. In this two-period model, all training would be in the present because there would be no time to obtain any p a y o f f from training undertaken in the future. The choice confronting the individual is whether or not to enter a training phase now. If not, then constant-dollar earnings would be the same in the two time periods, and the discounted present value of " l i f e t i m e " earnings would be wo + wo / (1 + r). If training is undertaken now, the expected value of future earnings will be p w 1 + (1 - p ) w ' 1 , because the individual has probability p of staying with the same employer, and probability (1 - p) of going to work for someone else (assumed to be the next highest bidder). The decision to stay or leave may be up to the individual or the employer; this point will be discussed further below. In any event, the present value of lifetime earnings if the person receives training is w 0 + { p w I + ( l - p ) w ~ } / ( 1 + r). The expected net present value of training is therefore: w0 +{pwl = P(wl -
+
t
t
(1-p)w~ } /(1 + r ) - w O - w 0 /(1 +r) t
I
t
w ' a ) / ( l + r ) + (w 1 - W o ) / ( 1 + r ) - ( w O - w O )
= specific payoff + general p a y o f f - cost. The expected net present value of training for the employee consists of three additive components. First is the specific payoff. It is the discounted difference between future earnings obtainable from the employer where training was received and earnings offered by the next highest bidder, multiplied by the probability of staying with the former employer. The second component of the p a y o f f from training is the general component, which is paid to the employee whether the person stays with the same employer or not. This is simply the discounted difference between future earnings obtainable from another employer after training and future earnings after no training. Finally, the third component of the net present value of training is the cost to the trainee, which is w o - w o . This is subtracted from the p a y o f f to the trainee. Direct extension of Becker's argument gives the conditions under which training would be profitable for the employer as well as the 160
Economic
Feasibility of On-The-Job
Training
employee. Let q o stand for the trainee's productivity in the present period, and ql denote future productivity if the trainee continues to work for the same employer. Then the employer's investment in training is w o - q o , and this must be no less than the discounted present value of the employer's expected payoff, which is p ( q l w 1 ) / (1 + r). That is, the employer will offer training only if: wo-qo
< p(q, -wl)/(l
+r)
or, w0 < q O + p ( q l
-Wl)/(l+r).
The employee, similarly, will participate in training only if the expected net present value of training is positive; that is, + ( w 'l - w
w 0' - w 0 < { p ( w , - w x ) '
or,
,
w0 - { P ( w l
-wl)
,
,
(wl
+
o)) / ( l + r )
,
-Wo)}/(l+r)
< w0 •
Putting these two conditions together implies that training will take place only if: LO5 - {/9 (W 1 -Z/J; )+ (ZJ1 - W ; ) } /(1 + r ) ~ ZOo ~ q o + P ( q l -7"01 )/(1 + r).
The expression on the left represents the smallest amount of compensation a trainee would accept in the present period, and the expression on the right is the largest amount the employer will pay during training. There exists some level of compensation for the trainee that makes training worthwhile for both parties only if: w0 -
{
, , p(wa-wl)+(wt-w;)
)
/(1 +r) < q o + p ( q l - W l ) / ( l + r ) .
This condition can be simplified to: (1 + r ) ( w ; - q o
t
) < P ( q l - w ' l ) + (w'l-Wo).
Neither w I nor w o appears in this condition, because this is the necessary and sufficient condition for training to be potentially profitable for both parties. Whether this potential profit exists is a separate question from h o w it is to be shared, which is determined by w o and w I . The statement of the condition for collective profita? bility has a straightforward interpretation: If w o and w'l represent the value of the trainee's time in alternative employments (or in unemployment), then (1 + r) ( w g - q o ) is the minimum desired value in the future of the p a y o f f from the value of time invested in training, w o - q o . The actual p a y o f f has a general component, w'l - w~), and a specific component, p (ql - w~ ). If the actual p a y o f f is at least 161
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as great as the m i n i m u m desired p a y o f f , t h e n there will be some a m o u n t s o f p r e s e n t and f u t u r e c o m p e n s a t i o n , w o and w~, that w o u l d m a k e training p r o f i t a b l e for b o t h e m p l o y e r and e m p l o y e e . It is quite possible, in reality, for training to be p o t e n t i a l l y profitable for b o t h parties, b u t for m i n i m u m wage laws to p r e v e n t the t r a n s a c t i o n f r o m o c c u r r i n g because the e m p l o y e r c a n n o t p r o f i t f r o m the training if the trainee m u s t be paid t o o high a wage. H o w m a n y O J T c o n t r a c t s are in fact p r e c l u d e d b y m i n i m u m wage constraints, even t h o u g h t h e y w o u l d be p r o f i t a b l e to b o t h sides, is an empirical question. M A R K E T - C L E A R I N G AND G L O B A L E F F I C I E N C Y So far, this m o d e l contains no explicit m e c h a n i s m for equating supply and d e m a n d . Is it possible to imagine a m a r k e t - c l e a r i n g m e c h a n i s m t h a t w o u l d p r o d u c e a P a r e t o - o p t i m a l allocation of training? Using Becker's c o n c e p t s , Rosen ( 1 9 7 2 b ) f o r m u l a t e d a m o d e l of the labor m a r k e t in which wage a d j u s t m e n t p r o d u c e d an efficient allocation of resources to training. H o w e v e r , in that m o d e l all O J T was assumed to be p e r f e c t l y general. E m p l o y e r s t h e r e f o r e have a clear incentive to " s e l l " training to e m p l o y e e s . An interesting result is t h e n o b t a i n e d f r o m the fact that e m p l o y e e s t e n d to " b u y " less training w h e n t h e y are older, " s i n c e there is less time available to capitalize f u t u r e returns as r e t i r e m e n t a p p r o a c h e s " ( R o s e n 1972b: 329). C o n s e q u e n t l y . . . an important implication of the analysis is that workers progress through a "hierarchy" of jobs with lesser learning content (and higher pay) over time and as their skill accumulates (p. 333). Some workers will progress through the entire sequence within the firm. If more workers are hired at entry-type jobs than there are spaces for further up the hierarchy, some workers will not be promoted and will seek jobs offering their desired level of (pay and further training) elsewhere (p. 336). In this m o d e l , m o v e m e n t of workers f r o m one firm to a n o t h e r does n o t penalize e m p l o y e r s because e m p l o y e e s have paid the full cost of training. M o b i l i t y also does n o t penalize the e m p l o y e e s because their training is assumed to be p e r f e c t l y general. B u t w h a t if training is specific? R o s e n (1972a) has also f o r m u l a t e d a d y n a m i c m o d e l of a firm in which there is l e a r n i n g - b y - d o i n g . In this m o d e l , the value of on-the-job learning is assumed to be c o m p l e t e l y specific to the firm. If this learning is e m b o d i e d in the era162
Economic Feasibility of On- The-Job Training ployees, as oppose d to the owners, Rosen asserts that " i t is Paretooptimal for all parties, to act as if labor cost is the alternative wage [i.e., the wage employees could obtain elsewhere] in making investment decisions, for such policies provide the largest surplus to be divided among t h e m " (p. 376, note 5, emphasis in original). Rosen does not indicate what the employees should or would actually be paid. But, as Becker pointed out in his original discussion and Rosen acknowledges, the question of how much to pay employees who have received specific training is important because it relates to the risk of turnover and consequent capital losses. The question becomes more complicated when we consider the hypothesis of Baily (1974), Azariadis (1975), and others who have argued that employees accept implicit contracts which expose them to the risk of layoff at times when demand for their labor decreases, but which protect those who remain employed against the risk of wage reductions in low-demand periods. Hashimoto (1975, 1979) has pointed out that employees who have invested in specific training actually should prefer some reduction in wages to being laid off, especially if l a y o f f is permanent. No one has yet produced an analysis of the labor market that shows how these competing desires can be accommodated efficiently. Hall (1980) has recapitulated and refined some of the separate arguments, but he concludes: Much remains to be understood about the failure of macroefficiency in an economy in which individual agents try hard to achieve micro-efficiency in their own employment arrangements (p. 93). Similarly, we must conclude that at present we lack a complete, consistent model to explain how wages, employment, and training could be determined when workers want predictable wages, when the suitability of a person for a particular job may be revealed only after some time (see f o o t n o t e 2), and when OJT has a specific component. Lacking such a model, we cannot tell whether the outcome would be Pareto-optimal in theory, or whether the model itself is consistent with what we observe in reality.
MAKING OJT MORE EFFICIENT Stopped, at least for now, from making global assertions about the efficiency of OJT, we may nevertheless approach the question locally. A n y change that makes training more profitable for some set of employees or employers, or both, without increasing any costs to 163
Economics o f Education Review others, could be considered an improvement in efficiency. The conditions under which OJT will be profitable for employees and employers were stated above. As mentioned earlier, these show the variables that might be altered in a given setting. OJT will become more profitable for employers or employees, or both, if any of the following can be achieved: 1 The productivity of employees during training, qo , is increased. This obviously reduces the real cost of training. 2 The productivity of employees after they are trained, q a , increases. This means a bigger specific p a y o f f from training. 3 The market rate of interest, r, is reduced, thus reducing the opportunity cost of training. 4 The productivity in alternative emph)yment where there is no OJT, Wo, is lower. This "also implies lower opportunity cost of training. 5 The productivity" of employ'ees who are trained but go to work elsewhere, w'l, is increased. This represents a bigger general p a y o f f from OJT. 6 The probability that a trainee will continue to work for the same employer, p, is increased. This improves the specific p a y o f f from training. This last variable may require some further explanation. Why is p ever less than one? The first reason is that some trainees may: not succeed in learning to perform at a satisfactory level in the time available. (In the model here, those who " t ] u n k " the training have to settle for w~ , which gives them credit for having learned at least something. In reality, the result could be worse, as shown in Rosenbaum [1979]). For those who do succeed in learning how to do the work, the second risk is that there may not be enough jobs, due to unexpected slowdowns in business activity, or because an unexpectedly high proportion of trainees completed the training successfully, or because the employer deliberately trained some extra people in order to be able to select the best or to avoid any risk of a shortage of trained people. For any of these reasons or possibly for other reasons, it could turn out that the actual productivity of the employee after training, q l , is less than the agreed-upon post-training wage, w l . Unless this wage can be reduced (see below), the profitseeking employer will dismiss the employee. It is also possible that an employee who successfully completes the training, and whom the employer wants to retain, will become aware of alternative employment that is, unexpectedly, more desir164
E c o n o m i c Feasibility o f O n - T h e - J o b Training
able. The rational employee would then quit and take the more desirable alternative. In short, at the time the training decision is made, the expectation is that q l > Wl > w[. But after the training is done, it may turn out that q l < w l or w 1 < w i , so that either the employer or the employee, respectively, decides to separate.
Efficient Contracting Separation is the collectively rational outcome if ql is so much less than expected, or w~ is so much more than expected, that q l < w~. The employee's time is simply more valuable in a firm other than the one in which he or she was specifically trained. But separation P will be rational for the employer if w 1 > ql > wa, or for the employee if ql > w~ > Wl, even though ql > W~ means the employee is still more productive where he or she is than in the alternative employment. Such separations are n o t collectively rational. Hashimoto and Yu (1980) have provided a careful analysis of conditions under which unilateral, non-optimal separations will occur when expectations are not met. They show that the risk of nonoptimal separations can be reduced ex a n t e by appropriate division of the quasi-rent to the specific human capital (agreement on w o and zo1 ); by prior agreement to use tamper-proof economic indicators to measure productivities after training (that is, objective indicators of ql and w~ ; see also Hall and Lilien [1979]); and by choosing among alternative rules to limit quitting or dismissal (ranging from tenure to indenture). These provisions would make e m p l o y m e n t contracts more efficient by protecting the employer's and employee's shared interest in specific h u m a n capital. But even the most efficient contracts cannot always completely eliminate the risk of non-optimal separation. And there is always the chance that a particular training decision will turn out to have been a mistake, in which case separation becomes the best resolution for both parties.
Training Insurance Therefore, in spite of efficient contracting, there is still some risk of separation after training, so that p < 1, and the present value of the expected gross p a y o f f for the employer who provides training is P ( q l - W l ) / ( 1 + r). But if the employer is averse to risk, then this expected p a y o f f would be considered less valuable than a certain p a y o f f of the same amount. The expected p a y o f f p ( q ~ - w1)/(1 + r) would be considered equally valuable as a riskless p a y o f f of P ( q l w~)/(1 + r) - D R ( p ) , where D R (p) > O is the employer's discount for risk, which is inversely related to p (at least for .5 <_ p < 1). 165
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Similarly, if an employee is risk-averse, the expected p a y o f f from training, { p ( w , - w ; ) + (w; - w o ) } / (1 + r), would be considered equally valuable as a certain p a y o f f of only { p ( w 1 - w'l) + (w; w~) )}/ (1 + r) - De (p), where DE (p) >_ 0 is the employee's discount for risk. Therefore, even if it were true that t
wO - { p ( w l
I
!
t
- W l ) + (Wl - % ) } / ( 1 + r ) < qo +P(ql - w l ) / ( l + r ) ,
it may not be true that 4-
[{p(w, -w',)+ (w; -w;)} /(l + r ) - DE (p)] <_ qo q-/)(ql -Wl)/ (1 + r ) - DR(p).
In other words, even if, on average, the employer and employee could both expect to benefit from training, they might be unwilling to incur the necessary risk. In theory, the risk of training could be further reduced for individuals by pooling risk among trainees, or among employers, or both. There could be a kind of "training insurance," through which winners indemnify losers. Among trainees, losers would be wholly indemnified if, upon leaving the employer who trained them, and having to settle for w[ instead of w l , they were paid an insurance benefit equal to their loss in pay, w I - w [ . If these benefits were financed by collecting a premium of (1 - p ) ( w I - w[)/(1 + r ) f r o m every trainee at the start of training, then all trainees would pay the same premium and obtain the same future earnings. The discounted present value of these future earnings, net of the insurance premium, would be {pw~ + ( 1 - p ) w[}/(1 + r), the same as the discounted present value of expected post-training earnings in the absence of an insurance plan. In other words, a risky investment would become a riskless one with the same expected value, so that risk-averse employees would not be deterred from making an investment from which they can expect to profit. Complete indemnification could also reduce trainees' incentive to work hard since they would have nothing to lose if they flunked the training. To preserve an incentive for trainees, the insurance benefit could be only some fraction of the difference between winners' and losers' earnings, c(w I - w[), where 0 < c < 1. Then actuarial balance would imply a premium of c(1 - p) (w I - w[)/(1 + r) to be collected from all trainees at the start of training. This would leave some risk since winners would again earn more in the future than losers. 166
Economic Feasibility of On-The-Job Training To get a rough idea of how this idea would translate into actual dollars, suppose it takes two years for the average new person on a particular job to become fully proficient. If the annual pay were $10,000 at the outset, suppose it rises to $11,000 (in constant dollars) after the two years of training. But if the employee for some reason had to change employers at the end of the two-year period, the highest annual pay he or she could obtain would be $10,300. These numbers are based on the averages reported by Duncan and H o f f m a n (1979) from the 1976 Panel Study of Income Dynamics. The $700 annual difference, discounted at a real interest rate of 0.05 for the remainder of the employee's working life, has a present value on the order of $10,000. At a real discount rate of 0.1 (more than most households can hope to receive as a return on investment), the loss in pay has a present value on the order of $5,000. Suppose for every employee who left after the two-year period there were three who stayed to reap the benefits of specific training (that is, p = 0.75). For simplicity, also suppose that employees either leave after two years or stay for the rest of their working lives. Then to make every mover just as well off financially as every stayer would require each employee to pay an insurance premium on the order of $600 to $1,200 each year during the two-year training period. Obviously, if movers were only partially compensated, the premium would be correspondingly less. A higher ratio of stayers to movers also implies a lower premium. For instance, if there were nine stayers for every mover (p = 0.9), then the premium required to fully compensate the mover would be $250 to $500 from each trainee each year during the two-year training period. Although these premium payments would reduce the net gain from training for those who stay, the expected value of training, calculated at the start of the two-year period, would be same as in the absence of insurance, because in return for the premium p a y m e n t the risk of moving is reduced or eliminated. Implementation of such a plan would require identification of groups of employees who face similar risk. Presumably, p a y m e n t of insurance benefits to an employee would require the employer to certify that he or she had been terminated. Possibilities for collusion between emi~loyer and employee to defraud the insurance fund, as well as other kinds of moral hazard, would have to be anticipated. The insurance fund would also have to be insulated against cyclical demands; otherwise a severe recession could destroy it. The purpose of training insurance is to compensate employees who are permanently separated from the employers who trained them, not to pro167
Economics of Education Review tect against temporary unemployment. Workers who are laid off subject to recall should n o t be eligible for training insurance benefits. Training insurance could also make it safer for employers to finance some of the cost of specific training. 3 Here implementation would require identifying groups of employers who face similar risks, and presumably benefits would be paid only if an employee certified that he or she had w)luntarily quit. Again problems of collusion and moral hazard would have to be anticipated.
Reducing Losses Due to Temporary Layoffs Training insurance would protect employers or employees against the risk of losing their investment in specific training as a result of permanent separation. Training insurance benefits should not be payable if a layoff is only temporary. But a large proportion of temporary layoffs do become permanent separations (Summers 1980:137). This is the efficient o u t c o m e if the employee continues to be more productive in the new j o b than in the j o b from which that person was laid off. But if the temporary layoff was caused by a temporary reduction in demand, and if the employee would be more productive when recalled to the old j o b than in any alternative job, then permanent separation is not efficient. Although the minority of workers who receive supplemental unemployment benefits to keep their incomes at normal levels while on temporary layoff would not be forced to make an inefficient separation just to meet their current living expenses, many other employees might be forced to do so, and in so doing they would forfeit their investment in specific human capital. One way to prevent this would be to create the option for an employee on temporary layoff to receive training under the employer's auspices, and possibly on the employer's premises, while the employee receives u n e m p l o y m e n t benefits. 4 The training would be designed to enhance the employee's performance when recalled, or even to enhance the employee's prospects for advancement. This would help protect existing investments in specific human capital against temporary reductions in demand. Another way to do this may be job-sharing financed by unemployment insurance. In California, for example, it is now possible for an employer to reduce hours of work for a larger group of employees instead of laying off a 3. Under the East German Ausbildungsplatzfoerderungsgesetz (" Law Fostering Apprenticeship") of 1976, employers in certain industries have set up funds which appear to have a very similar intent (Sadowski 1980). 4. This is similar to the Swedish " 2 5 - k r o n o r system" (Ericsson 1979).
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Economic Feasibility of On-The-Job Training smaller n u m b e r - a n d the employees whose hours are reduced receive u n e m p l o y m e n t benefits. Allowing u n e m p l o y m e n t benefits to be paid to employees who are still working, or who are at the work site as trainees, may tempt employers to use u n e m p l o y m e n t benefits to pay regular wages and salaries. If the experience-rating provisions of une m p l o y m e n t insurance did not provide enough disincentive to deter this, some additional deterrent would have to be created. Implementing these proposals for reducing risk of specific training might produce major efficiency gains or very little. The problems of enforcement and administration might be tremendous or trivial. The most straightforward way to find out would be to conduct field tests. Different models could be tested in different localities. Arguably, the possible social benefit of demonstrating how to achieve efficiency gains would justify allocating some tax revenues to pay for such field tests. Improving the Technology of OJT Direct experimentation would also be required to develop and test improvements in the technology of OJT itself. The lack of recorded, systematic knowledge about general questions like how best to combine formal instruction, simulation, coaching, and pure learning-bydoing makes it apparent that the " t e c h n o l o g y " of OJT has not been developed in any rigorous, purposive way. According to one recent review (Goldstein 1980), there has been virtually no consideration of systems which examine the total job and provide information on which activities should be learned in [off-the-job] training and which activities should be learned on the job. Similarly, no established procedures exist that empirically establish the content validity of a training program based upon a match of relevant tasks on the job and in the training program (p. 234). One current development that might lead to more knowledge in this area is the increasing number of college degree programs that are offering courses where people work, and in some instances are awarding credit for work that is part of the job (Business Week, August 4, 1980). Another development which is providing opportunities to learn more about efficient combinations of on-line and off-line training is the creation of productive enterprises based in schools. Traditionally, such enterprises have been used in vocational education to provide realistic experience for students (Harter 1980). More recently, school-based enterprises have been sponsored by federal programs for e m p l o y m e n t and training of young workers (Corporation 169
Economics of Education Review for Public/Private Ventures 1979). Both school-based enterprises and degree programs in the workplace represent hybrids of educational and productive organization. As such, both are possible sites for research on how to combine formal instruct.ion with on-the-job experience for efficient acquisition of work-related knowledge and skill. More generally, researchers in organizational behavior have begun to map out an ambitious program of research on learning in and by organizations (Staw 1979). Although OJT is usually conceived as a process of acquiring a limited set of skills and knowledge required for c o m p e t e n t performance in a particular job, it can also be conceived as an open-ended process of continual learning, resulting in continually improved performance. On-the-job learning can therefore encompass not only what other people already k n o w - t h e usual meaning of " t r a i n i n g " - b u t also new ideas, techniques, and "tricks" that others may not have discovered. Such open-ended learning is the objective of organizational devices like "quality circles" and Scanlon plans. The idea is to p r o m o t e on-the-job research, aimed at continual improvement in productivity. Whether and how OJT in the narrow sense is, can be, or should be combined with OJT in the broader sense, is a question well b e y o n d the scope of this article. The point here is that opportunities and incentives for on-the-job learning are conditioned b y the structure and ethos of the whole employing organization. What appears as a marginal change in the context of the whole labor market may be a global transformation for a particular employer. CONCLUSION Investment in specific human capital is risky because its value will be lost if a permanent separation occurs between the employer and the specifically trained employee. Recent work by Hashimoto and others has shown h o w an efficient agreement between employer and employee can reduce the risk. This article has suggested how the risk can be further reduced or even eliminated b y some form of training insurance which would pool risks among employees or employers. The net advantage of such arrangements in practice could be measured only b y actual field tests. Actual field studies will also be required if we are ever to see what really goes on inside the "black b o x " of OJT. Much work remains to be done to understand and improve the process of education in workplaces. 170
Economic Feasibility of On-The-Job Training REFERENCES Azariadis, Costas/1975 IMPLICIT CONTRACTS AND U N D E R - E M P L O Y M E N T EQUILIBRIA. Journal o f PoliticalEconomy 83, no. 6 (December): 1 1 8 3 - 1 2 0 2 . Baily, Martin Neil/1974 WAGES AND EMPLOYMENT U N D E R U N C E R T A I N DEMAND. Review of Economic Studies 41, no. 1 or no. 125 ( J a n u a r y ) : 3 7 - 5 0 . Becker, Gary S.[1964 HUMAN CAPITAL. New York: National Bureau of Economic Research. Benson, Charles S., and Paul R. Lohnes]1959 SKILL REQUIREMENTS AND I N D U S T R I A L T R A I N I N G IN D U R A B L E GOODS MANUF A C T U R I N G . Industrial and Labor Releations Review 12, no. 4 (July): 5 4 0 - 5 5 3 . Black, Matthew]1980 PECUNIARY IMPLICATIONS OF ON-TIlE-JOB SEARCH AND QUIT ACTIVITY. Review of Economics and Statistics 62, no. 2 ( M a y ) : 2 2 2 - 2 2 9 . Bowman, Mary J e a n / 1 9 7 9 O U T - O F - S C H O O L F O R M A T I O N OF HUMAN RESOURCES. In Economic Dimensions o f Education, edited by Douglas M. Windham. Washington, D.C.: National A c a d e m y of Education. E A R N I N G AN U N D E R G R A D U A T E DEGREE AT THE PLANT]1980 Business Week (August 4): 7 6 - 7 7 . Chapman, Bruce J., and Hong W. T a n / 1 9 8 0 SPECIFIC T R A I N I N G AND I N T E R - I N D U S T R Y WAGE D I F F E R E N T I A L S IN U.S. MANU F A C T U R I N G . Review o f Economics and Statistics 62, no. 3: 3 7 1 - 3 7 8 . Corporation for Public] Private Ventures (CP] PV) ] 1979 A D I R E C T O R Y OF T R A I N I N G AND EMPLOYMENT PROGRAMS IN THE PRIVATE SECTOR. Philadelphia. Duncan, G r e g J . , and Saul H o f f m a n / 1 9 7 9 O N - T H E - J O B T R A I N I N G AND EARNINGS D I F F E R E N C E S BY RACE AND SEX. Review of Economics and Statistics 61, no. 4 (November): 5 9 4 - 6 0 3 . Ericsson, Bo A./1979 THE EMPLOYMENT SITUATION IN SWEDEN: SOME MAIN ISSUES LOOKING AHEAD TO THE 1980S. Swedish Information Service: Election Year "79, no. 2 (June). New York: Swedish Consulate General. Gay, Robert S., and Michael Borus]1980 V A L I D A T I N G P E R F O R M A N C E INDICATORS FOR EMPLOYMENT AND T R A I N I N G PROGRAMS. Journal o f Human Resources 15, no. 1: 2 9 - 4 7 . Goldstein, Irwin L./1980 T R A I N I N G IN WORK O R G A N I Z A T I O N S . Annual Reviews o f Psychology 31: 2 2 9 - 2 7 2 .
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Economics of Education Review G u s t m a n , Alan L., and T h o m a s L. Steinmeier/1980 L A B O R MARKETS AND E V A L U A T I O N OF V O C A T I O N A L T R A I N I N G PROGRAMS IN THE PUBLIC HIGH S C H O O L S - - T O W A R D A F R A M E W O R K FOR ANALYSIS. Hanover, N.H.: D a r t m o u t h College. Hall, Robert E./1980 EMPLOYMENT F L U C T U A T I O N S AND WAGE RIGIDITY. Brookings Papers on EconomicActivity, no. 1 : 9 1 - 1 2 3 . Hall, Robert E., and David M. Lilien/1979 EFFICIENT WAGE BARGAINS U N D E R U N C E R T A I N SUPPLY AND DEMAND. American Economic Review 69, no. 5: 8 6 8 - 8 7 9 . Harter, J o h n , David Stern, and T h o m a s Strano/1980 ENTERPRISES F O R LEARNING. Albany, CA.
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Economic Feasibility of On-The-Job Training Rosen, Sherwin/1972b L E A R N I N G BY EXPERIENCE AS J O I N T PRODUCTION. Quarterly Journal of Economics 86, no. 3. ( A u g u s t ) : 3 6 6 - 3 8 2 . R o s e n b a u m , James] 1979 T O U R N A M E N T MOBILITY: C A R E E R PATTERNS IN A CORPORATION. Administrative Sciences Quarterly 24 (June): 2 2 0 - 2 4 1 . Sadowski, Dieter/1980 FINANCE AND G O V E R N A N C E OF THE GERMAN APPRENTICESHIP SYSTEM: SOME CONSIDERATIONS ON M A R K E T F A I L U R E AND ITS EFFICIENT CORRECTIONS. Stanford University: Institute for Research on Educational Finance and Governance. Smith, G. G.]1980 E M P L O Y E R - S P O N S O R E D R E C U R R E N T EDUCATION IN THE UNITED STATES: A R E P O R T ON RECENT INQUIRIES INTO ITS S T R U C T U R E . Washington, D.C.: National Institute for Work and Learning. Staw, Barry M., ed./1979 R E S E A R C H IN O R G A N I Z A T I O N A L BEHAVIOR. Greenwish, CT: JAI Press. Summers, Lawrence H./1980 COMMENTS ON H A L L Brookings Papers on Economic Activity, no. 1: 1 3 3 - 1 3 9 . T h u r o w , Lester]1975 G E N E R A T I N G INEQUALITY. New York: Basic Books.
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