Real Options and Human Capital Investment

This paper extends the standard human capital model with real options. Real options influenceinvestment behavior when risky investments in human capital are irreversible and individualscan affect the timing of the investment. Option values make individuals more reluctant toinvest in human capital and, as a result, required returns on the investment increase. Realoptions may help to explain a larger human capital premium for higher education, smallerresponsiveness of higher education investments to financial incentives, and larger sensitivityof higher education to low-return outcomes and human capital risks. Higher tax rates (orlower subsidies) depress human capital investments, but to a lesser extent than in the standardhuman capital model. A flat income tax remains neutral if education expenditures are fullydeductible.