Human Capital Theory

Human capital theory analyses the skills, knowledge, and experience of individuals as a form of capital that yields a return, in the form of higher earnings and productivity. The theory treats education and training as investments that individuals and societies make to increase their productive capacity.

Concept

Human capital comprises the skills and knowledge that people acquire through education, training, and experience. Like physical capital, it is an asset that yields a flow of benefits over time, and it can be accumulated through investment.

The theory holds that individuals invest in human capital by foregoing current earnings and incurring the costs of education and training, in expectation of higher future earnings. The decision to invest depends on the costs, on the expected returns, and on the individual's rate of time preference.

Returns to Education

The returns to education are measured by comparing the earnings of individuals with different levels of education. The estimates suggest that education raises earnings substantially, and that the return to an additional year of schooling is positive.

The measurement of the returns faces challenges. The correlation between education and earnings may reflect the effect of unobserved characteristics, such as ability and motivation, rather than the effect of education itself. The estimates must therefore address the problem of selection.

The returns to education vary across countries, across levels of education, and across fields of study. The variation reflects differences in the demand for skills, in the supply of educated workers, and in the quality of education.

Human Capital and Growth

Human capital is a central element of the analysis of economic growth. In growth models, human capital is an input into production, alongside physical capital and labour, and its accumulation contributes to the growth of output.

The accumulation of human capital can also generate externalities, since an educated workforce benefits not only the individuals but also the firms and the society in which they work. The presence of externalities implies that private investment in education may be below the socially optimal level, providing a rationale for public support.

The relationship between human capital and growth has been documented empirically, though the estimates vary. The evidence suggests that human capital is an important determinant of growth, and that the quality of education matters as much as the quantity.

Policy

The theory informs the design of education and training policy. It supports public investment in education, particularly at the levels where the returns are high and where access is limited by credit constraints.

The theory also informs the design of policies for lifelong learning, since the skills acquired in initial education may become obsolete as technology changes. Investment in training and in retraining is therefore required to maintain the productive capacity of the workforce.

The theory has implications for the analysis of inequality. Differences in access to education contribute to differences in earnings, and policies that reduce these differences can reduce inequality and raise growth simultaneously.

Education and Earnings

The relationship between education and earnings is one of the most studied relationships in economics. The evidence shows that individuals with more education earn substantially more, and that the return to education is positive and, in many countries, has remained high despite the growth in the supply of educated workers.

The interpretation of the relationship has been debated. Human capital theory holds that education raises productivity and therefore earnings. The signalling theory holds that education conveys information about the ability of individuals, so that the relationship reflects the selection of more able people into education rather than the effect of education itself.

The evidence suggests that both mechanisms are at work, and that the effect of education on earnings is partly a return to the skills acquired and partly a return to the signal conveyed. The relative importance of the two is a subject of research.

Training and Skills

Investment in human capital occurs not only through formal education but also through training and experience. Firms provide training, either general, which is useful in many firms, or specific, which is useful only in the firm that provides it.

The analysis of training emphasises the incentives of firms and of workers. Firms are more willing to pay for specific training, since they can capture the return, while general training is more likely to be paid for by workers, since they can use it elsewhere. The design of institutions affects the provision of training and the accumulation of skills.

Experience also contributes to human capital, through learning by doing and through the acquisition of firm-specific knowledge. The return to experience is reflected in the age-earnings profile, which rises with age and then flattens.

Human Capital and Technology

The relationship between human capital and technology is central to the analysis of growth. New technology requires skilled workers to develop and to operate it, and the accumulation of human capital facilitates the adoption of technology.

The complementarity between human capital and technology implies that the return to education rises with technological change, since skilled workers are better able to work with new technology. This is one explanation for the increase in the return to education observed in many countries.

The relationship also implies that the effects of technology on the labour market depend on the distribution of skills. Technology may raise the demand for skilled workers and reduce the demand for unskilled workers, contributing to the increase in inequality.

Summary

Human capital theory analyses education and training as investments that yield returns in the form of higher earnings and productivity. Its implications for the analysis of growth, of inequality, and of policy are central to the understanding of the modern economy.

See also

• Labour Economics
• Economic Growth
• Development Economics