Human Capital

Assume that the government wants to increase the overall production in the economy. To do so, the government invests a significant amount of its overall budget in education and training programs. Would it be a wise decision to make investments in human capital? To what extent human capital affects our economy, and what's its importance? Read on to find out the answers to all these questions, the characteristics of human capital, and much more!

Human Capital in Economics

In Economics, human capital refers to the level of health, education, training, and skill of workers. It is one of the primary determinants of the productivity and efficiency of labor, which is one of the four main factors of production. Because it includes worker education and skill, human capital can also be considered a component of entrepreneurial ability, the second factor of production. In all societies, the development of human capital is a key goal.

Any increase in human capital is considered to increase the supply of output that can be generated. That's because when you have more individuals working and having the necessary technical skills to produce certain goods and services, more output will be produced. Thus, human capital has a direct relationship with output.

This is true with both supply and demand in both Microeconomics (the operation of firms and markets within an economy) and Macroeconomics (the operation of the entire economy).

In Microeconomics, supply and demand determine the price and quantity of goods produced.

In Macroeconomics, aggregate supply and aggregate demand determine the price level and total amount of national output.

In both Micro and Macroeconomics, an increase in human capital increases supply, reducing prices and increasing output. Thus, raising human capital is universally desirable.

Figure 1. Impact of human capital on the economy, StudySmarter Originals

Figure 1 shows the impact an increase in human capital has on the economy. Notice that you have output on the horizontal axis and the price level on the vertical axis. An increase in human capital would enable more production to take place. Hence, it increases the output from Y₁ to Y₂, whilst simultaneously lowering prices from P₁ to P₂.

Human Capital Examples

A key example of human capital is workers' education level. In many nations, young people receive a tuition-free public education from kindergarten through the end of high school. Some countries also provide low-cost or completely tuition-free higher education, meaning education beyond high school. Increased education increases productivity by improving workers' skills and ability to quickly learn and perform new tasks.

Workers who are more literate (able to read and write) can likely learn new and complex jobs faster than those who are less literate.

Economies can increase human capital by subsidizing (providing government funds for) increased level of education.

A second example involves job training programs. Similar to education, job training programs also improve worker skills. Government funding for job training programs can increase national output (gross domestic product, or GDP) by giving unemployed workers the skills necessary to gain employment.

While traditional formal education and job training programs provide this benefit, job training programs are more direct at teaching workers specific, job-centric skills. Thus, increased government spending on job training programs increases the labor force participation rate, reduces unemployment, and increases national output.

A third example involves programs that support the health and welfare of workers. As with education and training, these programs can take many forms. Some may be offered by employers as part of health benefits like health and dental insurance, "employee perks" like free or subsidized gym memberships, or even on-site health practitioners such as a company health clinic. Government agencies, such as city or county health clinics, may offer others.

In some countries, the central government provides universal health care by paying health insurance for all residents through taxes in a single-payer system. Programs that improve workers' health increase human capital by helping workers be more productive.

Characteristics of Human Capital

Human capital characteristics include education, qualifications, work experience, social skills, and communication skills of the labor force members. An increase in any of the above characteristics will increase the productivity of an employed worker or will help an unemployed member of the labor force become hired. Thus, an increase in any characteristic of human capital will increase supply.

Education refers to a formal education provided by a K-12 school, community college, or four-year university. Completion of formal education typically confers diplomas or degrees. Since the end of World War II, the percentage of U.S. high school graduates going on to higher education, either at a community college or four-year university, has increased significantly. Many jobs require workers to have a four-year degree as part of their qualifications.

Qualifications include degrees and certifications, which are granted by various governing organizations. These typically include state or federal regulatory agencies and nonprofit industry regulators like the American Medical Association (AMA), American Bar Association (ABA), and the Financial Industry Regulatory Authority (FINRA). Certification programs are often found at community colleges. However, some universities may offer such programs for specific careers for those who have already completed bachelor’s degrees (4-year degrees). Governments can increase human capital by increasing funding for both formal education and subsidizing or funding certification programs.

Social and communication skills are considered to be improved by formal education and informal socialization that occurs through most job training and certification programs. Additional years of schooling are considered to boost social skills, making workers more productive by allowing them to better get along with colleagues, supervisors, and customers. Schooling improves communication skills by improving literacy - the ability to read and write - and verbal communication skills, such as through public speaking classes. Workers who are more literate and skilled at public speaking are more productive because they can learn new skills and converse with customers and clients more efficiently. Communication skills can also assist with negotiation, solving problems, and securing business deals.

Human Capital Theory

The human capital theory states that improving education and training is a primary factor in increasing productivity. Thus education and training should be invested in by society and employers. This theory is based on the original work by first economist Adam Smith, who published The Wealth of Nations in 1776. In this famous book, Smith explained that specialization and division of labor led to increased productivity.

Higher education involves specialization, as students choose to focus on specific areas. In 4-year degree programs and beyond, these are called majors. Certification programs and majors include developing skills in particular areas. As a result, these workers will be able to generate more output than those who have not specialized. Over time, those who become increasingly specialized tend to become more productive at those fewer tasks.

Division of labor allows for increased productivity by sorting workers into tasks based on skill, aptitude, and interest. This provides additional productivity gains on top of specialization, as workers who get to perform tasks they enjoy will likely be more productive. Without the division of labor, workers may have to inefficiently switch between different tasks and/or may not be able to perform tasks they enjoy. This reduces their output, even if they are highly educated and trained.

Human Capital Formation

Human capital formation looks at the overall development of the population's education, training, and skill. This typically includes government support for education. In the United States, public education has evolved significantly since the beginning.

Over time, public education became increasingly widespread in large cities. Then, it became compulsory for children of a certain age to attend public or private school or become home-schooled. By World War II, most Americans attended school up through the high school. Compulsory attendance laws ensured that most teenagers were in school and developing literacy and social skills.

Government support for higher education dramatically increased toward World War II's end with the G.I. Bill's passage. This law provided funding for military veterans to attend college. It quickly made higher education a common expectation for the middle class rather than just the wealthy. Since then, government support for education has continued to increase at both the K-12 and higher education levels.

Recent federal legislation like 'No Child Left Behind' has raised expectations in K-12 schools that students receive a rigorous education. Since the late 1940s, workers' productivity in the United States has consistently increased, almost certainly aided by increased expectations for education and training programs.