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50 Economics Classics: Human Capital

50 Economics Classics: Human Capital

Human Capital: a theoretical and empirical analysis

By Gary Becker

Gary Becker achieved renown thanks to his willingness to apply economic analysis to all areas of life: what will I get out of marriage? Will my firm falter if I hire only white workers? If I invest a lot of time and money in my kids, will they look after me when I am old?

But the question that occupied Becker the most concerned education. If you could do a cost-benefit analysis of going to college, compared to the money and time saved in not going, would it be worth it?

By the 1993 presidential election campaign, Bill Clinton and George W. Bush were using the phrase ‘investing in human capital’, and talking up college education and on-the-job training. Theodore Schulz coined the phrase ‘human capital’, but Becker’s book that popularised it.

When Becker was writing the first edition of Human Capital, it was acknowledged among economists that the growth of physical capital did not really account for the growth in incomes. That is, incomes grew at a faster rate than investments in machinery and land. The most obvious thing to account for this discrepancy was education.

Becker looked at census reports to see what the link was between personal income and education. He found that the rate of financial return (after tuition costs) on a college education for white males was 11% to 13%. White males got more benefit than black males, because there were more opportunities for them in the job market.

But why exactly are graduates more valuable to employers? Becker argued education provides not just knowledge and skills, but ‘a way of analysing problems’.

This is a valuable marketable commodity, and contradicts the idea that the value of education is simply in credentials, and in the time it saves employers in selecting the best people.Yet if it is true that the more productive students go to college in the first place, college only further increases their productivity, knowledge, skills and judgement.

One of Becker’s observations was that, unlike with other kinds of capital, returns on investment in human capital often increase over time. The payoff period for a college education, for instance, can be very long, making the initial investment a bargain.

Yet Becker also asked whether investments in education are superior or inferior to other investments. As an investment in a college education involves a fair degree of risk and is extremely illiquid, it is right to compare it to similar forms of risky and illiquid investment?

He referred to research by George Stigler which found that investments in manufacturing capital yield an average of around 7% over time, considerably lower than the 11 to 13% that Becker arrived at for college education.

However, actual money capital invested in education or training is only part of the total investment. The majority is in the opportunity cost of time invested in doing so. As the value of a person’s time rises as their amount of education rises, the cost of obtaining further education may not make sense in market terms.

Becker was careful to say that the case for a college education was strong, but only because the personal income data and GDP data showed its positive effects. When there was no longer a clear payoff then people should rationally reallocate their investments in human capital.

Final comments

‘The difference between the most dissimilar characters,’ Adam Smith wrote in The Wealth of Nations, ‘between a philosopher and a common street porter, for example, seems to arise not so much from nature, as from habit, custom and education.’ Becker agreed, arguing everyone has the same potential to benefit from investments in their human capital.

In a place where the quality of schooling is unequal, you will end up with very unequal distribution of income, because the payoffs from being in education increase over time. In contrast, in places where nearly everyone goes to the same government schools, which are of a similar standard, you will get more equality of income.

When, in the 1970s, there was a slump in the earnings of people with college educations, there was much talk of ‘overeducated Americans’, but in the 1980s the earnings of college-educated Americans hit new heights. Today, the college premium is even higher, proving Becker’s point.

The best investment, it seems, is in yourself.

Copyright © Tom Butler-Bowdon, 2017. The above is an abridged extract from 50 Economics Classics, priced at £12.99, by Tom Butler-Bowdon, published by Nicholas Brealey Publishing.

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