REVIEWED BY WILL KENTON Updated May 28, 2019
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. Volume 0%
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.
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 Information. Knowledge can be either “human capital” or “information.” The difference is the resource cost of transferring a body of knowledge from one person to another. Here is the classification scheme I have in mind:
Human capital is knowledge that is hard to transfer.
Information is knowledge that is easy to transfer.
(This is a specific technical meaning of the word “information” for economics. I use the word “information” in a more general philosophical sense in my post “Ontology and Cosmology in 14 Tweets.”) Note that a given body of knowledge can shift from one category to another when technology changes. The words of the Iliad and the Odyssey were “human capital” when the only means of transferring this knowledge was oral transmission and memorization. When printing arose, the words of the Iliad and the Odyssey became “information.” (See Albert Lord’s The Singer of Tales on the original oral transmission of the Iliad and the Odyssey.)
Now comes the mid-post homework problem. Read Daniel Little’s description of the knowledge of how to fix machines or my abridged version of it just below, and classify the knowledge of how to fix machines as human capital or information. Here is Daniel Little’s opening paragraph:
There is a kind of knowledge in an advanced mechanical society that doesn’t get much attention from philosophers of science and sociologists of science, but it is critical for keeping the whole thing running. I’m thinking here of the knowledge possessed by skilled technicians and fixers – the people who show up when a complicated piece of equipment starts behaving badly. You can think of elevator technicians, millwrights, aircraft maintenance specialists, network technicians, and locksmiths.
Here is Daniel’s account of the level of difficulty of transferring this knowledge, based on his conversations with a fixer of mining machinery:
I said to him, you probably run into problems that don’t have a ready solution in the handbook. He said in some amazement, “none of the problems I deal with have textbook solutions. You have to make do with what you find on the ground and nothing is routine.” I also asked about the engineering staff back in Wisconsin. “Nice guys, but they’ve never spent any time in the field and they don’t take any feedback from us about how the equipment is failing.” He referred to the redesign of a heavy machine part a few years ago. The redesign changed the geometry and the moment arm, and it’s caused problems ever since. “I tell them what’s happening, and they say it works fine on paper. Ha! The blueprints have to be changed, but nothing ever happens.”
I would trust Tim to fix the machinery in my gold mine, if I had one. And it seems that he, and thousands of others like him, have a detailed and practical kind of knowledge about the machine and its functioning in a real environment that doesn’t get captured in an engineering curriculum. It is practical knowledge: “If you run into this kind of malfunction, try replacing the thingamajig and rebalance the whatnot.” It’s also a creative problem-solving kind of knowledge: “Given lots of experience with this kind of machine and these kinds of failures, maybe we could try X.” And it appears that it is a cryptic, non-formalized kind of knowledge. The company and the mine owners depend crucially on knowledge in Tim’s head and hands that can only be reproduced by another skilled fixer being trained by Tim.
In philosophy we have a few distinctions that seem to capture some aspects of this kind of knowledge: “knowing that” versus “knowing how”, epistime versus techne, formal knowledge versus tacit knowledge. Michael Polanyi incorporated some of these distinctions into his theory of science in Personal Knowledge: Towards a Post-Critical Philosophy sixty years ago, but I’m not aware of developments since then.
As a practical matter, Polanyi’s distinction between “knowing how” (formal knowledge) and “knowing that” (tacit knowledge) is so important for the costs of transferring knowledge from one person to another that it closely parallels the distinction between human capital and information.
Pure Technology. Let me assume that your answer to the homework problem is the same as mine: knowledge of how to fix machines has a large element of human capital. This has an important consequence: “technology” as we usually think of “technology” is not just made of the easily copied “recipes” that Paul Romer talks about in his Concise Encyclopedia of Economics article “Economic Growth.”
Suppose for the purposes of economic theory, we insist on defining “pure technology” as a recipe that can be cheaply replicated. Then “technology” in the ordinary sense has an element of human capital in it as well as “pure technology,” much as “profit” in the ordinary sense has an element of return to capital in it as well as “pure profit.” The pure technology for mining would include not only
- a plan for how the machines are used and repaired, but also
- a plan for having new operators learn how to operate the machines and for having new machine repairers learn from more experienced machine repairers.
The “technology” in the ordinary sense is human capital for using and repairing the machines–that is, already embedded knowledge produced from 1, 2 and learning time.
Economic Metaknowledge. In addition to straight ideas or recipes, Paul Romer emphasizes the importance of meta-ideas:
Perhaps the most important ideas of all are meta-ideas. These are ideas about how to support the production and transmission of other ideas. The British invented patents and copyrights in the seventeenth century. North Americans invented the agricultural extension service in the nineteenth century and peer-reviewed competitive grants for basic research in the twentieth century.
There are many meaning of the prefix “meta.” Paul is using “meta” so that “meta-X” means “things in category X to foster the production and transmission of things in category X.” When another meaning of “meta-” might otherwise intrude, let’s use “economic meta-X” for this meaning. Then with the distinction between human capital and information in hand, there are at least four types of economic metaknowledge–knowledge to foster the production and transmission of knowledge:
- Meta-human-capital: human capital to foster the production and transmission of human capital. (Teaching skill is the most important example.)
- Economic meta-information: information to foster the production and transmission of information. (Many of the most important software programs are in this category: Microsoft Office, the software behind Social Media such as Tumblr, Twitter, and Facebook, TiVo’s software, the software behind the web itself…. Also, computer science and electrical engineering journals on library shelves contain some economic meta-information. In its time, a 17th Century printer’s manual would count.)
- Human capital to foster the production and transmission of ideas. (Research skill– including the skill of writing academic papers–is a good example.)
- Information to foster the production and transmission of human capital. (The contents of Daniel Willingham’s book Why Don’t Students Like School? are an excellent example that I highly recommend. He draws his suggestions for teaching from the U.S. Department of Education’s What Works Clearinghouse)
Extra Credit: Figure out how Paul Romer’s meta-ideas listed above–patents and copyrights, agricultural extension services, and peer-reviewed competitive grants–fit into this fourfold division of economic metaknowledge.
Rumsfeldian Metaknowledge. According to Colin Powell (as excerpted in the Appendix below and given more fully at this link) we can blame Donald Rumsfeld’s unchecked insubordination in disbanding the Iraqi Army for some portion of the long hard slog we faced in the War in Iraq since 2003, but Donald did coin a memorable description of another kind of metaknowledge. Here is the 21-second video, and here is the transcript:
[T]here are known knowns; there are things we know that we know.
There are known unknowns; that is to say there are things that, we now know we don’t know. But there are also unknown unknowns–there are things we do not know, we don’t know.
Metaknowledge in this sense of knowing what one knows and knowing what one doesn’t know often has great economic value, whether in daily life, business and policy making. But metaknowledge in this Rumsfeldian sense–even economically valuable Rumsfeldian metaknowledge–should be distinguished from “economic metaknowledge” as I define it above.
Appendix. Here is what Colin Powell wrote:
When we went in, we had a plan, which the president approved. We would not break up and disband the Iraqi Army. We would use the reconstituted Army with purged leadership to help us secure and maintain order throughout the country. We would dissolve the Baath Party, the ruling political party, but we would not throw every party member out on the street. In Hussein’s day, if you wanted to be a government official, a teacher, cop, or postal worker, you had to belong to the party. We were planning to eliminate top party leaders from positions of authority. But lower-level officials and workers had the education, skills, and training needed to run the country.
The plan the president had approved was not implemented. Instead, Secretary Donald Rumsfeld and Ambassador L. Paul Bremer, our man in charge in Iraq, disbanded the Army and fired Baath Party members down to teachers. We eliminated the very officials and institutions we should have been building on, and left thousands of the most highly skilled people in the country jobless and angry—prime recruits for insurgency. These actions surprised the president, National Security Adviser Condi Rice, and me, but once they had been set in motion, the president felt he had to support Secretary Rumsfeld and Ambassador Bremer.
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