Human Capital Theory – distorting reality with neo-classical economics

Human capital business diagram

Neo-classical economics = An approach to economics that relates supply and demand to an individual’s rationality and his or her ability to maximize utility or profit. Neoclassical economics also increased the use of mathematical equations in the study of various aspects of the economy. This approach was developed in the late-nineteenth century. Read more: http://bit.ly/1Q1lJAI

Guided reading and extracts

From – http://bit.ly/1Jv5jjb

BAPTISTE (2001) says the term human capital refers to knowledge, attitudes, and skills that are developed and valued primarily for their economically productive potential. It “refers to the productive capacities of human beings as income-producing agents in an economy” (Hornbeck & Salamon, 1991, p. 3) and to “the present value of past investments in the skills of people” (Blaug, 1970, p. 19).

Human capital formation is the name given to the process by which such capital is deliberately developed, and the expenditure (in time, money, etc.) is called human capital investment (Becker, 1962, p. 9). The 18th-century economist Adam Smith introduced the notion of humans as capital in his classic Wealth of Nations (Smith, 1776/1937). Others, such as Alfred Marshall (1890/1930) and Irvin Fisher (1906), kept the idea alive (Walsh, 1935). Notwithstanding its long history, the theory of humans as capital remained relatively undeveloped well into the 20th century.

Jamil (2004)  explains that Human Capital Theory argues that a person’s formal education determines his or her earning power. There are discrepancies surrounding the notion that education should be construed as a direct form of investment in one’s financial future. There are several reasons to dispute the notion that one’s education influences earnings.

The first is that non-educational factors also influence earnings.

Secondly, there are weaknesses in the way ‘benefits‘ and ‘costs’ of education in Human Capital research are defined.

Thirdly, there is skepticism of` the indicators of social benefits claimed to have resulted from investment in education.

Fourthly, limitations of data sources generally used in Human Capital research tend to distort reality. And finally, weaknesses are inherent in the way that Human Capital research is conducted due to its nature as an economic research.

Researchers fail to recognize that each variable has its own theory, for which their knowledge of that theory is often inadequate. In human capital research, researchers cannot simply take correlations found between earnings and education as a causal relationship without adequate knowledge of the full implications, nor without examination of all other altematives. These technical mistakes are often further aggravated by methods of measuring retums on human capital that concentrate only on certain costs / benefits, on the singular use of educational qualification to compare countries, and / or are based on data sources whose integrity is questionable.

Two critiques of Human Capital Theory (from http://bit.ly/1Jv5jjb)

Human Capital Theory has been criticised on a number of counts. Two critiques are outlined here: one external and one internal. The clearest statement of the deficiencies of human capital theory goes to the heart of neo-classical economics. The revival of economic sociology, in particular at the hands of Fred Block (1990: 21), seeks to challenge the basic assumptions motivating the methodology of neo-classical economics. He claims these rest on two basic building blocks.

The first is the idea that the economy is an analytically separate realm of society that can be understood in terms of its own internal dynamics. Economists are perfectly aware that politics and culture influence economy, but they see these as exogenous factors that can be safely bracketed as one develops a framework that focuses on purely economic factors.

The second key foundation is the assumption that individuals act rationally to maximise utilities. Here, again, economists are acutely aware that individuals are capable of acting irrationally or in pursuit of goals other than the maximisation of utility, but the strategy of excluding these deviations from the rationality principle is justified by the effort to identify the core dynamics of an economy.

For Block (1990), these assumptions on which neo-classical, and therefore also, human capital theory depends, are cast in universal and ahistorical terms. Given the facts that they emerged from a body of theory which was first formulated in the nineteenth century and that they continue to provide the basis for neo-liberal restructuring of the state in the 1980s and 1990s within most western liberal democracies, it is, perhaps, time that these original assumptions were re-examined. Together the two assumptions provide a basis for the model of the self-regulating market which harmonises transactions for products, labour and capital.

Economic sociology challenges the first assumption by arguing that the society and culture can not be arbitrarily split of from the economy. Clearly, both the society and culture shape the preferences of individuals in various ways. Social factors also influence economic contractual transactions. Even the contract rests on cultural understandings and the legal framework which is itself historically determined.

The methodological foundations of neo-classical economics obscure the social, cultural, and political determinants of economic action. Marginson (1993: 25) argues that this results in an analysis that is ahistorical and, through a tautological procedure, continually rediscovers the centrality of purely economic notions. Based as it is on the false premise of the ‘naturalness’ of the pursuit of economic gain by human inclinations, the ‘economic fallacy’ imagines that capitalist societies do not have cultures in the way that primitive or pre-modern societies do. When we recognise that the pursuit of economic self-interest is itself a cultural creation, then it is apparent that we too are ruled by deeply held, but unexamined, collective beliefs.

Human capital theory, then, is an impoverished notion of capital. It is unable to understand human activity other than as the exchange of commodities and the notion of capital employed is purely a quantitative one.

This misses the point that capital is an independent social force where the creation of social value comes about through its capital accumulation and continual transformation through the circulation of commodities. Under capitalism, labour is structurally separated from the means of production. Labour and the means of production are concentrated as commodities and capital in the hands of an opposing class. The means of production are not only physical but also appear in social relations. The individual under capitalism can only come to grips with the means of production through selling his or her labour commodity.

The struggle of the labourer to improve life’s conditions is mediated then through the social relations within which they find themselves. Given this explanation, human capital is an abstract form of labour – a commodity – and not capital. Commodities such as human capital are therefore part of the life cycle of capitalism as a form of labour and not able to be exchanged independently of it.

The second assumption exposed by Block (1990) which is of primary importance to human capital theory, is also open to criticism on a variety of grounds. In modern human capital theory all human behaviour is based on the economic self-interest of individuals operating within freely competitive markets. Other forms of behaviour are excluded or treated as merely distortions of the model.

Friedman (1962: 100-101) for example, has argued that all the benefits of vocational and professional education are limited to the individual who is educated. The maximisation of rational self-interest separate from the social group that the individual belongs, is a central article of faith in human capital theory. A criticism of the rational utility maximiser (Block, 1990: 25) suggests that the elevation of self-interest to a position of dominance on which much economic analysis rests, is itself a consequence of social arrangements.

What constitutes rational action depends to some degree on the context which human capital theory denies with its individualistic methodology. From a poststructuralist perspective, Elster (1983) emphasises the problematic nature of individual rationality that is behind any notion of self-interest. According to Elster (1983), under conditions of complexity and uncertainty, the gap between rationality in action and perfect rationality can be substantial.

Further criticism of human capital theory concerns a more technical problem with criticisms about the employment of the theory as a means of accounting for national economic growth. Arguments about economic growth accounting such as Becker’s (1994), show at best that education contributes to differences in earnings between people and then only in certain circumstances.

This criticism comes from Blaug (1987: 233) who contends, “it has to be said that the models so far examined in the growth accounting literature fail utterly to explain the mechanism by which this effect is produced”.

The contention that economic growth emanates from education is a non sequitur because, while it may be granted that education contributes to growth, so do many other activities. Blaug (1987: 231) says that what must be illustrated is “not that education contributes to growth, but that more education would contribute more to growth at the margin than more health, more housing, more roads, etc”.

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