How does human capital matter?

Eduardo writes*

Our capacity to learn and improve our skills is arguably the most important determinant of our future earnings. After all, we as students spend a considerable amount of money on education today as we expect a future payoff in terms of higher salaries or better jobs. This notion that investing in human beings today will provide returns in the future is central to the theory of human capital.

This concept has not only provided insights to how increases in labour skills and thus productivity is translated into higher income. More importantly, human capital has enabled economists to account for the growth residual given that capital and labour do not fully explain the totality of variation in economic growth. In other words, economists have found that human capital – conceived as the stock of skills and knowledge the labour force possesses – “is the main determinant of modern economic development”.

Of course, like any major advancement in research, the theory of human capital did not come without important criticisms, such as treating humans as just another form of capital. Human capital theory also suggests that the only purpose of education is to increase future incomes, which ignores other benefits such as satisfying intrinsic motivation or cultural aims.

In Capital in the Twenty-First Century Thomas Piketty argues that the importance of physical capital is likely to increase as it replaces labour. Branko Milanovic points out that human capital is inherently different than physical capital; the former requires “work” while the latter does not.

Regardless of the terminology or moral attributes, the concept of human capital has helped us understand how economies develop and grow. While before the 20th century economies grew mainly on a basis of physical capital accumulation, the importance of the knowledge economy has dominated the modern growth paradigm. Before, inequality or the concentration of savings among the top brackets of the income distribution was seen as a precondition for development. In contrast, contemporary findings suggest that inequality is harmful for growth and development. The shift is conceived in terms of the increasing relevance of human capital.

At the same time, relevant research suggests that institutions have an important effect on human capital development. This may lead us to think that certain institutional characteristics determine the process of human capita accumulation and subsequent economic growth. Thus, institutions may explain historical income divergences and inequalities among countries.

* Please help my Economic Growth & Development students by commenting on unclear analysis, alternative perspectives, better data sources, or maybe just saying something nice :).