The making of 'Human Capital theory': A historical investigation

Introduction:

Most of the countries have laws that mandate for one or other form of mandatory schooling and in most of the cases, schooling is provided free of cost by the state. This does not mean that education comes without any cost. There is always an opportunity cost associated with it. The investment that generally goes into education might be utilized for some other programs or benefits. Despite huge cost associated with it, why do governments tend to spend money on it? does the investment in education worth its salt? Despite being an expensive affair, why do states/nations spend billions funding universal public education? What does the society get in general from this investment? The answers to these questions are central to the debate on human capital theory and returns to education. The concept of human capital has been often deployed to devise the public investment priorities and make policy decisions. Since the development of Human Capital theory (Becker, 1964), numerous studies have prescribed investing in education in order to develop the human capital of the economy. In its personalized avatar, human capital of an individual is often seen through the benefits one accrues out of education she has achieved. These earning differentials of level of education often encourage individuals to invest in education. Education also has positive externalities and has direct or indirect impact on many societal outcomes such as poverty reduction, nutrition, fertility decisions, crime reduction etc. including more education leading to increased productivity in GDP and standards of living. Though economists tend to be very cautious while discussing the returns to education as the differences in earnings reflect a number of factors such as the nature of skills demanded in the labour market, the policies on minimum wages, collective strength of the workers, the supply of the workers at a given time and the relative incidence of part time and seasonal work. 

In this exploratory paper, I would make an attempt to look at some of these issues, and how the returns to education concept came to be so central to the educational decision-making. The attempt would also be made to review the some of the recent studies which have tried to investigate the returns to education in the context of developing countries. The paper would also discuss the heterogeneous nature of returns to education within and across the social categories, in order to make sense of the comparative figures within a geographical region. This heterogeneity might also demand differential policy actions and solutions.

Review of Literature:

The human capital model and the role of education

Any society which takes the decision to invest in education of its younger population bases it decision on certain assumptions. Several factors come to play the part here. At the very outset, a society might perhaps see (and rather inaccurately) what sort of income is associated with specific years of schooling and qualifications. A society which decides invest in eight years (just to give an example) of education for its children would presume to get certain income in return and if they invest in nine years of schooling, they would be expecting a little more by following the convention logic. Here society sees the direct costs of education such as school fees and the cost of traveling to the school or University. These costs if too high may discourage the society from investing in more education. These decisions are also influenced by the understanding of the indirect cost or opportunity cost of an extra year of education. If returns from the extra year of education is less that the direct cost and opportunity cost then the individual might decide against enrolling for education. When a society considers all these factors together, and then calculate the income from particular year of education, the society is calculating which now has been termed as private rates of return to education (Becker, 1994). These calculations are taken into account while deciding upon both the costs and benefits of education and making further investment in education. These acquired skills which has economic value in the labour market have been term has human capital by economists.  

Though it was Becker who first proposed education and training as an investment to human capital, it was Mincer (1974) who did a systematic analysis of investment in human capital. He proposed a model which looked at the aggregate earning and net investment among the White urban male in United States. He found that the years of experience was a more appropriate predictor of an individual’s income than his/her age. Though he seemed to have completely ignored the similar concerns among women, Black or other minority populations. His proposed econometric model where individual wages were the function of schooling and years of experience is still widely used in the empirical economics.

Empirical studies in Human capital and returns to education

Since Mincer’s conceptualization of education as a function to wages, many studies have looked at the differential earnings in the context of education. McNabb and Psacharpoulos (1981) studied the earning differential between While male and Black male in United Kingdom and explored the question whether the difference in their earnings was because of distinct human capital formation in Blacks or it was due to the discrimination. Chiswick (1988) studied the differential earnings among the races in United States and found that higher levels of schooling led to higher returns across the social groups though this return varied across the social group with gender being the most disadvantaged category in generating the returns. In further studies, Gender discrimination (Goldin and Polascheck, 1987) and income distribution (Mincer, 1958) were found to be contributing to the differential returns to the education.

Krueger (1993) sought to study the impact of technology on the wages by comparing workers who were using the computers with workers who did not use it. He estimated that the workers who used the computers earned 10 to 15 per cent more than the workers who were yet to use the computers. The use of computers by workers accounted for the one third to almost half increase in the returns to education. Psacharopoulos and Patrinos (2004) reviewed the returns to education studies published in the last fifty years and affirmed the importance of human capital theory. The returns to education seemed to converged across the countries as the developing countries sought to improve the literacy and life-chances of the individuals. The paper by Harmon, Oosterbeek and Walker (2003) emphasized on the education as a private decision to invest in education and found the large private returns to education in comparison to investment in other possible areas. Banarjee and Duflo (2005) investigated the within country heterogeneity in case of returns to education and found that there was huge variance in the returns to education across the social category within a country, than the variance across the countries. They attributed this variance across the social categories to the failure of optimal allocation. Jensen (2010) argued that while studies have linked the labour market outcomes of an individual to his/her years of schooling, it is the perceived returns that impact an individual’s decision about whether to enrol for further education or not. Using the data for eighth-grade students in Dominican Republic, he pointed out that while returns to secondary schooling in the country were high, people perceived it low-return investment.

King, Montenegro and Orazem (2012) tested the Schultz (1975) hypothesis where uncertainty, and technological shocks were found to be correlated with higher level of human capital. Using 122 household surveys conducted in 86 countries, they found that it was indeed true and there was a positive correlation between the return to human capital and economic freedom. The paper by Psacharopoulos and Layard (2012) used the model proposed by Mincer and found it inadequate to explain the earning differentials in the sample collected from British males as the regression model used by Mincer (1974) did not capture the complexities of the job market. The returns to education model has been facing criticism from scholars as they claim, it has ignored the heterogeneity of the population by basing its estimate on the average returns ((Fasih, Kingdon, Patrinos, Sakellariou and Soderbom), 2012). How heterogeneity plays out would be more evident if we compare the returns to education estimate for India and Pakistan. The returns are at the top of income distribution in India, while in Pakistan, the return is highest for lowest income groups. Economists have started incorporating heterogeneity in their economic models (Lemieux, 2008). The methodological problems with returns to education have come to the fore in last decade and it remains a challenging task to fit the education and learning to an appropriate model (Lemieux, 2006).

These studies and the available literature suggest the continuing relevance of human capital theory and the returns to education approach. There are now hundreds of estimates from across the world, with significant difference in methodologies and approach. The diversity in case of returns to education demands for different policy solutions. If a country has highest returns to education among the well-off section of the society, state spending on the education may not be an appropriate strategy but it makes perfect sense to invest in education if returns are high for the impoverished sections. If education leads to more inequality, then government needs to think about the way spending on education is being done.