Economics 101: the correlation between education and human capital

What is the human capital model of education, and how does it work in the GCC and beyond?

Throughout most of human history, economists considered education a purely intellectual pursuit. Students at higher education institutions such as Oxford University were considered the representative case: independently rich, and studying disciplines with little or no labour market value, such as theology. The fact that wealthier countries had more educated populations was attributed to education being a luxury that only the rich could afford, rather than because education was a contributing factor to economic prosperity.

After the Second World War, a group of economists, including Jacob Mincer, Gary Becker, Arthur Lewis and Theodore Schultz (the last three of whom went on to win Nobel prizes) proposed a different interpretation for education, popularising the term “human capital”. Rather than analysing education as an intellectual activity unrelated to labour productivity, they treated it as an effort that an individual makes to enhance their abilities, including those of interest to employers.

In last week's article in this space, we learnt that a key determinant of your labour market compensation is the degree to which the tasks that you perform increase the company's revenues. Education is therefore considered a way to improve your ability to generate revenues for firms. A doctor cannot earn their hospital money unless they have acquired the medical knowledge necessary to treat people, just as an architect cannot create designs for buildings that their employer sells without learning how to construct aesthetically pleasing buildings that do not collapse.

The reason for the term “capital” in human capital is that it is considered an investment: the investor bears an upfront cost, comprising tuition fees and forgone labour market earnings due to being enrolled in full-time education, in exchange for a delayed return, which is higher labour market earnings after graduation.

Different types of human capital vary in their labour market value, depending on the availability of other people with the same human capital, and the revenue-generating effectiveness of that human capital. Thus, some investments, such as a PhD in art history, offer a very poor, and likely negative, rate of return, compared to a bachelor’s degree in mechanical engineering. However, the human capital model does not purport to be the only explanation for education: economists still acknowledge the direct enjoyment benefits associated with certain educational qualifications, such as a film-making degree.

Advances in data availability have allowed economists to study the relationship between income and education, partially as a way of testing the human capital model of education. Statistical modelling has provided strong confirmation that individuals and countries with higher levels of education also exhibit higher income levels. (In next week’s article, we will discuss a different education model, known as the “signalling” model, which provides an alternative explanation for the observed link between education and income.)

Within the GCC countries, the relationship between income and education is standard, in that better-educated people have higher labour market earnings than their lower-educated brethren. However, at the country level, the GCC countries constitute an outlier in global comparisons, because income is much higher than would be predicted given the educational attainments of their people. Naturally, the primary reason for this is that the GCC countries are endowed with very large volumes of hydrocarbon resources, which generate income without requiring educated workforces.

The conviction that education improves abilities and hence income has driven many economists to support public subsidies to human capital accumulation. The abundance of free education across the world, sometimes even up to the PhD level, confirms that policymakers have been convinced by such arguments.

However, there are two potential flaws with such a plan. First, as mentioned above, many educational qualifications are of no consequence to an individual’s ability to deliver valuable services to others, or to contribute to a firm’s revenues. Second, identifying these “dud” qualifications is very difficult, because labour markets are highly dynamic. That is why all governments, including the GCC, should tread cautiously when considering educational subsidies, lest they create white elephants.

Omar Al Ubaydli is the programme director for international and geopolitical studies at the Bahrain Center for Strategic, International and Energy Studies, and an affiliated associate professor of economics at George Mason University in the US.

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