Human Capital

It refers to the economic value of a worker’s attributes that positively affect productivity. 

Author: Sid Arora
Sid Arora
Sid Arora
Investment Banking | Hedge Fund | Private Equity

Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a BS from The Tepper School of Business at Carnegie Mellon.

Reviewed By: Rohan Arora
Rohan Arora
Rohan Arora
Investment Banking | Private Equity

Mr. Arora is an experienced private equity investment professional, with experience working across multiple markets. Rohan has a focus in particular on consumer and business services transactions and operational growth. Rohan has also worked at Evercore, where he also spent time in private equity advisory.

Rohan holds a BA (Hons., Scholar) in Economics and Management from Oxford University.

Last Updated:September 23, 2023

What Is Human Capital?

It is the stock of knowledge a labour force possesses. In other words, it refers to the economic value of a worker’s attributes that positively affect productivity. 

These personal attributes include: 

  • Employee skills
  • Knowledge
  • Skillset
  • Technical expertise
  • Intelligence
  • Training
  • Skills
  • Experience
  • Health
  • Abilities

It also includes an employee’s character traits like employee judgment, wisdom, loyalty, and punctuality.

It is an intangible asset or resource that cannot be seen or reflected in a company’s financial statements. A firm tends to increase its human capital through employee training, education, and skill enhancement investments.

All labour is not considered equal. This is because several influencing factors, like the level of education and skills, vary. In addition, it requires continuous and long-term investments.

The knowledge possessed by the labour force is an important indicator of economic growth. This can be attributed to the fact that technological change, a driving factor of economic growth, is not possible without human resources. 

Thus, it increases productivity and profitability and generates wealth for a firm or an economy. Therefore, managing and developing human resources in an economy is an important indicator of economic performance. 

While firms may invest in people through training, governments resort to public infrastructure, like schools, libraries, medical clinics, etc., to provide an educated and healthy workforce.

Irving Fisher first used the term. However, the concept of including 'the acquired and useful abilities' as an input to production was first given by Adam Smith in the 18th century in his book 'An Inquiry into the Nature and Causes of the Wealth of Nations.

However, the term was popularized in the 1960s through the works of economist Theodore Schultz. He used the term to describe human capacities as a form of capital to improve the level and quality of production.

Key Takeaways

  • Human capital refers to the economic value of a worker's attributes that positively affect productivity, including skills, knowledge, technical expertise, experience, and character traits.
  • Investment in human capital through employee training and education is crucial for increasing productivity and generating wealth for a firm or economy.
  • Human resource management practices focus on overall employee development to achieve personal and professional goals, creating value for the employee and the firm.
  • The value of human capital can be measured through factors like education, skills, abilities, judgment, leadership qualities, and health, which all contribute to employee productivity.
  • The Human Capital Index (HCI) published by the World Bank measures a nation's ability to derive economic value from its citizens, considering education and healthcare quality, with Singapore having the highest HCI score as of 2021.

Human resource vs. Human capital

The human resource capitalism concept states that the principal determinant of economic productivity is people's capacity. This concept used by social scientists views human resources as an asset to production. 

It was common to see firms treat their employees as a means to an end, the end being maximized profits. However, as the world shifts towards a global knowledge economy, employee health and skills are more important than ever.

Firms can no longer deny the existence of a positive relationship between overall employee well-being and productivity. This deemed necessary a shift from human capital management practices to human resource management practices.

While human capital refers to the development of employee skills for maximization of profits through increased productivity, human resource is a holistic term referring to the overall development of an employee to help him achieve personal and professional goals. 

Human capital management is narrow in focus and includes rewarding and managing employees, appraisals and reviews, hires and lay-offs, etc. 

On the other hand, human resource is a composite term comprising capital management practices, leadership training, succession planning, managing relationships among employees, etc.

Human resource management practices are crucial in employee development and skill enhancement as it focuses on creating value for the employee and not just the firm. 

Firms heavily invest in human resource management systems and human resource departments to improve workforce quality and satisfaction. A lower turnover rate is usually associated with higher employee productivity and capital in a firm. 

By improving the quality of the workforce through investment in increasing worker skills and abilities and reward-based compensation, a firm can create more flexible and innovative employees.

Human Capital Vs. Human Resource
  Human resource Human capital
Focus Personnel and workforce of an organization. Skills, knowledge, and capabilities of employees.
Concerned with Administrative aspects of managing employees. Nurturing employee development and growth.
Time horizon Short-term employee needs and roles. Long-term potential and value employees bring to the organization.
Management Traditional approach to managing personnel. Modern approach to managing talent and organizational success.
Integration Limited integration with the strategic goals of the organization. Strong integration with the strategic objectives and vision of the organization.

Measurement of Human Capital

The skills of employees cannot be measured. However, its value is reflected in the total profits of the firm.

Since it is affected by the firm's investment value, the Return on Investment(ROI) of human capital can be calculated by dividing the company's total profits by its total investment in human resource management.

It is important to know that human resources are susceptible to depreciation, similar to physical capital. This may occur due to the following reasons:

  • Unemployment
  • Injury 
  • Mental decline
  • Inability to keep up with innovation
  • Old age

Human resources are also mobile. As a result, people tend to migrate for higher compensation or better working conditions. This concept is dubbed brain drain or capital flight.

Workers are often seen moving to developed economies. Brain drain is a significant reason some economies stay undeveloped or developing over long periods.

The value of an employee cannot be measured only through education and training. For example, a highly qualified professor in an educational institution may not connect with students, which leads to lower productivity.

Various other factors determine the value of the labour force. Some common factors are:

  1. Higher education determines the knowledge of an employee.
  2. Operational intelligence and skills an employee possesses.
  3. Technical and non-technical qualifications, expertise, and abilities of an employee.
  4. Judgment and wisdom are possessed by an employee and are usually cultivated through experiences and personal characteristics.
  5. Innovation in approach and ability to work efficiently is usually seen in managing and leadership roles.
  6. Communication and learning skills dictate the flexibility and adaptability of an employee. Firms value such employees.
  7. Brand worth/value, like in the case of a brand ambassador employed by a firm for endorsement. 

An important factor to consider while evaluating the value of employees is their health.

A healthy employee relates to higher productivity in terms of punctuality and employee contribution. On the other hand, a sick employee, though highly skilled, may not be regular or consistent. 

Human Capital Index (HCI)

It is a report published by the World Bank that measures the ability of a nation to derive economic value from the potential of its citizens. However, it also measures inefficiency in human resources due to a lack of quality education and healthcare.

The index accounts for the following attributes in the workforce:

  • Quantity of education by accounting for expected years of schooling by the age of 18
  • Quality of education
  • Adult survival rates, i.e., the share of 15-year-olds that survive till age 60 in %
  • Stunting rates of children under the age of 5 in % to account for healthy growth among children

By measuring the above parameters, each country is assigned an HCI score between 0 and 1, where 1 signifies maximum potential. As of 2021, Singapore has the highest HCI score of 0.88.

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Researched and authored by Manya Bhardwaj | LinkedIn

Reviewed & Edited by Ankit Sinha | LinkedIn

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