Identifying Human Capital Externality: Evidence from China

Using data from two well-known individual surveys in China, we estimate human capital externality. We find a positive and statistically significant effect of city-level human capital on individual earnings. Fixed-effects estimates show a one-year increase in city average education could increase individual earnings between 7.3% and 8.9%. Our IV estimate indicates a 7.6% increase. This finding confirms a long-held belief by economists that there are external benefits of education that are not captured by the individuals who invested in human capital. By extension our finding also offers a justification for an active role of the government in promoting education. We also find that the estimated effect of human capital externality is larger in coastal cities than in non-coastal cities and is larger in the non-state sector than in the state sector. We ascribe these heterogeneities to differences in institutional and technological environments across cities and sectors.