Thomas Sowell on Human Capital

One of the most significant passages from Thomas Sowell’s Basic Economics:

“Even among those who are conventionally called workers or laborers, much of what they contribute to the economy is not labor but capital—“human capital,” as economists call it. It is not so much physical exertion as job skills that constitute the contribution of a machinist, or entertainer. Most American workers today do not contribute merely work but skills, which is why their incomes increase substantially over their lifetimes. If it were their physical exertions that matter, their capabilities would be greatest in their youth and so would their incomes. But, where it is human capital that is being rewarded, then it is this is far more consistent with their incomes rising with age. As their human capital grows, the profit they receive on that capital grows, even though it is called wages.

A failure to understand the importance of human capital contributed to the defeat of Germany and Japan in World War II. Experienced and battle-hardened fighter pilots represented a very large investment of human capital. Yet the Germans and the Japanese did not systematically take their experienced pilots out of combat missions to safeguard their human capital and have them become instructors who could spread some of their human capital to new and inexperienced pilots being trained for combat. Both followed policies described by the Germans as “fly till you die.”

The net result was that, while German and Japanese fighter pilots were very formidable opponents to the British and American pilots who fought against them early in the war, the balance of skills swung in favor of the British and American pilots later in the war, after much of the German and Japanese human capital in the air was lost when their top fighter pilots were eventually shot down and replaced by inexperienced pilots who had to learn everything the hard way in aerial combat, where small mistakes  can be fatal. Economic concepts apply even when no money is changing hands.”

It is a fantastic quote that describes the importance of what Peter Drucker also described as the importance of acquiring specialized skills that can be integrated into tasks. It offers some of the most useful entrepreneurial and investment selection advice that I have ever encountered.

In my own life, from a labor perspective, I relied heavily upon this notion of embracing hard case files that no one else wants to touch in part because it is a way to build human capital because when a similar situation arises in the future, I will have developed the human capital to recognize the pattern and know what methods to apply and not apply to move the case forward.

As an investor analyst, I remember observing Radioshack laying off many of its most senior employees that had institutional memories of the firm. Shortly thereafter, there was a brief earnings spike followed by a higher stock price. At no point was I ever interested in buying the shares, as I saw these particular layoffs as the elimination of human capital that effectively killed off whatever competitive advantage Radioshack may have retained over Best Buy or Amazon.

If I were to make a list of the most important reading materials that someone could consult to become much more intelligent as rapidly as possible, I would highly recommend reading anything and everything that touches upon a deep analysis of the development of human capital, beginning with Professor Sowell’s excellent work.