Human Capital

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The Basic Theory of Human Capital
1. General Issues
One of the most important ideas in labor economics is to think of the set of marketable skills of workers as a form of capital in which workers make a variety of investments. This perspective is important in understanding both investment incentives, and the structure of wages and earnings.

Loosely speaking, human capital corresponds to any stock of knowledge or characteristics the worker has (either innate or acquired) that contributes to his or her “productivity”. This definition is broad, and this has both advantages and disadvantages. The advantages are clear: it enables us to think of not only the years of schooling, but also of a variety of other characteristics as part of human capital investments. These include school quality, training, attitudes towards work, etc. Using this type of reasoning, we can make some progress towards understanding some of the differences in earnings across workers that are not accounted by schooling differences alone.

The disadvantages are also related. At some level, we can push this notion of human capital too far, and think of every difference in remuneration that we observe in the labor market as due to human capital. For example, if I am paid less than another Ph.D., that must be because I have lower “skills” in some other dimension that’s not being measured by my years of schooling–this is the famous (or infamous) unobserved heterogeneity issue. The presumption that all pay differences are related to skills (even if these skills are unobserved to the economists in the standard data sets) is not a bad place to start when we want to impose a conceptual structure on


Lectures in Labor Economics
empirical wage distributions, but there are many notable exceptions, some of which will be discussed later. Here it is useful to mention three: (1) Compensating differentials: a worker may be paid less in money, because he is receiving part of his compensation in terms of other (hard-to-observe) characteristics of the job, which may include lower effort requirements, more pleasant working conditions, better amenities etc.

(2) Labor market imperfections: two workers with the same human capital may be paid different wages because jobs differ in terms of their productivity and pay, and one of them ended up matching with the high productivity job, while the other has matched with the low productivity one.

(3) Taste-based discrimination: employers may pay a lower wage to a worker because of the worker’s gender or race due to their prejudices. In interpreting wage differences, and therefore in thinking of human capital investments and the incentives for investment, it is important to strike the right balance between assigning earning differences to unobserved heterogeneity, compensating wage differentials and labor market imperfections. 2. Uses of Human Capital

The standard approach in labor economics views human capital as a set of skills/characteristics that increase a worker’s productivity. This is a useful starting place, and for most practical purposes quite sufficient. Nevertheless, it may be useful to distinguish between some complementary/alternative ways of thinking of human capital. Here is a possible classification:

(1) The Becker view: human capital is directly useful in the production process. More explicitly, human capital increases a worker’s productivity in all tasks, though possibly differentially in different tasks, organizations, and situations. In this view, although the role of human capital in the production process may be quite complex, there is a sense in which we can think of it as represented (representable) by a unidimensional object, such as the stock 4

Lectures in Labor Economics
of knowledge or skills, h, and this stock is directly part of the production function.
(2) The Gardener view: according to this view, we should not think of human capital as unidimensional, since there are many many dimensions...
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