Human Capital

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Human Capital

According to marginal analysis, each factor of production is paid according to its contribution to production, and the market constitutes a mechanism that establishes a moral rule of distributive justice in the society. This theory of marginal productivity was put forth around the turn of the twentieth century by the American economist John Bates Clark (1847–1938). In the neoclassical analysis of the labor market, the equilibrium wage is set at the point of intersection of the demand and supply curves of labor. The level of the equilibrium wage set by the intersection of the two curves guides the allocation of workers across firms in such a way that an efficient allocation of resources is achieved. The implication is that wages are equal to the value of the marginal product of labor, which is the same for all workers and every firm. To achieve this condition, firms and workers should operate in a perfectly competitive environment, anonymity for both sides should be present, and the allocation of labor to firms should be random. However, wage differentials are present in the labor market, and several attempts have been made to explain the reasons for these wage differentials.

Adam Smith (1723–1790) was the first economist to introduce the idea of wage differentials and attempt to offer reasons for its existence. According to Smith, one reason for wage differentials is the common idea that wages vary positively, everything else being held constant, with the disutility of labor. This argument was later formalized by William Stanley Jevons (1835–1882) and states that an individual is willing to offer more labor input only if the wage is higher; this is because leisure time gets scarcer and thus becomes more valuable to an individual. Another reason for relative wage differentials put forward by Smith is related to the concept of human capital, which has been introduced only recently into economic analysis. According to Smith, the cost of a person’s education or training can be viewed as an investment in the individual’s future earnings capacity, analogous to an investment in physical capital. To be economically justified, this investment must be recuperated over the lifetime of the student or trainee. Thus, those with education or training will generally earn more than those without. In recent years, this interpretation of wage differentials has given rise to numerous attempts to measure the rate of return on investment in education and training. In general, these efforts have sought to check whether such investments in education and training do, in fact, earn normal profits for an equally valuable capital.

Neoclassical theory has never abandoned the idea that wages tend to equal the net product of labor; in other words, the marginal productivity of labor rules the determination of wages. However, it has also been recognized that wages tend to retain an intricate, although indirect, relationship with the cost of rearing, training, and sustaining the energy of efficient labor. All these factors cause wage differentials, and they make up what is known as human capital in economic literature. Human capital, in mainstream economics, is similar to the physical means of production—for example, factories and machines—and is defined as the knowledge and skills possessed by the workforce that can be accumulated. Human capital, therefore, is a stock of assets that one owns and that allows one to receive a flow of income, similar to interest earned. In modern times, human capital is largely a product of education, training, and experience. Within this approach, investment in human capital is treated similarly to investment in physical capital and is considered, in many cases, as a principal factor for the observed differences in developmental levels between nations. It is argued that investment in human capital can take various forms, including improvements in health services, formal education, and training of employees, and it can help eliminate blockages in productivity enhancements. It is worth clarifying that the acquisition of more human capital is not related to the number in the workforce but to the improvement of labor services and the concomitant increase in labor productivity.

Today, new growth theorists put a lot of emphasis on human capital: “The main engine of growth is the accumulation of human capital—or knowledge—and the main source of differences in living standards among nations is a difference in human capital. Physical capital plays an essential but decidedly subsidiary role. Human capital takes place in schools, in research organizations, and in the course of producing goods and engaging in trade” (Lucas 1993, p. 270). Within this framework, a lot of emphasis is given to the policies promoting human capital, such as investment in education or health. More than that, according to the economists Theodore W. Schultz (1902–1998) and Anthony P. Thirlwall, it is argued that differences in the quality of human capital are the cause of the different levels of development among nations and that the improvement of human capital might reduce the need for physical capital.

In addition, literature about organizational behavior and human resource management has emphasized the role of human capital in promoting the development and implementation of national and corporate strategies. Hence, human capital is a very important asset and may serve as a useful link in the chain between employee and business performance; moreover, human capital, human-resources practices, and firm performance are areas that need to be explored together to design better corporate strategies.

MINCER’S WAGE EQUATIONS

Modern human capital theory was initiated by the work of Jacob Mincer, in which investment in human resources is considered similarly to other types of investments. In Mincer’s first model (1958), individuals are assumed to be identical prior to any training, thereby forcing a differential wage to employment based on the length of the expected training period. The size of the compensating differential is determined by equating the present value of the future net earnings stream (gross earnings minus costs) with the different levels of investment. The formal presentation of Mincer’s first simple model is:

lnw (s ) = lnw (0) + rs

where lnw (s ) represents the log of the annual earnings of an individual with s years of education, lnw (0) represents the log of the annual earnings of an individual with basic years of education, and r is the internal rate of return to schooling years s. According to the above equation, individuals with more training receive higher earnings. The difference between earning levels of individuals with different years of schooling is determined by the second term of the right-hand side of the equation. If one defines the internal rate of return to schooling as the discount rate that equates the lifetime earnings stream for different educational choices, then the internal rate of return to schooling can be estimated by the coefficient on years of schooling. This simple framework offers a number of interesting implications. However, the whole analysis relies on some unrealistic assumptions, which can be summarized as follows:

the individuals are all identical prior to making choices;
the age of retirement does not depend on years of schooling;
the only cost of schooling is foregone earnings;
earnings do not vary over the life cycle; and
there is no post-school on-the-job investment.

Mincer’s second model (1974) allows for the on-the-job investment and yields an earnings specification that is similar to the first. To establish the relationship between potential earnings and years of labor-market experience, assuming that observed earnings are equal to potential earnings less investment cost, the following relationship for observed earnings is produced:

lnw (sx ) = a ₀ + ρ_s s + β ₀ x + β ₁ x ²

where lnw (sx ) stands for the observed earnings, x is the amount of work experience, ρ_s is the rate of return on formal schooling, and s represents the years of education. The intercept term is the product of the log skill price and the initial ability of the individual. The coefficients β ₀ and β ₁ stand for the return to experience.

This second expression is called Mincer’s standard wage equation, which regresses the log earnings on a constant term, on a linear term of the years of schooling, and on a quadratic term of the labor-market experience. Mincer’s standard wage equation transforms a normal distribution of years of schooling into a log-normal distribution of earnings. Under the assumption that post-school investment patterns are identical across individuals and do not depend on the schooling level, Mincer shows that there is an important distinction between age-earnings profiles and experience-earnings profiles, where experience means years since leaving school. More specifically, he shows that the log-earnings-experience profiles are parallel across schooling levels and that log-earnings-age profiles diverge with age across schooling levels.

By the early 1970s, the estimation of the returns on schooling using Mincerian wage regressions had become one of the most widely analyzed topics in applied econometrics. The reason is that the human-capital earning function has several distinct characteristics that make it particularly attractive:

the functional form is not arbitrary, and the identity is based on the optimizing behavior of individuals as captured by the outcome of the labor-market process;
it converts immeasurables (the dollar cost of investment in human capital) into measurables (years of schooling and years of labor-market experience);
it can include instrumental variables to capture a dichotomous variable describing some characteristics such as race or sex; and
the coefficients of the regression equation may be attributed with economic interpretations.

While the human-capital literature has now been generalized to incorporate on-the-job training, it should be noted that the Mincerian wage regression equation is a representation of the statistical relationship between wages and experience (given schooling) for an exogenously determined rate of on-the-job training. The Mincerian wage regression disregards the endogeneity of post-schooling human-capital accumulation and treats schooling and training symmetrically. More precisely, Mincer’s approach ignores the possibility that schooling may change the human-capital accumulation process that takes place on the job.

THUROW’S JOB-COMPETITION MODEL

C. Lester Thurow’s job-competition model serves as an interesting counterpoint to the traditional models in explaining the distribution of earnings. In his book Generating Inequality: Mechanisms of Distribution in the U.S. Economy (1975), Thurow shows that for the period 1950–1970, changes in the educational attainments of white males 25 to 64 years old did not affect their earnings. He finds that educational distribution is equalized through the years while income distribution is not, and he notes that the expected arguments and results from marginal productivity are not fulfilled. To explain the distribution of wage earnings, Thurow rejects market imperfections as a possible explanation of unexpected observations in labor markets. In fact, he argues that individuals compete against one another for job opportunities based on their relative costs of being trained to fill a job position instead of based on wages they are willing to accept. He argues that wages are based on the marginal productivity of the job, not of the worker. Workers who compete for jobs offered at fixed wages determine the labor supply, and workers compete for relative positions based upon their training costs to employers rather than on wages. Hence, job competition prompts people to overinvest in formal education for purely defensive reasons. Moreover, technology, the sociology of wage determination, and the distribution of training costs determine the distribution of job opportunities.

Even though the advantages of education are frequently exaggerated in terms of their strictly economic results, there is no doubt that education is advantageous in earning a higher income and also teaches general skills that improve the quality of labor and, by extension, human capital. However, recent literature on issues related to human capital stresses the need to consider other dimensions of human identity that contribute to the formation of human capital. In fact, modern labor economics has criticized the simple approach that tries to explain all differences in wages and salaries in terms of human capital as a function of knowledge, skills, and education. The reason is that the concept of human capital can be infinitely elastic, including unmeasurable variables such as culture, personal character, or family ties. Many other factors, therefore, may contribute to wage differentials, such as gender or race. The existence of imperfections in labor markets implies mostly the existence of segmentation in labor that causes the return on human capital to differ between different labor-market segments. Similarly, discrimination against minority or female employees implies different rates of return on human capital. Most of these studies in their wage equations use the technique of instrumental (or dummy) variables to introduce specific characteristics of the labor segmentation that takes place. The statistical significance of these instrumental variables indicates their importance in forming human capital and the concomitant wage differentials. In addition, over the past few decades several writers, including Rhonda Williams (1991) and Howard Botwinick (1993), have begun to develop alternative approaches to the analysis of discrimination and wage differentials that are based on a more classical analysis of capitalist competition and accumulation.

HUMAN CAPITAL AND RELATED FIELDS

The theoretical discussion about the meaning of human capital is vast and extends into the fields of human development and human resource management. For instance, human-development literature often distinguishes between specific and general human capital, where the first refers to specific skills or knowledge that is useful only to a single employer, while the second refers to general skills, such as literacy, that are useful to all employers. Human-development theories also differentiate social trust (social capital), sharable knowledge (instructional capital), and individual leadership and creativity (individual capital) as three distinct forms of human participation in economic activity.

Indisputably, the term human capital is used everywhere in economic and business analysis in which labor has to count as an input in the production process. The term has gradually replaced terms such as laborer, labor force, and labor power in the relevant analysis, giving an impression that these traditional terms are socially degraded. Moreover, in the strict sense of the term, human capital is not really capital at all. The term was originally used as an illustrative analogy between, on the one hand, investing resources to increase the stock of ordinary physical capital (such as tools, machines, or buildings) in order to increase the productivity of labor and, on the other hand, investing in educating or training the labor force as an alternative way of accomplishing the same general economic objective. In both sorts of investment, investors incur costs in the present with the expectation of deriving future benefits over time. However, the analogy between human capital and physical capital breaks down in one important and very crucial respect. Property rights over ordinary physical capital are readily transferable by sale, whereas human capital itself cannot be directly bought and sold on the market. Human capital is inseparably embedded in the nervous system of a specific individual and thus it cannot be separately owned. Hence, at least in regimes that ban slavery and indentured servitude, the analogy between human capital and physical capital breaks down.

BIBLIOGRAPHY

Botwinick, Howard. 1993. Persistent Inequalities: Wage Disparity under Capitalist Competition. Princeton, NJ: Princeton University Press.

Gintis, Herbert, Samuel Bowles, and Melissa Osborne. 2001. The Determinants of Individual Earnings: Skills, Preferences, and Schooling. Journal of Economic Literature 39 (4): 1137–1176.

Lucas, Robert E., Jr. 1993. Making a Miracle. Econometrica 61: 251–272.

Mincer, Jacob. 1958. Investment in Human Capital and Personal Income Distribution. Journal of Political Economy 66 (4): 281–302.

Mincer, Jacob. 1974. Schooling, Experience and Earnings. New York: National Bureau of Economic Research.

Schultz, Theodore W. 1962. Reflections on Investment in Man. Journal of Political Economy 70: 1–8.

Thirlwall, Anthony P. 1999. Growth and Development. London: Macmillan.

Thurow, C. Lester. 1975. Generating Inequality: Mechanisms of Distribution in the U.S. Economy. New York: Basic Books.

Williams, Rhonda. 1991. Competition, Discrimination and Differential Wage Rates: On the Continued Relevance of Marxian Theory to the Analysis of Earnings and Employment Inequality. In New Approaches to Economic and Social Analyses of Discrimination, eds. Richard R. Cornwall and Phanindra V. Wunnava. New York: Praeger.

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International Encyclopedia of the Social Sciences