Chapter 4

HUMAN CAPITAL AND DEVELOPMENT

INTRODUCTION

Capital embodied in human beings in the form of education and health which make them more
productive is called human capital.

Physical capital human resources or human capital plays a significant role in determining
economic development. More education makes the human beings more productive through
enhancing their skills, abilities, knowledge and better health enables them not only to participate
in the production process but increase their capabilities to produce more.

Thus education and health can add to the value of production in the economy and also to the
incomes of the persons who have been educated and made healthy.

The human capital is embodied in human beings. Human capital comprises the education,
knowledge, the skills, better health and the capacities of all people in the society to undertake
production.

On the other hand, the physical capital consists of produced means of production such as machines
that are used in producing other goods. Economic development calls for both forms of capital
accumulation. And both forms of capital call for investment.

Investment in human capital has therefore been called ‘investment in man’. Education plays a
crucial role in the ability of a country to absorb modern technology and to generate the capacity
for self-sustained growth and development. Health is also essential for increase in productivity of
labour and, therefore, not only raises the private incomes but also contributes to the growth of
GDP.

Thus, Todaro and Smith write, “Both health and education can also be seen as vital components
of growth and development as inputs to the aggregate production function. Their role as both inputs
and output gives health and education their central importance in economic development.”

Till recently economists have been considering physical capital as the most important factor
determining economic growth and have been recommending that rate of physical capital formation
in developing countries must be increased to accelerate the process of economic growth and raise
the living standards of the people. But in the last three decades economic research has revealed the
importance of education as a crucial factor in economic development. Education refers to the
development of human skills and knowledge of the people or labour force.

It is not only the quantitative expansion of educational opportunities but also the qualitative
improvement of the type of education which is imparted to the labour force that holds the key to
economic development.

Because of its significant contribution to economic development, education has been called as
human capital and expenditure on education of the people as investment in man or human capital.

Speaking of the importance of education or human capital, Prof. Harbison wrote “Human resources
constitute the ultimate basis of production; human beings are the active agents who accumulate
capital, exploit natural resources, build social, economic and political organisations, and carry
forward national development. Clearly, a country which is unable to develop the skills and
knowledge of its people and to utilise them effectively in the national economy will be unable to
develop anything else.”

INTENDED LEARNING OUTCOMES

After studying this module, the students will be able to:

1. Define Human Capital and Development;
2. Explain how human development depreciate;
3. Discuss the Return on Investment in Education;
4. Differentiate Consumption Benefits of Education from External Benefits of Education

What Is Human Capital?

Human capital is an intangible asset or quality not listed on a company's balance sheet. It can be
classified as the economic value of a worker's experience and skills. This includes assets like
education, training, intelligence, skills, health, and other things employers value such as loyalty
and punctuality.
The concept of human capital recognizes that not all labor is equal. But employers can improve
the quality of that capital by investing in employees—the education, experience, and abilities of
employees all have economic value for employers and for the economy as a whole.

Human capital is important because it is perceived to increase productivity and thus profitability.
So the more a company invests in its employees (i.e., in their education and training), the more
productive and profitable it could be.
Understanding Human Capital

An organization is often said to only be as good as its people. Directors, employees, and leaders
who make up an organization's human capital are critical to its success.
Human capital is typically managed by an organization's human resources (HR) department. This
department oversees workforce acquisition, management, and optimization. Its other directives
include workforce planning and strategy, recruitment, employee training and development, and
reporting and analytics.

Human capital tends to migrate, especially in global economies. That's why there is often a shift
from developing places or rural areas to more developed and urban areas. Some economists have
dubbed this a brain drain, making poorer places poorer and richer places richer.

Human Capital

Calculating Human Capital

Since human capital is based on the investment of employee skills and knowledge through
education, these investments in human capital can be easily calculated. HR managers can calculate
the total profits before and after any investments are made. Any return on investment (ROI) of
human capital can be calculated by dividing the company’s total profits by its overall investments
in human capital.
For example, if Company X invests $2 million into its human capital and has a total profit of $15
million, managers can compare the ROI of its human capital year-over-year (YOY) in order to
track how profit is improving and whether it has a relationship to the human capital investments.

 Human capital is an intangible asset not listed on a company's balance sheet and includes
things like an employee's experience and skills.
 Since all labor is not considered equal, employers can improve human capital by investing
in the training, education, and benefits of their employees.
 Human capital is perceived to have a relationship with economic growth, productivity, and
profitability.
 Like any other asset, human capital can depreciate through long periods of unemployment,
and the inability to keep up with technology and innovation.

Special Considerations

Human Capital and Economic Growth

There is a strong relationship between human capital and economic growth. Because people come
with a diverse set of skills and knowledge, human capital can certainly help boost the economy.
This relationship can be measured by how much investment goes into people’s education.
Some governments recognize that this relationship between human capital and the economy exists,
and so they provide higher education at little or no cost. People who participate in the workforce
who have higher education will often have larger salaries, which means they will be able to spend
more.
Does Human Capital Depreciate?

Like anything else, human capital is not immune to depreciation. This is often measured in wages
or the ability to stay in the workforce. The most common ways human capital can depreciate are
through unemployment, injury, mental decline, or the inability to keep up with innovation.
Consider an employee who has a specialized skill. If he goes through a long period of
unemployment, he may be unable to keep these levels of specialization. That's because his skills
may no longer be in demand when he finally reenters the workforce.

Similarly, the human capital of someone may depreciate if he can't or won't adopt new technology
or techniques. Conversely, the human capital of someone who does adopt them will.

A Brief History of Human Capital

The idea of human capital can be traced back to the 18th century. Adam Smith referred to the
concept in his book "An Inquiry into the Nature and Causes of the Wealth of Nations," in which
he explored the wealth, knowledge, training, talents, and experiences for a nation. Adams suggests
that improving human capital through training and education leads to a more profitable enterprise,
which adds to the collective wealth of society. According to Smith, that makes it a win for
everyone.

In more recent times, the term was used to describe the labor required to produce manufactured
goods. But the most modern theory was used by several different economists including Gary
Becker and Theodore Schultz, who invented the term in the 1960s to reflect the value of human
capacities.

Schultz believed human capital was like any other form of capital to improve the quality and level
of production. This would require an investment in the education, training and enhanced benefits
of an organization's employees.

But not all economists agree. According to Harvard economist Richard Freeman, human capital
was a signal of talent and ability. In order for a business to really become productive, he said it
needed to train and motivate its employees as well as invest in capital equipment. His conclusion
was that human capital was not a production factor.

Criticism of Human Capital Theories

The theory of human capital has received a lot of criticism from many people who work in
education and training. In the 1960s, the theory was attacked primarily because it legitimized
bourgeois individualism, which was seen as selfish and exploitative. The bourgeois class of people
included those of the middle class who were believed to exploit those of the working class.
The human capital theory was also believed to blame people for any defects that happened in the
system and of making capitalists out of workers.
Human Capital and Economic Development:

Gross domestic product of a country depends on not only the amount of labour (i.e. work-hours)
used for producing goods and services but also on its productivity. One of the important factors
that determine productivity of worker is human capital, that is, education.

As seen above, in the modern economics the concept of capital is not confined to physical capital
such as machines, tractors, capital equipment, etc. that raises productivity of labour but also
includes what is called human capital.

By human capital we mean the skills and knowledge that workers acquire through education and
training. This human capital, that is, knowledge and skills, are accumulated by human beings
through education during the time they spend in primary and secondary schools and up to
graduation and post-graduation in colleges or universities.

Besides, specialised professional education such as engineering, computer training, management

education and others raises greatly the productivity of workers. Therefore, accumulation of human
capital is generally called investment in people.

Just as a firm considers whether to invest in physical capital, individuals decide whether to invest
in their own human capital. When a firm purchases machinery or other capital equipment to
produce more output and increases its future profits, individuals invest in education or acquiring
skills to raise their productivity and their future earnings. Investment in education or acquiring
new skills is called investment in human capital.

While usual models of labour supply assume that wage rate of individuals is fixed, however
through investment in human capital the individuals can raise their wages or earnings as
investment in human capital raises their productivity and it has been found that in the United States
rate of return on investment in secondary education is 10 to 13 per cent higher.

According to Prof. Amartya Sen, the improvement in the availability and quality of education
results in higher level of functionings and capability of labour. He has shown in his works that for
a country a low level of education lowers the growth of GDP due to shortages of labour with
appropriate skills.

Besides, the empirical evidence available suggests that countries which have invested more in
education as measured by average years of schooling tend to experience, other things remaining
constant, higher rate of growth. Furthermore, higher technical education helps to discover new
inventions and innovations and thereby promote technological progress.

Human capital, though less tangible than physical capital, is similar to it in many ways. First, like
physical capital, accumulation of human capital increases the ability of a country to produce more
goods and services. Secondly, like physical capital, human capital is a produced factor of
production.

Producing human capital requires investment in inputs such as student time, teachers, books and
libraries, college buildings. Thirdly, like the physical capital, the accumulation of human capital
increases the productivity of workers and therefore causes their wages to rise. Fourthly, like the
accumulation of physical capital, the accumulation of human capital requires the sacrifice of some
present consumption so as to have more consumption in future.

Cost of Human Capital or of Acquiring Skills:

Human capital is built through acquiring more education or skills by spending more time in school,
college or university.
Thus, in spending more time in acquiring more education, one not only delays one’s entry into
labour force but also sacrifices income or wages which he could have earned by working during
the time he spends for acquiring education. This is the opportunity cost of acquiring more
education, skills and grades (i.e., accumulating more human capital).

But they spend time in acquiring more human capital with the expectation that they would be able
to earn higher income or wages in the future as more education and higher skills raise the
productivity of the workers and therefore their wages.

Thus, the students, like the people who save, face a trade-off between less consumption today for
more consumption in the future.

Thus, “spending more on education today (reducing consumption) raises future income but each
additional investment in education provides a smaller and smaller return”. It follows from above
that, like physical capital, expenditure on education also represents investment in capital which
raises productivity in the future.

Besides, investment in education is tied to specific human being and therefore it is called human
capital. Thus, according to Mankiw, “Like all forms, capital education represents an expenditure
of resources at one point in time to raise productivity in the future.
But unlike an investment in other forms of capital, investment in education is tied to a specific
person and this linkage is what makes it human capital.” It is important to note that workers
endowed with higher education (i.e., more human capital) earn more income or wages than those
having less education.

The differences in wages between those with more education and those with less education are
quite large and have been increasing. For example “College graduates in the United States earn
about twice as much as those workers who end their education with a high school diploma “.

It may be noted that this difference in earnings between workers with more human capital and
those with less human capital on an average tends to be even larger in developing countries where
educated workers are in scarce supply.

That investment in education or human capital has a cost can be easily illustrated. Economists are
generally concerned with the opportunity cost of time spent in acquiring education or human
capital. If you are attending a class acquiring education you cannot be working simultaneously at
a job yielding you some income.

Therefore, by attending computer classes you forgo some wages or earnings and hence some
consumption which represents the cost of acquiring human capital.

Another fact worthwhile to note is that private return to education tends to fall as level of
development (measured by the level of per capita income) increases.

Besides, there are social returns to investment in education which take into account the
externalities which do not enter into the calculations of private individuals in their assessment of
private return on education.

Other sources include the efficient use of available resources, economies of scale, a shift of labour
force from low-productivity agricultural sector to higher productivity industrial sector which
contributed about 10 per cent to growth in GDP. It may however be noted that Denison could not
measure directly the contribution of advances in knowledge. He measured the contributions of
other four sources of growth, namely, more labour work, accumulation of physical capital,
increased education, and others, and assumed that all economic growth that could not be explained
by other sources was the contribution of advances in knowledge.
As it pays to the individual to invest in human capital (education or skill formation), similarly, the
community as a whole can raise its consumption or living standards by investing in human capital.

Measuring Contribution of Education to Economic Growth:

Several empirical studies made in developed countries, especially the U.S.A., regarding the
sources of growth or, in other words, contributions made by various factors such as physical
capital, man-hours, (i.e., physical labour), education etc. have shown that education or the
development of human capital is a significant source of economic growth.

It may be pointed out that economists generally hold that while some investments in education are
‘economic’ in the sense that they promote growth directly, other expenditures on education and
development of the human resources are basically of the form of ‘social investment’ which,
therefore, should be determined residually. It is not possible to separate out the consumption and
investment parts of the expenditure on education so that it is very difficult to estimate the rate of
financial return on education in the same manner as in the case of a factory or a dam. At best, one
can only recognize the probable importance of the expenditure on education in the process of
economic growth.

The estimation of return on investments in education or human capital is beset with many
difficulties. The fact is that human resource development encompasses a wide field. It cannot be
solely examined in economic terms. For instance, it is not very realistic to estimate the return on
education purely in terms of the increases in individual incomes or the income of the economy
taken as a whole. Also, the increases in productivity do not by themselves constitute the
effectiveness of human capital. Notwithstanding these considerations, economists have attempted
to measure the contribution of education to economic growth solely on the basis of economic
criteria.

In broad outline, the basis on which return and therefore, role of investment in human resources,
particularly education, has been sought to be incorporated in the mainstream of economic analysis.

The following are the main approaches that have been developed to gauge the productivity
of investment in education:

1. The Residual Approach or Production Function Approach:

There have been some attempts to estimate the proportion of the measured increase in gross
national product attributable to education. This is sought to be done by first determining the
increase in gross national product on account of the measurable inputs of labour and capital. Then
this figure is subtracted from the figure of GNP, to get a ‘residue’ which represents the increase in
GDP due to the improvements in the quality of labour as a consequence of education.

Professor Solow who was one of the first economists to measure the contribution of human capital
to economic growth, estimated that for United States between 1909 and 1949, 57.5per cent of the
growth in output per man-hour could be attributed to the residual factor which represents the effect
of the technological change and of the improvement in the quality of labour mainly as a
consequence of education. He estimated this residual factor determining the increase in the total
output on account of the measurable inputs of capital and labour (man hours). He then subtracted
this figure from the total output to get the contribution of residual factor which represented the
effect of education and technological change, the physically immeasurable factors.

As explained above, Denison, another American economist, made further refinement in estimating
the contribution to economic growth of various factors. Denison tried to separate and measure the
contributions of various elements of ‘residual factor’. According to the estimates of Denison, over
the period 1929-82 in the USA during which total national output grew at the rate of 2.9 per cent
per annum, increase in labour input accounted for 32 per cent, the remaining 68 per cent was due
to the increase in productivity per worker. He then measured the contributions of education of per
worker, capital formation, technological change and economies of scale.

Denison found that 28 per cent of contribution to growth in output due to growth in labour
productivity was due to technological change, 19 per cent to capital formation and 14 per cent due
to education per worker and 9 per cent points due to economies of scale. It is thus clear that
education and technological progress together made 42 per cent (14 + 28) contribution to growth
in national product.

Limitations:
However, the above estimates are not fully reliable. The basic reason for this is that the methods
used in calculating the contribution of education, are not free from flaws. Moreover, the data which
have been used in the calculations applies only to formal education. It completely ignores on-the-
job training. Also, only private return on education is measured. But education makes a
considerable social contribution also in the form of increased mobility, adaptability and the growth
of applied technology. In this sense, these calculations make underestimation of the contribution
of education.

There being interrelation between capital formation, technology and growth of knowledge, the
component in the residual ascribed to increased knowledge may, in fact, include some capital
assets. But, in these methods no distinction has been made between formal and informal education.
Again, the differences in the quality or content of education have been ignored.

Notwithstanding these limitations, these estimates highlight the significance of the improvements
in the quality of human resources through education, in the process of economic growth.

2. Rate of Return Approach– Further Elaboration:

The contribution of education to economic growth has also been measured through the rate of
return approach. In this approach rate of return is calculated from expenditure made by individuals
on education and the measurement of the flow of an individual’s future earnings expected to result
from education. The present value of these is then calculated by using appropriate discount rate.
For calculating the present value of future earnings with education the appropriate present value
formula is used. This method has been used by Gary S. Backer who measured income differential
arising from the cost or expenditure incurred on acquiring a college education in the United States.
His estimates show that the rates of return on education in the U.S.A. for urban white population
were 12.5 per cent in 1940 and 10 per cent in 1950.’

Another study on similar lines was made by E.F. Reneshaw. He used Schultz’s earlier estimates,
for USA of total earnings forgone and the cost of education in high schools, colleges and
university. Doing this, he found that the average return on education ranged between 5 and 10 per
cent for the period 1900 to 1950.

It is worth noting that estimates of rate of return on investment in education are based upon private
rates of returns to individuals receiving education. However, by assuming that differences in
earnings in a market economy reflect differences in productivity, the rate of return on investment
in education is taken to be the effect of education on the output of the country.

Limitations:
However, these estimates of the return on education are valid only to the extent to which the
underlying assumptions are valid. The expenditure on education has two components- the future
earnings and the future consumption. While the educational investment results in increase in the
future earnings, it also entails the consumption element in the sense of the direct satisfaction
derived from education so obtained.

The latter, i.e., the consumption component of investment in education wherein resides the source
of future utilities, nowhere enters into the measured national income. To the extent these estimates
ignore the future utilities and other external economies of acquiring knowledge; they
underestimate the returns on education.

Moreover, the earning capacity of individuals with varying educational levels is not entirely the
function of formal education. Other factors such as on-the-job training, experience, family income,
social status and natural abilities also influence the earning capacity. But the estimates of return
on education take no account of these other factors.

Furthermore, these estimates concentrate only on the measurement of the private rates of return on
educational investment. At best, they take into account merely the indirect effects of education on
the output of the country on the assumption that the earnings differentials in a market economy
reflect the differentials in productivity. But the various groups such as engineers, doctors, teachers
and manual workers through collective efforts or trade unionism may distort the relative earnings
in the economy. What is more, it is difficult to even estimate the private returns on education where
the costs of running an educational institution are negligible. For instance, in India there are a large
number of single teacher schools where no fee is charged from the pupils.

Again, as has been argued by Eckaus, the cost (or price) of educated labour which is used in
evaluating the rate of return ought to reflect the relative scarcities of the factors involved. However,
when the primary burden of educational investment is borne by the government, the prices of
educated labour fail to reflect the scarcities of factor inputs that are so used.

Also, these estimates of rate of return on education undervalue the importance of education as a
stepping stone to further education. The fact is that one level of education leads to another. As
such, a comparison of individuals with primary education with those who lack it would simply
underestimate the significance of primary education as the basic prerequisite to acquire further
education. Further, these estimates of return on education provide no information as to the quantity
and quality of education most conducive to economic development.

3. Schultz Approach – Comparing Expenditure on Education with Income Earned:

Another approach to measure the contribution of education is based upon the analysis of the
relationship between expenditure on education and income. Using this approach Schultz studied
the relationship between expenditure on education and consumer’s income and also the
relationship between expenditure on education and physical capital formation for the United States
during the period 1900 to 1956.
He found that when measured in constant dollars, “the resources allocated to education rose about
three and a half times (a) relative to consumer income in dollars, (b) relative to the gross formation
of physical capital in dollars”. This implies that the “income elasticity” of the demand for education
was about 3.5 times over the period or in other words, education considered as an investment could
be regarded as 3.5 times more attractive than investment in physical capital. It may however be
noted that these estimates of Schultz only indirectly reflect the contribution of education to
economic growth.

In the above analysis it is explained that education is regarded as investment and like investment
in physical capital, it raises productivity of the labour and thus contributes to growth of national
income. The increased earnings or higher wages made by more educated workers have been
considered as benefits not only to the private individuals, but also to the society as a whole. This
is because higher earnings presumably reflect higher productivity, increased output in real as well
as monetary terms.

Consumption Benefits of Education:

We have explained above the investment benefits of education and therefore its effects on
productivity and national output. But investment benefits are the only benefits flowing from
education. Education also yields consumption benefits for the individual as he may “enjoy” more
education; derive increased satisfaction from his present and future personal life. If the welfare of
society depends on the welfare of its individual members, then the society as a whole also gains in
welfare as a result of the increased consumption benefits of individuals from more education.
Economic theory also helps us in quantifying the consumption benefits derived from education. In
economic theory, to measure the marginal value of a product or service to a consumer we consider
how much he has paid for it.

An individual would not have purchased a product or service if it were not worth its price to him.
Besides, an individual would have bought more units of a product if he thought that the marginal
utility he was getting was more than the price he was paying. Thus relative prices of various
products reflect the marginal values of different products and the amount consumed of various
products multiplied by their prices would, therefore, indicate the consumption benefits derived by
the individuals.

It may, however, be pointed out that the prices in a free economy are influenced by a given income
distribution and the presence of monopolies and imperfections in the market structure and therefore
they do not reflect the true marginal social values of different goods. However, an objective
measure of consumption benefits of education is difficult and has yet to be found out. It may also
be noted that, according to the new view, economic development is not merely concerned with the
growth of output but also with the increase in consumption and well-being of the society.

Thus Prof. Amartya Sen writes, “Education can add to the value of production in economy and
also to the income of the person who has been educated. But even with the same level of income,
a person may benefit from education in reading, communicating, arguing, in being able to choose
in a more informed way, in being taken more seriously by others and so on”. Therefore,
consumption benefits of education may also be regarded as developmental benefits.

External Benefits of Education:

We have explained above the investment benefits and consumption benefits flowing from more
education both for the individual and the society. The analysis of benefits has been based on the
assumption that private interests of individuals are consistent with the social good. However,
private and social benefits do not always coincide; for instance, social benefits may exceed private
benefits.

This is the case with the education of an individual which not only benefits individual privately
but also others. First, education makes people better neighbours and citizens and makes social and
political life more healthy and meaningful. Secondly, the, most important external benefit of more
education is its effect on technological change in the economy. More education, especially higher
education, stimulates research and thereby raises productivity which undoubtedly benefits the
society.

The individual inventor may not receive earnings equal to his contribution to the research.
Denison’s study of contribution of education to growth, whose main findings have been explained,
clearly shows the external benefits of education. After estimating the contribution of labour
(including educated labour) and physical capital to economic growth he obtained an average
residual of about 32 percentages to annual growth of 2.9 per cent in the U.S. during the period
1929-60. Denison attributed this to the increase in knowledge which is the direct result of research
and indirectly of higher education.

This is in addition to 14 per cent contribution to the annual growth made directly by increase in
education. Therefore, Harris and James concludes – “If the entire residual indeed stemmed
ultimately from education, as some human capital enthusiasts have implied, this would mean that
education, directly or indirectly, contributed over 40 per cent of total output growth and 80 per
cent of increased productivity from 1929 to 1957.” If Denison’s residual is regarded as mainly due
to research stimulated by additional education, then this is indeed a major external benefit of

Prepared by:

Asst. Prof. INESIO H. SADIANGCOLOR

ECO 310 Economic Development