Some Human Capital Controversies and Meditations

Some Human Capital Controversies and Meditations

Some Human Capital Controversies and Meditations

The idea that job skills and experience can be viewed as an investment in future production–with the costs occurring in the present and a stream of payoffs going into the future–is an idea that goes back a long way.

For example, when Adam Smith was writing in The Wealth of Nations back in 1776 about types of “fixed capital” in an economy (in Book II, Ch. 1), he offers four categories: “machines and instruments of trade,” “profitable buildings,” “improvements of land,” and a fourth category made up

. . of the acquired and useful abilities of all the inhabitants or members of the society. The acquisition of such talents, by the maintenance of the acquirer during his education, study, or apprenticeship, always costs a real expense, which is a capital fixed and realized, as it were, in his person. Those talents, as they make a part of his fortune, so do they likewise of that of the society to which he belongs. The improved dexterity of a workman may be considered in the same light as a machine or instrument of trade which facilitates and abridges labour, and which, though it costs a certain expense, repays that expense with a profit.

The concept wasn’t new to Adam Smith, and wasn’t neglected by other economists of that time, either. For example, B.F. Kiker wrote about “The Historical Roots of the Concept of Human Capital” back in the October 1966 issue of the Journal of Political Economy and offers numerous examples of discussing what we now call “human capital” from the late 17th century up through Adam Smith and up to modern times. As Kiker pointed out:

Several motives for treating human beings as capital and valuing them in money terms have been found: (1) to demonstrate the power of a nation; (2) to determine the economic effects of education, health investment, and migration; (3) to propose tax schemes believed to be more equitable than existing ones; (4) to determine the total cost of war; (5) to awaken the public to the need for life and health conservation and the significance of the economic life of an individual to his family and country; and (6) to aid courts and compensation boards in making fair decisions in cases dealing with compensation for personal injury and death.

However, the terminology of “human capital” has been the source of various overlapping controversies. Putting a monetary value on people is in some cases necessary for certain practical kinds of decision-making. For example, a court making a decision about damages in a wrongful death case cannot just throw up its hands and say that “putting a monetary value on a person is impossible,” nor can it reasonably say that a human life is so precious that it is worth, say, the entire GDP of a country. But in making these practical decisions, it’s important to remember that estimating the economic value produced by a person is not intended to swallow up and include all the ways in which people matter. When a more formal economic analysis of “human capital” was taking off in the early 1960s, Theodore W. Schultz delivered a Presidential Address to the American Economic Association on this subject (“Investment in Human Capital,” American Economic Review, March 1961, pp. 1-17). He sought to explain the concerns over the terminology of “human capital” in this way:

Economists have long known that people are an important part of the wealth of nations. Measured by what labor contributes to output, the productive capacity of human beings is now vastly larger than all other forms of wealth taken together. What economists have not stressed is the simple truth that people invest in themselves and that these investments are very large. Although economists are seldom timid in entering into abstract analysis and are often proud of being impractical, they have not been bold in coming to grips with this form of investment. Whenever they come even close, they proceed gingerly as if they were stepping into deep water. No doubt there are reasons for being wary. Deep-seated moral and philosophical issues are ever present. Free men are first and foremost the end to be served by economic endeavor; they are not property or marketable assets. And not least, it has been all too convenient in marginal productivity analysis to treat labor as if it were a unique bundle of innate abilities that are wholly free of capital.

The mere thought of investment in human beings is offensive to some among us. Our values and beliefs inhibit us from looking upon human beings as capital goods, except in slavery, and this we abhor. We are not unaffected by the long struggle to rid society of indentured service and to evolve political and legal institutions to keep men free from bondage. These are achievements that we prize highly. Hence, to treat human beings as wealth that can be augmented by investment runs counter to deeply held values. It seems to reduce man once again to a mere material component, to something akin to property. And for man to look upon himself as a capital good, even if it did not impair his
freedom, may seem to debase him. No less a person than J. S. Mill at one time insisted that the people of a country should not be looked upon as wealth because wealth existed only for the sake of people [15]. But surely Mill was wrong; there is nothing in the concept of human wealth contrary to his idea that it exists only for the advantage of people. By investing in themselves, people can enlarge the range of choice available to them. It is one way free men can enhance their welfare. …

Yet the main stream of thought has held that it is neither appropriate nor practical to apply the concept of capital to human beings. Marshall [11], whose great prestige goes far to explain why this view was accepted, held that while human beings are incontestably capital from an abstract and mathematical point of view, it would be out of touch with the market place to treat them as capital in practical analyses. Investment in human beings has accordingly seldom been incorporated in the formal core of economics, even though many economists, including Marshall, have seen its relevance at one point or another in what they have written.

The failure to treat human resources explicitly as a form of capital, as a produced means of production, as the product of investment, has fostered the retention of the classical notion of labor as a capacity to do manual work requiring little knowledge and skill, a capacity with which, according to this notion, laborers are endowed about equally. This notion of labor was wrong in the classical period and it is patently wrong now. Counting individuals who can and want to work and treating such a count as a measure of the quantity of an economic factor is no more meaningful than it would be to count the number of all manner of machines to determine their economic importance either as a stock of capital or as a flow of productive services.

Laborers have become capitalists not from a diffusion of the ownership of corporation stocks, as folklore would have it, but from the acquisition of knowledge and skill that have economic value [9]. This knowledge and skill are in great part the product of investment and, combined with other human investment, predominantly account for the productive superiority of the technically advanced countries. To omit them in studying economic growth is like trying to explain Soviet ideology without Marx.

As Schultz mentions, it has been a convenient analytical device for a long time now to divide up the factors of production into “capital” and “labor,” with capital owned by investors. The idea of “human capital” scrambles these simple categories and leads to various logical fallacies: for example, if capitalists own capital, and “human capital” exists, then aren’t economists claiming that capitalists own humans, too? Such strained verbal connections miss the basic reality that what differentiates high-income and low-income countries is not primarily the quantity of physical capital investment, but rather the skills and capabilities of the workers. If you wish to explain growth of economic production or differences in production around the world, discussing how these skills and capabilities can be enhanced and how they affect economic production is not an avoidable question.

The Summer 2022 issue of the Journal of Economic Perspectives (where I work as Managing Editor) includes a short two-paper symposium on human capital. Katharine G. Abraham and Justine Mallatt discuss the methods of  “Measuring Human Capital” (pp. 103-30). As Kiker noted back in his 1966 essay:

Basically, two methods have been used to estimate the value of human beings: the cost-of-production and the capitalized-earnings procedures. The former procedure consists of estimating the real costs (usually net of maintenance) incurred in “producing” a human being; the latter consists of estimating the present value of an individual’s future income stream (either net or gross of maintenance).

Abraham and Mallett discuss the current efforts to carry out these kinds of calculations. Both approaches present considerable difficulties. For example, it’s possible to add up spending per student on education, adjust for inflation, make some assumptions about how the human capital created by education depreciates over time, and build up a cost-based approach to estimating human capital. But obvious questions arise about how to adjust for the quality of education received, or whether to include other aspects of human capital, including physical health or on-the-job training.

Similarly, it’s possible to start with the idea that workers with more education, on average, get paid more, and then work backwards into an extended calculation of what their earlier education must have been worth, if it resulted in this higher pay level. Doing this calculation across generations with very different education and work outcomes places a lot of stress on the available data and requires copious assumptions on issues like how to treat those who may still be completing their education, along with estimates of future growth in wages and how best to discount these future values back to a single present value. It turns out that estimates of human capital based on the income received from education are often 10 times larger than estimates of human capital based on the costs of providing that education–which suggests that further research that clarifies the parades of underlying assumption is needed.

In the other JEP paper, David J. Deming discussed the state of the evidence on “Four Facts about Human Capital” pp. (75-102). He writes:

This paper synthesizes what we have learned about human capital … into four stylized facts. First, human capital explains a substantial share of the variation in labor earnings within and across countries. Second, human capital investments have high economic returns throughout childhood and young adulthood. Third, the technology for producing foundational skills such as numeracy and literacy is well understood, and resources are the main constraint. Fourth, higher-order skills such as problem-solving and teamwork are increasingly economically valuable, and the technology for producing them is not well understood. We have made substantial progress toward validating the empirical predictions of human capital theory. We know how to improve foundational skills like numeracy and literacy, and we know that investment in these skills pays off in adulthood. However, we have made much less progress on understanding the human capital production function itself. While we know that higher-order skills “matter” and are an important element of human capital, we do not know why.

In my own mind, the essays make a compelling case that understanding human capital is of central importance for understanding many aspects of the economy. Maybe a different label than “human capital” would be more rhetorically pleasing: I certainly would not claim that the economic profession has been especially graceful or sensitive in its framing and nomenclature. But it is a striking fact that no country with broadly high levels of educational human capital is also a low-income country. When I think about the importance of human capital for entrepreneurialism and innovation that can address major problems, I sometimes find myself saying that “in the long run, a country’s economic future is all about its human capital.”

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Timothy Taylor

Global Economy Expert

Timothy Taylor is an American economist. He is managing editor of the Journal of Economic Perspectives, a quarterly academic journal produced at Macalester College and published by the American Economic Association. Taylor received his Bachelor of Arts degree from Haverford College and a master's degree in economics from Stanford University. At Stanford, he was winner of the award for excellent teaching in a large class (more than 30 students) given by the Associated Students of Stanford University. At Minnesota, he was named a Distinguished Lecturer by the Department of Economics and voted Teacher of the Year by the master's degree students at the Hubert H. Humphrey Institute of Public Affairs. Taylor has been a guest speaker for groups of teachers of high school economics, visiting diplomats from eastern Europe, talk-radio shows, and community groups. From 1989 to 1997, Professor Taylor wrote an economics opinion column for the San Jose Mercury-News. He has published multiple lectures on economics through The Teaching Company. With Rudolph Penner and Isabel Sawhill, he is co-author of Updating America's Social Contract (2000), whose first chapter provided an early radical centrist perspective, "An Agenda for the Radical Middle". Taylor is also the author of The Instant Economist: Everything You Need to Know About How the Economy Works, published by the Penguin Group in 2012. The fourth edition of Taylor's Principles of Economics textbook was published by Textbook Media in 2017.

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