Unlock growth by understanding human capital. Explore its introduction, impact on economic development, and the true cost of investing in your workforce.
Human Capital: Introduction, Economic Development, and Cost
A clear introduction to human capital. Understand its role in economic development, the costs involved, and how to maximize its value for success.
1. Introduction to Human Capital
Human capital is the value embodied in people through education and health, which increases their productivity. It includes the knowledge, skills, health, and capacities of all people in a society to undertake production.
Unlike physical capital, which consists of produced means of production (like machines), human capital is inseparable from human beings. Both physical and human capital accumulation require investment for economic development. Investment in human capital is often referred to as ‘investment in man’.
Education is crucial for a country’s ability to adopt modern technology and achieve self-sustained growth. Similarly, good health is essential for increasing labor productivity, which boosts private incomes and contributes to GDP growth. Economists like Todaro and Smith view both health and education as vital components and inputs to the aggregate production function, giving them central importance in economic development.
While physical capital was traditionally considered the most important factor for economic growth, recent research has highlighted the significant role of human capital. The quantitative expansion and qualitative improvement of education and training are key to economic development. As Prof. Harbison stated, human resources are the ultimate basis of production, and a country unable to develop its people’s skills and knowledge will be unable to develop anything else.
2. Human Capital and Economic Development
A country’s Gross Domestic Product (GDP) depends not only on the amount of labor used but also on its productivity. A major determinant of worker productivity is human capital, acquired through education and training (e.g., primary, secondary, professional education). Accumulation of human capital is thus termed investment in people.
Individuals, like firms investing in physical capital, invest in their own human capital (education and skills) to raise their productivity and future earnings. Investment in human capital allows individuals to raise their wages, as evidenced by higher rates of return on secondary education in the United States. Prof. Amartya Sen highlights that better education enhances labor’s capabilities and functionings, and a low level of education can hinder GDP growth due to a shortage of appropriately skilled labor.
Empirical evidence suggests that countries with greater investment in education (measured by average years of schooling) tend to have higher growth rates. Furthermore, higher technical education fosters technological progress through new inventions and innovations.
Human capital shares several similarities with physical capital:
- Both increase a country’s ability to produce more goods and services.
- Both are produced factors of production, requiring investment in inputs (e.g., student time, teachers, books for human capital).
- Both increase worker productivity, leading to higher wages.
- Both require sacrificing some present consumption for greater future consumption.
3. Cost of Human Capital or of Acquiring Skills
The most significant cost of acquiring human capital (education or skills) is the opportunity cost: the income or wages forgone by spending time in school, college, or university instead of working. This delay in entering the labor force is a sacrifice of present consumption made with the expectation of higher future earnings due to increased productivity. This represents a trade-off between less consumption today and more consumption in the future.
The decision to invest in human capital is an expenditure of resources at one point in time to raise future productivity. It is called human capital because the investment is tied to a specific person.
The difference in wages between those with more education and those with less education is substantial and growing. For example, US college graduates earn about twice as much as high school graduates, and this gap is often larger in developing countries where educated workers are scarcer.
Illustration of Human Capital Investment
The investment in education involves a trade-off between consumption in youth and consumption in later working years (adulthood). Individuals forgo present consumption (e.g., by attending computer programming classes instead of working) to enhance their future productivity and earning capacity.
This process is subject to diminishing marginal returns, meaning each extra hour of class provides a successively smaller increase in earning ability. An individual chooses the optimal level of investment (point E on the production possibility curve) based on their preference for present versus future consumption. The sacrifice of consumption in youth leads to a much larger increase in consumption during adulthood due to higher earnings from human capital.
Return on Investment in Education
Studies, including those by the World Bank, suggest that the economic returns on investment in education are often higher than in alternative investments, particularly physical capital. Private returns to education at all three levels (primary, secondary, higher) are consistently found to be higher in developing countries (Sub-Saharan Africa, Asia, Latin America) than in developed OECD countries, as shown in the work of George Psacharopoulos. Generally, the private return on education tends to fall as the level of development increases. Additionally, there are social returns to education, which include externalities not accounted for in private calculations.
Education and Sources of Economic Growth
The supply of human capital is a crucial driver of economic growth. Edward F. Denison’s study (1929-1969) in the United States showed that the most important source of economic growth was advances in knowledge (31.1% to 34%), resulting from increased education and R&D. Increased labor quantity contributed about 28.7%, while the accumulation of physical capital contributed only 15.8% to 21.6%. Increased education contributed 14.1%. If the contributions of increased education and advances in knowledge are combined, they account for about 45% of growth, highlighting the significant role of human capital.
4. Measuring Contribution of Education to Economic Growth
Measuring the contribution of education to economic growth is complex, as it is difficult to separate the ‘economic’ (growth-promoting) investments from ‘social’ investments or to quantify the consumption and non-monetary benefits. Economists have developed several approaches based on economic criteria:
1. The Residual Approach or Production Function Approach
This method estimates the portion of GDP growth attributable to education by subtracting the growth explained by measurable inputs (physical labor and capital) from the total GDP growth. The remaining ‘residue’ represents the increase due to improvements in labor quality (education) and technological change.
- Solow’s Estimate (1909-1949, USA): Attributed 57.5% of the growth in output per man-hour to the residual factor (technological change and improvement in labor quality/education).
- Denison’s Refinement (1929-1982, USA): Separated elements of the residual. Found that of the growth in output per worker: 28% was due to technological change, 19% to capital formation, and 14% to education per worker. Combined, education and technological progress made a 42% contribution.
Limitations:
- Estimates are based on formal education, ignoring on-the-job training.
- They primarily measure private return, underestimating the social contribution (mobility, adaptability, applied technology).
- The residual factor may include some capital assets due to the interrelation between capital, technology, and knowledge.
- Ignores differences in the quality or content of education.
2. Rate of Return Approach
This approach calculates the rate of return from an individual’s expenditure on education and the resulting flow of expected future earnings, using an appropriate discount rate. It has been used to estimate private returns to individuals.
- Gary S. Becker’s Estimate (USA): Showed rates of return on college education for urban white population were 12.5% in 1940 and 10% in 1950.
- E.F. Reneshaw’s Estimate (USA): Found an average return on education between 5% and 10% for the period 1900 to 1950.
Limitations:
- Assumes earnings differentials reflect productivity differences, which may be distorted by factors like trade unionism.
- Ignores the consumption component of education (direct satisfaction/future utilities), thus underestimating returns.
- Fails to account for other factors influencing earning capacity (e.g., on-the-job training, experience, natural ability, family background).
- Concentrates on private rates of return, making it difficult to estimate social returns.
- Does not apply well where educational costs are negligible (e.g., free schools).
3. Schultz Approach – Comparing Expenditure on Education with Income Earned
Schultz analyzed the relationship between expenditure on education and consumer income, as well as physical capital formation in the United States (1900–1956). He found that resources allocated to education rose about 3.5 times relative to consumer income and physical capital formation. This suggested that, as an investment, education was about 3.5 times more attractive than physical capital. This method only indirectly reflects the contribution of education to economic growth.
Beyond the investment benefits (increased productivity and earnings), education yields: Stimulating technological change through research (especially higher education), which raises productivity for the entire society. Denison’s “residual” is largely attributed to this external benefit of education-stimulated advances in knowledge.
- Consumption Benefits: The enjoyment and satisfaction derived from being educated (e.g., reading, communicating, making informed choices). Economic theory suggests the price paid reflects the marginal value, but objective measurement is difficult. Prof. Amartya Sen argues that education contributes to a person’s “functionings and capability,” which are developmental benefits.
- External Benefits: Social benefits that exceed private benefits, such as: Creating better neighbors and citizens, leading to a healthier social and political life.