What Is the Human Capital Theory and How Is It Used?

What Is Human Capital?

Human capital is a loose term that refers to the educational attainment, knowledge, experience, and skills of an employee. The theory of human capital is relatively new in finance and economics. It states that companies have an incentive to seek productive human capital and to add to the human capital of their existing employees. Put another way, human capital is the concept that recognizes labor capital is not homogeneous.

The Origins of the Human Capital Theory

In the 1960s, economists Gary Becker and Theodore Schultz pointed out that education and training were investments that could add to productivity. As the world accumulated more and more physical capital, the opportunity cost of going to school declined. Education became an increasingly important component of the workforce. The term was also adopted by corporate finance and became part of intellectual capital, and more broadly as human capital.

Intellectual and human capital are treated as renewable sources of productivity. Organizations try to cultivate these sources, hoping for added innovation or creativity. Sometimes, a business problem requires more than just new machines or more money.

The possible downside of relying too heavily on human capital is that it is portable. Human capital is always owned by the employee, never the employer. Unlike structural capital equipment, a human employee can leave an organization. Most organizations take steps to support their most useful employees to prevent them from leaving for other firms.

Critiques of the Human Capital Theory

Not all economists agreed that human capital directly raises productivity. In 1976, for instance, Harvard economist Richard Freeman argued that human capital only acted as a signal about talent and ability; real productivity came later through training, motivation, and capital equipment. He concluded that human capital should not be considered a factor of production.

Around the same time, Marxian economists Samuel Bowels and Herbert Gintis argued against the human capital theory, stating that turning people (i.e. labor) into capital essentially squashes arguments around class conflict and efforts to empower workers' rights.

In the 1980s and 1990s, with the rise of behavioral economics, new critiques were leveled at the human capital theory in that it relies on the assumption that human beings are rational actors. Therefore, the human capital theory will experience the same defects and limitations when it attempts to explain phenomena because its basic assumptions on human motives, goals, and decisions are, it turns out, not well-grounded.

More modern critiques from sociologists and anthropologists argue against the human capital theory, saying it offers extremely simple principles that purport to explain everyone’s wages, all the time—or, a universal connection between human capital, productivity, and income. But when researchers look closely at this, for the most part, productivity differences between individuals cannot be measured objectively.

According to a 2018 paper, studies that claim to find a link between income and productivity do so by using circular logic. And when we restrict ourselves to the objective measurement of productivity, we find that individual productivity differences are systematically too small to account for levels of income inequality.