Human Resource Economics

When firms hire workers they are, knowingly or unknowingly, acquiring human capital. The idea is far from new but only recently has it acquired enough stature to be considered a factor of production in its own right. Human Capital Theory and the Resource View of Firm maintain that to prosper, a business must create value in ways that rivals cannot. The wellspring of innovative thinking this requires is the knowledge worker capable of 'learning by doing.' Such at least is the current economic thinking that drives the more traditional human resource function of screening, selection, training and development.

Keywords Core Competency; Cost-Based Valuation; Educational Stock; Factors of Production; Human Capital; Human Capital Theory; Human Resources; Income-Based Valuation; Resource-Based View of the Theory of the Firm; Sustainable Competitive Advantage; Tacit Knowledge; The Resource-Based View of the Firm; Theory of Production

Economics > Human Resource Economics

Overview

We live in a 'post-industrial' age where our individual and collective prosperity increasingly depends on how well or ill we acclimate to the 'knowledge' economy. But in order to succeed at this, we will have to see ourselves as more than just hard-working members of the labor force. High wages and steady employment will increasingly go to those of us who think of themselves as an investment in 'human' capital. We must, in a word, build a sophisticated 'skills-set' that adds value to prospective employers' products and services. The alternative is to become a casualty of the onward rush of technology and globalization and eke out an uncertain living at a succession of low-paying jobs. It's a grim choice with a decidedly contemporary edge to it. Actually, though, the idea of people as 'human' capital was discussed in 1776 by the 'father' of classical economics, Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations.

Any worker who invests time and effort into mastering a skill, Smith maintained, has a right to a wage over and above a common laborer's. To Smith, this higher wage was just compensation not only for the years of grueling apprenticeship the worker endured to become a tradesman but also for the immediate gratification of other needs that he willingly postponed (Wöβmann, 2003). Over the next two centuries, then, economists considered learning a form of consumption driven by a particular individual's utility function — the sum of goods, services and activities afforded by working that each of us finds uniquely satisfying. To this day, ambitious people forgo income and leisure time to undertake years of demanding academic training to maximize their long term utility. But today, pivotally, this is seen as an investment in 'human capital' rather than a household purchase-decision.

Human Capital

What exactly though is 'human capital'? The formal concept arose in the 1960s out of the work of two American economists, Theodore Schultz and Gary Becker. Schultz had observed how parents in rural households willingly chose to sacrifice their own material comfort in order to finance their children's college educations, so convinced were they that the improved earning powers a degree would bestow on their offspring. Both he and Becker was struck by how their decisions were really no different than a firm's forward-looking decision to re-invest profits in new plant and equipment. The two, in fact, were so similar, they further concluded, that intangible knowledge and concrete physical capital actually mirrored each other in key respects. That very idea was the centerpiece of Becker's ground-breaking 1962 book, Investment in Human Capital: a Theoretical Analysis.

It was a timely introduction, for the traditional factors of production — land, labor and physical capital — added together no longer accounted for all the yearly growth in gross domestic product recorded for the U.S. economy in the 1950s. Initially at a loss to explain the growing discrepancy, economists assigned it the non-descript label, the 'residual' factor. Human capital proved a far more satisfying theoretical explanation (Nafukho, Hairston & Brooks 2004). One that, in hindsight, correctly assessed the pivotal importance technology would assume in production, service-delivery and information processing in the coming decades (Iacob & Andrei, 2011).

Human Capital Theory

Crucially, though, Human Capital Theory as it became known was applied only to the household and the nation as a whole. The firm, the source of all the productive capacity and most of the employment in a national economy, was yet to be incorporated. Still, as originally formulated, it did bridge the labor-capital divide prevalent in previous economic thinking on the subject. Education and training no longer necessarily belonged in the broader definition of labor, which stemmed from the axiom that work could be both mental and/or manual. Knowledge gleaned from a firm's direct experience with production processes, alternatively, no longer had to necessarily be considered a form of physical capital.

Amendment to the Theory of Production

Before the construct could be applied to the firm, though, one of the most basic models in all of microeconomics — the Theory of Production — would first have to be amended. It conceives the firm strictly as a production 'function' where profits are maximized by turning raw materials, labor and fixed capital goods, its 'inputs', into goods and services, it 'outputs'. Whether a business succeeds or fails depends on its ability to simultaneously minimize short-run costs and maximize both short- and long-run profits. To do this, it has to decide the price it will charge and how much to produce. These decisions, in turn, are heavily influenced by the rents, wages and interest it must pay out and the quantities of each productive factor it will require to meet its output quota.

The Resource-Based View

It would take another twenty years for a successor model, the resource-based view of the firm, to come along. Here, a firm is the sum of the strategic resources available to it. And, significantly, many of these are decidedly less tangible forms of assets than the usual plant, equipment, financial capital, etc. Resources like organizational processes, knowledge, technical expertise, in fact, contribute more towards building a sustainable competitive advantage, provided, that is, they are rare, inimitable and non-substitutable. So the morphing of the traditional personnel department into its modern human-resources re-incarnation is more than just cosmetic. For, fundamentally, the processes, knowledge, technical expertise and other strategic resources vital to the survival of today's firm are the product of its human capital (Crook, Combs, Todd, Woehr & Ketchen, 2011). A company has to either make or buy it and retain and encourage it thereafter. And therein lies the reason for the name change.

Further Insights

Compared to Human Capital Theory, marginal analysis, the prevailing neoclassical construct of its day, comes across as mechanistic and one-dimensional. As well it might considering how simple the basic idea behind it is: The amount of output created by one additional unit of input of labor or capital is a very useful measure. And that's because all a firm has to do to maximize its profits is ensure its marginal costs equal its marginal revenues. Formulated at the turn of the twentieth century, it bears all the hallmarks of the era of mass industrialization when most of the labor employed in manufacturing was unskilled and therefore homogeneous. The labor force since then, of course, has grown ever more heterogeneous and the attendant wage differentials among workers more pronounced (Teixeira, 2002). Though not as quantitative perhaps, Human Capital Theory acknowledges this changed reality. Firms that embrace it, moreover, do so because by investing in human capital, a firm is better able to increase its productivity while keeping its wages relatively constant, a sure route to profitability in the twenty-first century.

The Valuation Problem

Still, human capital is an intangible product of the mind and therefore cannot be quantified as easily as rents, wages or investments in plant and equipment. Yet, if it is a full-fledged factor of production as its supporters contend, it must have monetary value, like land, labor, and physical capital. But how exactly do you go about this? Economists have been grappling with the larger question of how to determine the intrinsic net worth of the individual since 1694, but at the national not the firm-level. For centuries, the preferred method relied on calculating the net present value of an individual's lifetime earnings net his living expenses. Applied across an entire population, income-based valuation assays the monetary worth of a nation's stock of 'human' capital. One such exercise conducted in 1914 estimated the stock of 'human' capital in the U.S. was six to eight times that of conventional capital (Kiker, 1966).

An alternate, cost-based method of valuation first proposed in the nineteenth century simply tallied up the expenses incurred in raising a child from birth to age 25. Subsequent refinements have veered from this original formula only in so far as drawing a distinction between the costs of someone's physical maturation on the one hand and the enhancement of the quality or productivity of his or her labor on the other. This latter category, it must be said though, is rather expansive: Besides education and training, outlays for health, transportation and other so called 'social' costs are included. More recently, attention has turned to the more focused valuation a country's educational-stock: The aggregate sum of all the costs of every citizen's formal schooling and vocational training. Included here is tax-payer spending on public education, tuition paid to private academic and trade schools, company outlays for in-house training programs, etc.

Although individual or national in scope, each valuation method can also be applied more narrowly to the firm. So, for example, a firm's aggregate spending on training is one measure of its investment in human capital. But by the same token, so is its spending on finding qualified new hires or its total expenditures on human resources. A separate set of income-measures might include productivity per employee, return on investments in new products, licensing fees earned from patents held by the company, etc. It's fair to say, though, that no one figure completely captures the total value of a firm's human capital. Nor will there likely be one until accounting practices standardized the requisite balance-sheet line items.

Human Capital in Perspective

Should knowledge in all its form be considered an asset or just some specialized subset germane to the firm's business or its industry? As far as Becker was concerned, the terms education and human capital were more or less interchangeable. He did however draw a distinction between 'general' and 'specific' education — the former being traditional schooling, the latter on-the-job training — yet considered each a part of a greater whole. Firms, needless to say, have long relied upon academic performance to gauge the innate cognitive abilities of prospective employees. Moreover, the reasoning, writing, numeracy and problem-solving skills honed during the most general of liberal arts educations is thereafter at the firm's disposal. This kind of screening, though, ignores other forms of human capital — mechanical, technical, artistic, interpersonal, and leadership aptitudes — firms can readily take advantage of.

Theorists since Becker have thought long and hard about how best to properly weigh the economic importance of different levels of knowledge and skill. One widely accepted pyramidal hierarchy parses knowledge and skill according to whether it's specific to an individual, an industry or a firm. Here, the more generic the knowledge and skill, the less it contributes directly to a firm's competitive advantage. Companies always benefit from hiring people with a good academic grounding in a particular vocational field like accounting or electronics and/ or prior managerial or entrepreneurial experience. Though specialized to a degree, academic and vocational knowledge or functional skills of this sort can be put to use across a wide spectrum of industries. More importantly from a cost-benefit perspective, new entry-level hires generally have already acquired the requisite knowledge and skills at their own or others expense, not the company's.

Still, successful careers in any line of business are predicated on a life-time's worth of learning about its evolving technology-platforms, manufacturing processes, product benefits, customer needs, etc. As rational economic agents, then, we have a vested interest in industry-specific knowledge. For, the more one knows about these relatively arcane subjects, the greater an asset one becomes to any firm competing in a particular market space. Too specialized for the general public yet not proprietary in nature like the firm-specific variety, industry-specific knowledge lies half-way between the two (Dakhli & De Clercq, 2004). Sometimes, though, the boundary-lines become blurred: companies occasionally exchange firm-specific knowledge when unsolved problems with enabling technologies stand in the way of developing a new class of product. At other times, the enthusiasm of most technical specialists for their work being what it is fosters informal, intermittent communication among colleagues at rival firms.

Firm-Specific Human Capital

At the pinnacle of the pyramid sits the non-transferable, firm-specific knowledge. Few would dispute that the highly specialized knowledge instrumental to creating competitive advantage is much more of an asset to a firm than the general knowledge individuals use every day or industry-specific knowledge: Enough of an asset in fact to be the centerpiece of the resource-based view of the firm that puts a premium on rare, hard-to-imitate 'core' competencies a firm develops internally. Purists further argue that the costs directly related to their development constitute the sum-total of a firm's human capital. If other firms have access to the same knowledge and skill-sets, they do not in and of themselves create competitive advantage (Lin & Wang, 2005). Perhaps not the firm's sole form of human capital, it nonetheless may well be its single most important, ongoing investment. To prosper, a firm has to be better at providing customers a unique benefit and/or reducing production costs. For, over time, more conventional bulwarks — branding, market share, capitalization and the like — are less unassailable; competitors can and will respond in kind. Be it product-design, manufacturing processes, marketing plans, etc., then, the only durable defense is to continually innovate; something talented, knowledgeable and technically-skilled employees excel at (Youndt & Snell 2004).

Indeed, it has become almost an article of faith that a firm can successfully fend off any competitor by leveraging knowledge it alone possesses. The resource-based view of the firm stresses the value of human capital for a reason. Innovation comes about through complex social interactions involving the informal exchange of tacit knowledge between coworkers on an ongoing basis (Hatch & Dyer, 2004). That value is created via these undocumented, often spontaneous, knowledge-transfers is a widely-accepted premise even though the evidence to support this claim is still largely qualitative and anecdotal. In the workplace as in the rest of the real world, essentially, learning and creative collaboration takes many forms and flows through many channels; some obvious, others not. Exiting cost accounting practices, simply put, do not and perhaps cannot itemize such sub-rosa exchanges. For its importance notwithstanding, how exactly do you assess the amount of a firm's profits flowing directly from something so ephemeral and episodic? That's not the same as saying human capital plays little or no role in creating value, but just that it is very difficult to isolate and quantify (Gallié & Legros, 2012).

Conclusion

Individuals continue to invest time and money today to acquire marketable skills on their own, much like the artisan of Adam Smith's day. Spurred on by the prospect of mutual gain, moreover, high-tech firms and knowledge-workers seek each other out in much the same way as buyers and sellers in any marketplace have done for centuries. What's changed is the extent to which a firm's success today, tomorrow and five years from now increasingly hinges on the organizational processes that supply the knowledge and skills it needs to carve out a defensible competitive position. Screening, selection, training and development of the firm's human resources are strategically vital tasks. Without the complimentary funding of extensive in-house training and compensation packages commensurate with the value an individual creates, and the indirect costs of structuring and perpetuating an organization where information flows freely and workers 'learn by doing,' these efforts will be for naught. Human capital is fast becoming as important as physical capital, and any firm that fails to adjust accordingly does so at its peril.

Terms & Concepts

Core Competency: Specialized expertise a company has in the design and manufacture of products or delivery of services that competitors cannot easily duplicate.

Cost-Based Valuation: When first proposed in 1883, the cost of raising a child from birth to age 25. Refined periodically from the 1960s onwards, the term now refers to the monetary investment made in a person's maturation and the investment subsequently made in enhancing the quality or productivity of his or her labor.

Educational-Stock: The amount of formal education a company's employees or a nation's citizens have. .

Factors of Production: In classical economics, land, labor, and physical capital are all considered necessary prerequisites for the manufacture of goods or the provision of services. Contemporary economics considers entrepreneurship and human capital to also be full-fledged factors.

Human Capital: The skills and knowledge people acquire that create or add value to goods and services.

Human Capital Theory: Firms materially benefit from having a knowledgeable, skilled workforce and should therefore invest in its education and training just as individuals do.

Human Resources: A business support function tasked with finding, screening, hiring and training employees and administering their benefits.

Income-based Valuation: A person's human capital is equivalent to The net present value of his/her anticipated lifetime's earnings minus his/ her living expenses originally formulated in 1853.

Resource-Based View of the Theory of the Firm: States that the critical core competencies that give a firm a competitive advantage must be developed internally and remain exclusive to the firm.

Sustainable Competitive Advantage: Exists whenever a firm leverages a core competency to create unique value for customers other firms cannot easily duplicate and so locks in above-average long-term profits.

Tacit Knowledge: Internally-generated knowledge rarely if ever formally articulated embedded in and used collaboratively by a firm's employees.

Theory of Production: How a firm uses factors of production to earn a profit.

Bibliography

Basdevant, O. (2004). Some perspectives on human capital and innovations in growth models. Compare: A Journal of Comparative Education, 34, 15-31. Retrieved October 14, 2007, from EBSCO Online Database Education Research Complete. http://search.ebscohost.com/login.aspx?direct=true&db=ehh&AN=12917213&site=ehost-live

Crook, T., Combs, J. G., Todd, S. Y., Woehr, D. J., & Ketchen Jr., D. J. (2011). Does human capital matter? A meta-analysis of the relationship between human capital and firm performance. Journal of Applied Psychology, 96, 443-456. Retrieved on November 19, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=60868735&site=ehost-live

Dakhli, M., & De Clercq, D. (2004). Human capital, social capital, and innovation: A multi-country study. Entrepreneurship & Regional Development, 16, 107-128. Retrieved November 9, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=12511408&site=ehost-live

Gallié, E., & Legros, D. (2012). Firms' human capital, R&D and innovation: A study on French firms. Empirical Economics, 43, 581-596. Retrieved on November 19, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=80039952&site=ehost-live

Hatch, N., & Dyer, J. (2004). Human capital and learning as a source of sustainable competitive advantage. Strategic Management Journal, 25, 1155-1178. Retrieved November 22, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=15088227&site=ehost-live

Iacob, A., & Andrei, A. (2011). Human capital and organizational performance. Managerial Challenges of the Contemporary Society, , 130-136. Retrieved on November 19, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=77410496&site=ehost-live

Kiker, B. (1966). The historical roots of the concept of human capital. Journal of Political Economy, 74, 481. Retrieved November 9, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5055753&site=ehost-live

Le, T., Gibson, J., & Oxley, L. (2003). Cost- and income-based measures of human capital. Journal of Economic Surveys, 17, 271-307. Retrieved November 9, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=9933261&site=ehost-live

Lin, K., & Wang, M. (2005). The classification of human capital according to the strategic goals of firms: An analysis. International Journal of Management, 22, 62-70. Retrieved November 9, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=12511408&site=ehost-live

Nafukho, F., Hairston, N., & Brooks, K. (2004). Human capital theory: Implications for human resource development. Human Resource Development International, 7, 545-551. Retrieved October 14, 2007, from EBSCO Online Database Education Research Complete. http://search.ebscohost.com/login.aspx?direct=true&db=ehh&AN=15544716&site=ehost-live

Teixeira, A. (2002). On the link between human capital and firm Performance: A theoretical and empirical survey. Working Papers (FEP) — Universidade do Porto, , 1-38. Retrieved October 14, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=18278984&site=ehost-live

Wöβmann, L. (2003). Specifying human capital. Journal of Economic Surveys, 17, 239-270. Retrieved October 14, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=9933262&site=ehost-live

Youndt, M., & Snell, S. (2004). Human resource configurations, intellectual capital, and organizational performance. Journal of Managerial Issues, 16, 337-360. Retrieved October 14, 2007, from EBSCO Online Database Education Research Complete. http://search.ebscohost.com/login.aspx?direct=true&db=ehh&AN=14829087&site=ehost-live

Suggested Reading

Henderson, D., & Russell, R. (2005). Human capital and convergence: A production-frontier approach. International Economic Review, 46, 1167-1205. Retrieved October 14, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=18515350&site=ehost-live

Hitt, M., Biermant, L., Shimizu, K., & Kochhar, R. (2001). Direct and moderating effects of human capital on strategy and performance in professional service firms: A resource-based perspective. Academy of Management Journal, 44, 13-28. Retrieved October 14, 2007, from EBCSO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=4131589&site=ehost-live

Monteils, M. (2004). The analysis of the relation between education and economic growth. Compare: A Journal of Comparative Education, 34, 103-115. Retrieved October 14, 2007, from EBSCO Online Database Education Research Complete. http://search.ebscohost.com/login.aspx?direct=true&db=ehh&AN=12917212&site=ehost-live