The Role of Human Capital in Production

March 18, 2020

This 20-minute podcast was released March 18, 2020.

Alex Monge-Naranjo | St. Louis Fed

“Essentially, human capital is the aggregate of all those investments that we make on humans to increase their productive capacity,” says Alexander Monge-Naranjo, an economist and officer in the Research department at the Federal Reserve Bank of St. Louis. He talks with Greg Cancelada, a senior editor at the St. Louis Fed. They discuss the role of human capital as a determinant of a country’s income.


Greg Cancelada: Welcome to Timely Topics, a podcast series from the Federal Reserve Bank of St. Louis. I’m Greg Cancelada, your host for this podcast. With me today is St. Louis Fed economist Dr. Alexander Monge-Naranjo. Alex, thanks for being here.

Alex Monge-Naranjo: It’s my pleasure.

Cancelada: Now, traditionally microeconomics have focused on physical inputs, the use of manual labor and machinery to produce widgets. But in recent decades, economists have increasingly focused on the role of human capital in production. Now, how do you define human capital? And also how do you measure it?

Monge-Naranjo: Yeah. I think human capital is perhaps the most important capital that countries or individuals or households can think of. Human capital, you should think of it as all the investments that we make on ourselves, on our children that increase their productive capacity. And these investments traditionally are divided in two areas: education and health. Every time you go to the gym, every time you eat healthy, you know that you’re increasing your potential capacity to produce goods and services. And the same every time that you, you know, invest in learning some skills or some abilities or learn something new, those skills eventually are going to be productive. So essentially human capital is the aggregate of all those investments that we make on humans to increase their productive capacity.

Now, how we measure it? Well, it’s a complicated concept. But typically you can use inputs—I mean, how many units of time or how many goods or books or hours of professors or teachers or instructors—and you try to measure what is the market value of all these inputs. And that comes with a measure of how much you have invested.

Alternatively, you can look at how to measure human capital by output: How much more productive I become after investing in some education. And that’s, I think, the most common way to measure human capital is trying to compare individuals with different levels of skills and look at the difference and use that as a measurement of how much more human capital one worker has relative to others.

Cancelada: Now, human capital, at least for on the individual level, the skillset can be very specific to their job. So you can actually have a mismatch. Right? You could have a very educated population, but if they’re not doing what they’re trained to do or what they potentially can be trained to do, then you have some problems. Right?

Monge-Naranjo: Oh, definitely. I mean, and when it comes to human capital it’s a very broad concept. And of course you can look at subcategories. There is a specific human capital. And then you can ask it’s specific to what? It can be specific to the occupation that you do or a particular job. You know, things like that are specific to a place. And that can be very useful. But if you move the worker to a different factory, all that knowledge is completely useless.

So there is a level of a specificity. And economists, we normally talk about general human capital, things that can be used in multiple occupations. For example, the ability to speak English and communicate with other workers can be useful for doing many different tasks, not only for a particular program and job that you are doing.

But there is, as I said, there could be some jobs that are quite specific. And when it comes to measuring the human capital, sometimes you have to deal with the fact that there is, as you mentioned, misalignment or mismatch—that some workers are qualified for doing some jobs but those skills are not really being used by the current job that they are doing. So, I mean, the fact that, for example, I may be a great soccer player—I am not—but the fact that I work as an economist, it means that I may not be using my skills.

Still, thinking about these mismatches or misallocation, I think it’s an important part of research of how to separate what is actually human capital versus how well allocated the human capital is across the workers and the occupations of, in a particular time in a particular economy.

Cancelada: So why does human capital matter in terms of economic development?

Monge-Naranjo: Oh, I think if you ask my own opinion is that if you don’t have good human capital, nothing is really going to be productive. To me, human capital is the first input, is a necessity for development. You may not use it, and then you can have other problems. And misallocation could be one of those. But I think it’s essential for development. Once, my view is that once you have a well-allocated, well-trained, and a healthy labor force, technologies, other inputs, other forms of capital will find a way into the economy.

But if you have workers that don’t really know how to use a particular technology, then you can grant or give equipment and technology to the country. But if the workers inside there, no one knows how to use it, it’s going to be completely useless.

Cancelada: And I guess a smart, educated workforce, even if they don’t know how to use new technology, they can figure it out pretty quickly.

Monge-Naranjo: They will find out. I mean, and also the owners of technology, they’re all the time looking for where is it that I can get the best worker for the best value for my dollars in terms of hiring workers. So I think human capital, especially now in a globalized economy, is becoming more and more important as a determinant of the income of a particular country.

Cancelada: Now, how did you first get interested in human capital?

Monge-Naranjo: So thinking back, when I was a little kid, I remember, as it was yesterday, my father insisting on the difference between having something and being someone. And I don’t think he gave like a formal definition in terms of human capital. But deep down, that difference is, it boils down to whether you own some physical capital or some money versus whether you in yourself have the set of skills and education and health and even the connections and the recognition of your colleagues that we came to call human capital in general.

Later on I had the luck of getting my Ph.D. from the University of Chicago, where human capital was I think one of the central concepts of the discussion. Gary Becker, one of the key figures at the Chicago School of Economics, was one of the leaders of pushing human capital as a key factor for understanding the behavior of individuals, families, neighborhoods and countries.

Cancelada: You co-authored a very interesting paper. You discussed how the redistribution of human capital across the globe could dramatically raise world economic output. Tell me a little bit more about that paper.

Monge-Naranjo: Yeah. So what we were doing in that paper is trying to control for how different aggregate inputs in the production, how they are distributed across all the different countries in the world. It’s a very macro calculation in the sense that we know countries are quite complicated. When we think about the U.S., you have all sorts of different types of industries and markets and workers.

But in macro, we try to see always the big picture and say, OK, if I want to compare the U.S. with Brazil, we know that there is not one Brazil, there is not one U.S. But we can try to take an average of the U.S. and take an average of Brazil and take an average of Argentina, England, Japan, and so on and so forth. That’s what we do in this paper. And we try to control natural resources, physical capital, and a measure of the average quality of the labor force in terms of education. And we measure that using the output approach, that is, there is some data out there available on how to compare the earnings of different workers and then look at the composition of the labor force across the different countries.

And with that, we can see on average how productive workers could be in different countries. And what we argue is that there is room for improving the global productivity—that is the productivity of the entire world—if you could allocate some of the workers from one country to another. And typically what we see is that the countries that are richer are the ones in which adding an additional worker will increase output more. That’s what economists, we call the marginal product of labor. So there is an important difference in the marginal product of labor across different countries.

And we see that there is a widening gap between those factors. That gives you a sense of why is it that at the aggregate level we see movements of workers from one country to another. And part of it is because they are more productive. And being more productive, they can get higher earnings. And because of that, they can sustain a higher quality of life.

And of course there is all sorts of barriers and there are all sorts of additional considerations that machines don’t have. I mean, if you buy a car in Japan, you can bring it here. The car doesn’t have anything to say. But if you want to hire a worker from one country and bring it to another, well, the worker may just not come, just resign. And also there could be political issues about reallocating workers from one place or another.

So what we do in this paper is simply come up with a back-of-the-envelope calculation using standard models and see how more productive the workers are and what are the trends. And what we find is that the gap between the productivity of workers in rich countries relative to poor countries is widening. Which is different from the productivity of physical capital.

In a previous paper with the same team of co-authors, we argued that what we see is that there is a trend to a more efficient allocation of physical capital—that the margin of productive capital between rich and poor countries is getting together, the gap is closing.

Cancelada: But in terms of the disparities, in terms of human capital, why is it widening?

Monge-Naranjo: That’s a very deep question that has multiple answers. First, the coverage of education, the quantity of education. Why is it that in some countries you see that there is a bigger increase in the education attainment of workers. The second is the quality of the education.

There is also issues about the misallocation that we mentioned before. It could be that some country may have some workers that are not really well used. I have other work that suggests that that could be an important dimension. That poor countries not only have fewer qualifications, but also they are not well used, they are not well allocated.

Cancelada: So maybe someone who has a physics degree in a developing country may not be able to use it in the way that someone in the United States could be able to use it.

Monge-Naranjo: Yeah.

Cancelada: That’s very interesting. Now obviously the paper is very theoretical and there are many barriers to movement of human capital throughout the globe. But what kind of insights could a policymaker draw from your paper?

Monge-Naranjo: The paper can show why the economic pressures are out there. You can put a barrier and say, well, we don’t want workers to move from one country to another. But if the differences are out there, you know that the pressures are going to be there, that the workers will try to eventually make the move.

Alternatively, especially for industries in which if you cannot get the worker to come to your factory, there is also the potential of the factory moving to where the worker is. So one thing that as an economist I think we’re pretty good at is understanding why is it that some business opportunities, if you try to regulate them, if you try to block them, will find a way to materialize in ways that the regulation may have failed to foresee.

And also that if there is, if eventually there is a potential increase in the output of the work, policies that block the efficient allocation of factors or the productive reallocation of factors—and productive defined in the sense that if we switch a worker from one place or activity to another place or activity, the total output increases——then we know that the paper could give you a sense, and our paper and many other papers using a similar idea, can give you a sense of what is the cost of this type of regulation. How much output are we giving up by blocking this reallocation?

Cancelada: Perfect. Now in some ways a mass reallocation of human capital happens within countries, such as a movement from rural areas to urban areas. Whether it’s 19th century New York or 20th century Rio, slums are a large part of the urbanization story. What role does human capital play in this?

Monge-Naranjo: I think human capital is a central piece of the story because it explains what’s going on. I mean, we can think of the humans, this human aspect. And that certainly gives me a lot of motivation to write, to be writing and revising this paper is because deep down I’m making a contribution to I think understanding what’s going on to a big mass of individuals. And in this paper we are talking about Brazil. But this is something that is going on in many countries, developing most of them, but certainly some of these issues are similar in developed countries.

Deep down what the markets are doing is essentially reallocating human capital. That some workers are being paid more, they get more for the human capital in some urban areas than how they used to get in the places where they grew up in rural areas. Now in the case of slums, what we are seeing is a double coincidence: a group of individuals who are not really well prepared for the cities and cities that are not well prepared for the new workers that are coming along.

So the paper talks about why a big chunk of individuals voluntarily decide to leave where they grew up in the rural area and relocate to an urban area even if their conditions that they’re going to be meeting there are dreadful. That it could be very dire conditions for themselves and for their families. When I say voluntarily is that we are not talking about refugees or people running away from a war. It’s essentially a group of individuals who unconsciously or consciously make a calculation of what type of life they could have in the place where they are coming from versus the type of life that they are getting once they move to the urban areas.

And to be sure, I’m fully aware that those are dire conditions. But one of the points that we highlight in the paper is that, as bad as those conditions are, they represent an improvement to what arguably is a really bad, you know, set of conditions for people with low human capital, in particular in the case of Brazil.

So that’s trying to explain the causes of the emergence of slums. But the second part of the paper in which also human capital is an essential component, is what are the consequences of the slums. I mean, here again we compare the counterfactual — what will have happened if we don’t allow those individuals and their families to grow up in these urban slums. And, again, even though those conditions are dire.

What we emphasize here is the intergenerational aspect. And one thing that we highlight is that when this household moved to urban areas, even though they don’t live in the formal or the nice areas, they live in marginal parts and live in slums, by doing that they have access to labor markets. It may take one hour. It may take long for them to relocate from, you know, one of the slums away close to the airport in Rio to get to downtown Rio de Janeiro or Sao Paolo. But essentially they can commute.

So one aspect that we emphasize is that the households that live in the slums, the adults of those households have access to labor markets of the urban area. However, if we look at the children, most of the children stay at home, stay in the area. So even though the grown-ups effectively integrate themselves in the labor markets of the urban area as a whole, the children remain in the marginal neighborhood. So the occasional opportunities, the access to accumulation of human capital is segmented.

And we see that in effect, the education attainment. How many years of a school and what type of jobs these children will get when they grow up is quite different. So once we start putting things and, from a macro perspective, when we see what will be the consequences for the city of Rio, for the Brazil as a country—and then, again, I want to emphasize that this applies to Mexico, to India, to many developing countries. It also determines the path or the development that the country’s going to have.

So we use the model first to explain what’s going on. And then we use the model to understand what will have happened if the country had adopted different policies. What will have happened if first you don’t allow the slum dwellers, so essentially you reduce the opportunity of poor people in the country? Alternatively, what happens if you have policies that actively integrate the children these poor households to formal schools in the cities? And also what happens if you have different alternative, if you use different housing policies?

And all these policies will have actually a quite large impact on what will have been the behavior of the country 30 years or 60 years back. So we argue, for example, that if you had prevented the slum dwellers from settling in the main cities in Brazil, the country would be way more rural, way less educated, and the cities would be smaller.

On the other hand, if you had a policy that promotes the schooling of slum dwellers, then you will have initially many more slums. Because now you give an incentive to individuals to come to the cities. And we argue that one of the big factors is the education of the children. But eventually the country will be much more modern. It will be more educated. You will have fewer households that will opt to live in the slums because they have more human capital: They will get higher income and, therefore, they can afford their own housing. So there is all sorts of macro implications that we can get from this simple model.

Cancelada: So it’s interesting. There’s like a sort of a law of unintended consequence. If you try to restrict the growth of slums by restricting the number of people coming into the cities, then basically you’re creating a larger uneducated or less educated workforce and actually making the human capital more unequal within the same country, even though there may be technically no barriers.

Monge-Naranjo: Yeah. You can think of this as putting a dam. Yeah, you can prevent the water flowing from the river. But eventually the water is going to find a way. This is a paper that is very dear to me both intellectually but also because I think it’s dealing with issues that are at the center of the well-being not only of the current poor but also the future, the children of those individuals.  

Cancelada: Well, thank you very much, Alex.  

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