Uncertainty in Human Capital Investment and Earnings Dynamics

This paper provides a human capital theory‐based explanation for the presence of a permanent component in earnings levels as well as individual heterogeneity in earnings slopes. We incorporate uncertainty about the future rental rates of human capital into a life‐cycle human capital investment model and obtain an earnings equation implied by the solution to the worker's optimal investment decision. While heterogeneous growth stems from individual heterogeneity in the ability of human capital production, permanent errors are induced by the response of optimal investments to transitory rental rate shocks. We empirically show that both components are present.