How Economic Theories From the US in the 1960s Still Impact Human Capital Thinking Today (a work in progress)

Friday, July 20, 2012
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Although primarily focusing on division of labor and quantities of labor in relation to productivity, Adam Smith touched upon human capital theory when he acknowledged the productivity enhancing impacts of the “dexterity” of workers nearly 200 years ago. Yet, when Pigou (1912)contended that firms would not invest in training their workforce in a free economy due to the threat of turnover and unclear profitability implications, the embrace of human capital theories was far from certain. Pigou maintained that firms seek to maximize “private net product” and have no incentive to train employees for societal benefits which he labeled “social net profit.” Pigou theorized that employer training was unlikely but may occur based upon the prospect of continued employment, which was more likely in industries that produced “proprietary goods” with specialized labor. However, training potential employees, which amounted to investing in “social net profit,” was the responsibility of the government. Several years later Marshall (1920 )broached the topic of human capital in describing general ability, general knowledge and intelligence required by industry, and specialized ability, technical knowledge required for specialized, individual trades. He maintained that specialized, nontransferable manual skill was becoming less demanded as a production factor in favor of general skills. He went as far as to say “… what makes the workers of one town or country more efficient than those of another, is chiefly a superiority in general sagacity and energy which are not specialized to any one occupation.” Marshall championed universal general and technical educational access and improvement as the primary source of general abilities. Rosentein-Rodan (1943) advances this line of reasoning further arguing that large scale industrialization required skilling agrarian workers to transition them for work in industry to raise incomes, reduce unemployment, strengthen national markets, and diversify economies. Similar to Pigou and Marshall, he argues that the state, rather than firms which lose capital by providing training as a result of turnover, is more apt to invest in the Pigouvian ”social net profit” of training a nation’s workers. The effect of these early contributions was to highlight the policy preference at the time for government subsidies for human capital development both in the form of schooling and on-the job training (Acemoglu and Pischke 1998). These contributions also underscore evolving thinking that directly linked skill formation to national economic development, firm-level success, and larger macroeconomic objectives.

Much of the rise of human capital theory and its empirical foundations In the 1960s is attributed to the Second Chicago School of Economics. Due to its origins in the United States, Human capital theory was heavily influenced by the “new” economy in the early twentieth century which was characterized by increased demand for flexible, general, and widely applicable skills not tied to particular occupations met by practical mass education that enabled youths to continue with college or exit for work (Goldin 2001). In this economic environment the concept of the small, entrepreneurial, Marshallian firm was eclipsed by updated theories of production and the firm which focused on large organizations with hierarchical administration and decision making structures competing on product innovation and incremental improvement, increased levels of R&D, and improved distribution rather than physical production (Johnson 1960). Johnson (1960) captures the transition in thinking concerning human capital from the first half of the nineteenth century to the 1960s as follows:

Industrial Revolution, as in the underdeveloped countries today, labour could reasonably be thought of predominantly as the application of crude force, with which individual labourers could be assumed to be roughly equally endowed, together with some decision-taking of a rather trivial kind. But in an advancing industrial society both the provision of force and the elementary decision taking are increasingly taken over by machinery, while what the worker brings to his task are the knowledge and skill required to use machinery effectively. His knowledge and skill in turn are the product of a capital investment in his education in the general capacities of communication and calculation required for participation in the productive process, and the specific capacities required for the individual job, a capital investment which is variously financed by the state, the worker himself, and the employer. Thus the labourer is himself a produced means of production, an item of capital equipment.

It is against this economic and sociological backdrop that the initial empirical foundations of human capital theory emerged. For example, challenging theories that related the natural ability of individuals to income distribution, Mincer operationalized an economic model that linked difference in training levels to wage differentials. His model assumed that individuals, at the time of choosing an occupation, rationally make training decisions based on the expectation that the cost of training (including deferral of earnings for the period of training; cost of the education and equipment such as tuition, books; but not including living expenses) will be equal or less than the present value of lifetime earnings. This equalization implies higher pay in occupations that require more training with the implication that income dispersion is positively related to investment in training.

In advancing this model, Mincer (1958) observes “When labor is subdivided by occupations differing in training and skill, it can be viewed as a set of distinct factors of production differing in the extent of capital accumulated in them.” This statement was one of the earliest references to human capital in modern neoclassical economic literature. In another early example, Schultz breaks with beliefs and values of the time in the economics field that inhibited looking at human beings as wealth that can be augmented by investment by drawing a link between investment in human capital and economic growth and productivity. Schultz maintained that not including human capital as a form of capital influenced by investment perpetuated the notion of labor as the capacity of homogenous workers to do manual work requiring little knowledge and skill. He observed that knowledge and skill are products of human capital investment and account for the productive superiority of technically advanced countries (Schultz 1961).

The link between human capital and economic growth was made more specific by Becker who observed “Since human capital is embodied knowledge and skills, and economic development depends on advances in technological and scientific knowledge, development presumably depends on the accumulation of human capital (Becker 1994).” The work of Becker laid the foundation for a more comprehensive definition of human capital that incorporated the knowledge, skills, and abilities of individuals and has shaped much of the current thinking on human capital (Acemoglu and Pischke 1998). As described in Figure X below, Becker (1962) defines two categories of human capital: specific and general. General human capital is defined as skills which are useful to many firms or which are broadly useful in certain country, industry, or occupational contexts. He argues that individuals pursue general skilling as long as the value stream of future higher earnings are more than net earnings foregone, training, and equipment expenses. Because the property rights to general training vest with individuals who derive higher wages from higher levels of training, Becker reasons that individuals would be willing and incentivized to pay the costs of general skilling. In a competitive labor market in which generally trained employees received their marginal product, firms would be incapable of recouping their investment in general training and would be unlikely to pay for general training. If a firm did provide generalized skills, in the form of say an apprenticeship, the firm would seek to shift the skilling cost onto the trainee in the form of lower wages. Specific human capital consists of firm-specific skills with productivity enhancing effects that would have no effect on productivity if deployed outside the firm. Because firms are more able to recoup the costs of specific skilling investments, specific training would be provided by firms whenever the return discounted at an appropriate rate is at least as large as the cost of training. Becker maintains that employees would not be willing to pay for specific skilling since property rights accrue to the firm, and the ability of a specifically trained employee to demand higher wages elsewhere is independent of his level of specific skills. The willingness of firms to pay for specific skilling, however, is tempered by the likelihood of turnover. For this reason, firms offer specifically trained employees a pay premium to preserve their capital investment in training.

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