Saturday, February 21, 2015

Is human capital really capital?

Is "human capital" really capital? This is the topic of the latest econ blog debate. Here is Branko Milanovic, who says no, it isn't. Here is Nick Rowe, who says yes, it is. Here is Paul Krugman, who says no, it isn't. Here is Tim Worstall, who says yes, it is. Here is Elizabeth Bruenig, who says that people who say it is are bad.

So as usual, it's up to your friendly neighborhood Noah to settle the debate once and for all. *chuckle*

Here's the thing. Calling anything "capital" at all requires a simplification and abstraction. A drill press is different than a building, an oil field, or a computer. Lumping a bunch of stuff in together, putting a dollar value on it, and calling it "capital" is a huge abstraction. This was pointed out in a famous debate called the "Cambridge Capital Controversy." Well, folks, that's how modeling works. Any time you make a model, you make simplifications and abstractions.

Human capital, no matter what you call it, is different than other kinds of capital. It's different in the way it's produced. It's different in the ownership laws applied to it. It's different in the way you extract value from it (in the costs of extraction, how it enters into production functions, etc.). It's different in the way it depreciates with time and with usage. Etc.

Lumping human capital in with other forms of capital requires you to take a stand and say "I don't think those differences are important, at least for the phenomena I'm trying to model right now." Other times, if you think the differences matter, you'd keep human capital and other capital separate.

Economists do the same thing with consumption. In models where economists think the main important feature of consumption is its timing, you lump all consumption together if it happens during a certain period. That's where you get your "u(c)" in macro models. But if you want to model the consumption of, say, peanut butter and jelly, you might separate your utility into u(c_peanutbutter, c_jelly). Etc.

There's nothing wrong with this, per se. You can make stupid assumptions, of course, but that doesn't mean all simplifying assumptions are stupid.

So how should we think about human capital? Here's an analogy that I think works well. You agree that a chainsaw is capital, right? OK, now imagine a chainsaw that you graft permanently onto someone's arm, like Bruce Campbell in the movie Evil Dead 2. It's so thoroughly grafted on that you can't remove it without making it permanently useless.

This chainsaw is very very much like human capital.

Like human capital, the arm-attached chainsaw requires resources to create, including the resources of the eventual owner (he has to hold his arm still, at least, and spend some time undergoing the grafting procedure). Like human capital, you can use the chainsaw to create future value - for example, you can use it to chop up skeletons, demons, and other baddies, like Bruce Campbell does in Army of Darkness. Like human capital, creating value from the chainsaw requires the owner to sacrifice some leisure. Like human capital, the owner can rent the chainsaw out, but he can't sell it to anyone.

(The main difference between the chainsaw and human capital is depreciation. Skills often increase as you use them, while the chainsaw will eventually wear out from chopping up baddies.)

So if you think a chainsaw is capital until you graft it onto Bruce Campbell's arm, but then suddenly becomes non-capital, fine. But now the ways in which human capital acts like other forms of capital should be clear. (By the way, if you think this example is fanciful, watch this video.)

Here's another analogy that I think is useful for understanding the difference between "capital" and "labor". It's a finance analogy. "Capital" is an option (which gives you the right to extract value from something), and "labor" is the exercise fee for that option. "Human capital" is an option you can't resell - the only way to extract value from it is to pay the exercise fee (the labor). "Physical capital" and "land capital" are options you can resell.

Therefore, whether human capital is really capital depends on what decisions you're trying to model. It might be, or it might not be. If you're trying to model a company's decision to invest in worker training, and the workers have lifetime employment, then you probably can go ahead and model human capital the same as other capital. If you're modeling a country's decision to invest in education as a development strategy, you can also probably treat human capital as capital. But if you're modeling people's decisions to get PhD's, then you probably shouldn't model human capital the same as other capital.

For some applications, actually, you can actually represent anything as capital - just calculate its expected present discounted value, and voila, you're done.

So what about the moral dimension of human capital?

If our social welfare function cares about wealth inequality, should we count human capital as wealth? Well, I think it depends on that exercise fee - on the disutility of labor. Suppose I really love writing silly blog posts, and I know that people will always be willing to pay me to do it. In this case, my blogging skill really is a kind of wealth, because since I love doing it anyway, the exercise fee is low. But suppose I also had coding skills with which I could make money, but really hated to sit around coding. Well, in that case, the cost of extracting value from my human capital would be very high, and it wouldn't really represent much wealth.

Some people oppose the use of the term "human capital" because they think it allows conservative types to claim that wealth inequality isn't as severe as it appears, since poor people have human capital. Actually, this is wrong - if you count human capital, wealth inequality will be much much much worse. Rich people have a lot more lifetime earning potential than poor people, and their work is probably more pleasant too.

Other people oppose the term "human capital" because they value leisure as a special good. If I own physical capital I can resell my capital, and have all the leisure I want. But if I have human capital, I have to give up leisure to get value. The more our social welfare function values leisure relative to other things, the less human capital adds to welfare.

You are, of course, entitled to your own social welfare function, so you can care about anything you darn well please. And you're also entitled to your own modeling conventions and definition of terms. So whether human capital is capital is up to you.

Update: One more objection to the use of the term "human capital" is that it objectifies people - it seems to imply that human beings can be bought and sold (even though this is not actually the case, as the chainsaw analogy demonstrates). In fact, "skills capital" would be a better term - especially because in the future, AIs will be able to learn skills too. One great thing about economics is that you can make up and use your own terms. So I say, if you don't like "human capital", use the term "skills capital" instead. There's really no reason not to. Maybe it will spread.


  1. Anonymous11:05 PM

    Opposite Konczal: The Theory of Everything

    "Normally, the next point in the Uber narrative is self-driving cars screwing those Uber drivers, but that misses the real point — it misses the real answer to Konczal and Summers.

    There are two gains here, not being focused on:

    1. Real consumption increases wildly, but it doesn't show up in nominal aggregate demand. It’s overall deflationary in fact.

    2. Fun jobs.

    Note: these are major claims I make in Uber for Welfare as well."

    We see the Bruenig breakdown here very clearly:

    "Suppose I really love writing silly blog posts, and I know that people will always be willing to pay me to do it. In this case, my blogging skill really is a kind of wealth, because since I love doing it anyway, the exercise fee is low. But suppose I also had coding skills with which I could make money, but really hated to sit around coding. Well, in that case, the cost of extracting value from my human capital would be very high, and it wouldn't really represent much wealth."

    Uber for Welfare explains the real problem with the Bruenig frame - any requirement to work, regardless of how much fun it is or any effort to see leisure as something we can tax of the "leisure wealthy" - which John Rawls expressly supports, leaves them without an inalienable claim on sustenance held by others, and that's the only interesting argument they make. Poof! It's gone.

    "Who will help me plant the wheat?" is the winner by knock-out.

    1. Anonymous8:01 PM


      Do you risk failure? Yes.

      Is your money invested? Yes.

      Human Capital

      Do you risk failure? Yes.

      Is your time invested? Yes.


      Do you risk failure? No.

      Is your time invested? Yes.


      Do you risk failure? No.

      Is your time or money invested? No.

  2. Anonymous11:17 PM

    Telegram to the August Noah Smith,

    Did you read and are you in the agreement with this famous article about human capital by a team of scientists from University of Utah?

    Link find here:

    Your humble servant

  3. I want to take your class.

  4. I think some oppose the term on purely ethical grounds. It monetizes implitcly humanity. I don't want live in a world where people walk in a world where people walk around with dollar signs on their heads though I realize I do. Intuitively I know my stock market acct. is radically different than my salary. As a buy and hold I don't pay much attention to markets but I prep for work every day. Human capital implies human worth. What is aman worth? Tolstoy had a response : an 8 foot box in the ground.

    Trapped in time._.Surrounded by evil._.Low on gas.

    1. Heh.

      You mean, the term "human capital" just sounds objectifying and materialistic? It's an aesthetic objection??

    2. It is inelegant, but it's more ethical. The question, what constitutes huan value is an ancient one. And I think once you assign implied value to certain people over others you're in bad historical territory. And what ishuman value? Ghandi and Kafka didn't provide a lot of material wealth.

      Human potential, excellence, compassion and wisdom are traits I'd prefer.
      Calling people money or objects seems not just vulgar but wrong.

      Ilike this blog btw and typos._Tpying on a PS4 controller.

    3. PS4 - hehe. Nice. :-)

      How about "skills capital" or "educational capital"?

    4. Anonymous3:26 AM

      I think the argument probably comes out of the marxist tradition. "Human Capital" is the most transparent way of viewing humans as a good to be exchanged instead of human beings.

      It's probably better to frame it as skills capital, but the distinction is meaningless. The left wing will ultimately have to get over with how we characterize things (because the notion of human capital in most academic settings is benign)

  5. I was recently blog-talking with Deitz, and it really hit me an important difference between human and standard, relatively liquid, capital, with regard to the new wave of intelligent machines debate. At:

    "…In any case, in a world where most of the unskilled and low skilled have close to zero wealth from their lifetime labor, you could say, let’s give them some robots! Let’s give everybody some stocks to live off of.

    Well, think about that. In the past a low-skilled person might have lifetime labor value worth, say, $1.5 million in present-value. So, let’s just now give them $1.5 million in stock in an index fund!

    But, I have a career in personal finance. If someone has $1.5 million in present-value of lifetime labor they can’t blow that (aside from becoming an alcoholic, or something like that). Some shyster can’t just sucker it away from them over the next year. They can’t decide to spend it all on a giant house and a Mercedes (and even with credit, there’s bankruptcy, and a limit of 25% in wage garnishment, zero in some states).

    You’re for the most part forced to spend your lifetime labor slowly and steadily. And, sure you could lose it with disability or old age, but so far, no amount of billionaire powered propaganda has gotten people to vote for not providing at least some minimum for the aged and seriously disabled.

    But give people a lump of liquid wealth to replace the plummeting in the value of their lifetime labor, and that they can blow easily. Even if they’re very responsible, shysters everywhere (and even well intentioned people) can get them to invest in a restaurant, some “hot” single stock, commodities, derivatives, sector funds, actively managed funds that are far riskier than they understand, an invention, and so on.

    A close example we see today, where a very large percentage of lifetime wealth is liquid, is with retired athletes, and we see disastrous results. According to this Sports Illustrated article in 2009,…"

  6. Shouda mentoned this. Kant . Human beings are an end not a means. When I invest in equities this is ameans to profit . If see another person I may have economic relations with them, but I must see them as human, an ends. We have names , not numbers. We have kids, not flesh investments.

    1. Human capital is a positive not normative description. Human beings are means to an end, however you should not treat them as such. Two different claims.

    2. So how about "skills capital"?

    3. So how about "skills capital"?

      No problem. I'm a lawyer. I have no doubt that my professional skills are a capital asset that cost money to create, cost money to maintain, generate an incremental income stream and depreciate towards the end of my working life.

      Investment in individual skills costs money and has huge economic consequences. Economic analysis of those skills as capital assets is not only appropriate, it is absolutely necessary.

  7. Noah, don't you think that this is a bit of a silly debate?

    Let's say that in 50-100 years the human brain can be uploaded to a machine, then the human capital can be transferred the same way that a map of New York can be transferred by xeroxing it. Alternatively, let's say that in 200 years brain patterns in humans can be copied from one brain to another, then human capital can also be transferred.

    My point is that this is a technological problem. It's a constraint that it cannot be transferred and we don't let constraints define what something is or is not. We just add these to see how the answer to our problem changes.

  8. Anonymous4:55 AM

    This is how the Oxford Dictionary of Physics defines mass:

    mass. A measure of a body's inertia, i.e. its resistance to acceleration. ...
    Mass can also be defined in terms of the gravitational force it produces. ...

    But, given the simplifications and abstractions I used in my model, I decided to define mass as the rate of change in the position of a body in a given direction.

    Probably my physics professor, the silly old goose, would think I lost my mind and would try to fail me (or would give me a lift to the funny farm).

    But now I have the perfect defense! I'll tell him to speak to you:

    "Well, folks, that's how modeling works. Any time you make a model, you make simplifications and abstractions".

    For the record, this is how the Penguin Dictionary of Economics defines capital:

    Capital. 1. Assets which are capable of generating income and which have themselve been produced. ...
    2. In more general usage, any asset or stock of assets - financial or physical - capable of generating income.

    See the word? ASSETS.

    1. Man, your witty charm is a real asset.

    2. Anonymous9:02 PM


      Delightful irony added to wisdom and sex appeal. I wanna study with you... <3

  9. Just last week I read about the Cambridge Capital Controversy, and apparently Samuelson conceded the argument. So I'm not sure if human capital actually saves the Solow-Swan growth model. With Piketty, the question of capital is back.

    1. So what? Samuelson is not a sage. If you don't understand what it means that he "conceded" the argument, and if you can't think through the implications of what he said, don't just city his name as an authority!

    2. Apparently you won't find what its about from our host. Samuelson insisted for over a quarter of a century that Robinson and Sraffa deserved a "Nobel" prize.

      One would think that those who lay out a model would be clear about what is given and what are endogenous variables, found by solving the model. Economists who, without caveats, write down production functions with "capital" as an argument measured in dollars (or numeraire units) are probably hopelessly confused. The quantities and composition of a dollars worth of capital goods differ at different distributions of income. (Since economic theory imposes no restrictions on the direction of real Wicksell effects, Champernowne's chain index does not provide a way out.)

      Proponents of neoclassical endogenous growth models, like Paul Romer, have often shown themselves confused about these matters. And they are also confused about human capital. Until they sort out their understanding of physical and financial capital, I must be allowed to doubt that talking about "human capital" clarifies anything.

      A final conclusion of the CCC: supply and demand theory is "all bosh", to use Robinson's phrase.

    3. A final conclusion of the CCC: supply and demand theory is "all bosh", to use Robinson's phrase.

      It has its uses.

    4. Anonymous2:07 PM

      Gosh, if the noted and successful scholar Robert Vienneau says it, it must be true. We should all just hang ourselves now. Or, maybe, he's just an Internet crackpot. Which seems more likely?

    5. I am always amused by the breadth of my fan base.

    6. Anonymous3:57 PM


      I would really like to read a post by you about the ccc.

      Best, Chris

    7. For anybody who cares, the following links to a journal article about one aspect of the CCC:

  10. It does require capital to put into effect a system to hire, train, manage, and retain workers. So 'human capital' could refer to the system and not to the workers.

  11. I can see why it's a good idea to scrub away offensive language like "Washington Redskins," but "human capital?" That's language that permeates economics, for good reason - it's useful. The language keys you into the fact that human capital has things in common with physical capital. There are intertemporal tradeoffs involved. We invest today - something is foregone in the present - in order to get something in the future. What we get when we invest today is an asset, and we can measure the value of that asset. And the asset has particular properties - liquidity, maturity, rate of return, risk - that help us to think about what it does. By calling this stuff human capital, we make it clear that, while like physical capital, it's different. Physical capital might depreciate at a higher rate the more intensively we use it, but that doesn't seem true of human capital, as Noah notes. Human capital seems to depreciate at a higher rate if we don't use it, though sometimes physical capital has that property too - a machine not in use may rust and be very hard to start up again.

    So, what's the fuss? Seems like a non-issue to me. The same people who object to talking about human capital probably take offense at the notion of a "labor market." How awful that human beings' time is bought and sold like slabs of meat. Those people should find some more important things to worry about.

    1. Yep.

      A lot of people are just really uncomfortable with the idea that we live in a (somewhat) market economy. They don't like anything that reminds them of that.

      Actually, I think this might create a tiny negative externality on all market transactions...

    2. And some people are only comfortable with the old tripartite distinction from early 19th century economics: labourers own labour; capitalists own capital; and landlords own land. And then "human capital" comes along and messes up their nice neat distinctions.

    3. Thank you Stephen! This debate itself has been an utter waste of human capital, although it does help us price some human capital more accurately. For example, the human capital of anyone who believes that the term shouldn't be used or that human capital doesn't exist should immediately be priced much lower.

  12. Good post.

    I think you missed a better title though: "Humans aren't Androids; they're Cyborgs"

    1. Heh. I also could have gone with a number of Army of Darkness quotes.

  13. The trouble with skills capital as a measure of someone's worth is that it will be used to justify policies to euthanize the near zero or zero skills capital people by the 1%.

    This is similar to the way IQ is used as a measure of intelligence and people assume that IQ tells the complete story and develop institutions and hiring/promotion rules based upon IQ alone.

    Entire books have been written about the determinant. Yet, after all, a single number only tells you so much about a matrix... (G. Strang)

    1. No model of people's economic earning power should ever be used to determine the worth of their life.

    2. No model of people's economic earning power should ever be used to determine the worth of their life.

      The courts do it all the time in assessing damages.

    3. That's kind of fucked up. Really?

    4. Niels: As far as I know there already is such a thing - comparing GDP per capita to costs for preserving life by for instance investing in safer roads etc. Does this mean we have to stop measuring GDP?

    5. As well they should. Especially when calculating monetary damages.

    6. We do it all the time when calculating economic damages for insurance claims. As in, every single day. We also value the human capital of businesses through valuation of "key men," value of workforce in place, etc.

    7. Also, in many jurisdictions, "personal goodwill" is a common consideration in business valuation.

  14. Anonymous7:20 PM

    So if it's only analogous to capital some of the time, why not use a term that doesn't include the word "capital"? The term is too ingrained to change now, but if this phenomenon wasn't named before, would this be the name we would choose now?

  15. This debate strikes me as both pedantic and misguided. The critics of the term "human capital" claim, from what I gather, that the term is vague and may treat people as a commodity.

    But they are really missing the point. The term "human capital" does not *literally* imply that humans are tradeable or that they have a fixed financial value. It is not intended to imply that people are like commodities. It's also not intended to imply that people literally have a calculated value.

    Instead, "human capital" is a *metaphor.* It's intended to imply that people are valuable *like* the assets of a company, and more specifically, that investments in educating people, training people, keeping them happy, keeping them loyal, and building institutional knowledge ... like CapEx, can have tremendous long term value.

    Business managers who are bean counters sometimes forget this. The value of happy skillful workers doesn't show up on a financial statement, but it should not be neglected. I imagine that economists could also neglect this. The metaphor "human capital" reminds us to be mindful of this value, and careful not to neglect it.

    Great companies don't view their workers as fungible cogs in a machine. Instead they realize that the happiness, talent and longevity of each individual employee contributes to the success of the company. The term "human capital" is a metaphor for discussing this value, and it is valuable in that it encourages companies and policymakers to look for ways to find shared success by developing the productivity of everyday workers.

  16. Noah missed some links. David Ruccio writes about human capital:

    Magpie's Asymmetric Warfare writes on the same topic:

  17. Anonymous8:52 AM

    I think there is one more argument to be made that "human capital" can be bought and sold: If Ash Williams signs a contract to only use his chainsaw in defense of the realm against the Army of Darkness, then there would be fundamentally little difference between Ash owning the chainsaw and whichever king he signed with. He could either use it the way his employer wants, or not use it at all.

    This is essentially what has happened with modern non-compete agreements. Even Jimmy John's sandwich makers are selling their capital to Jimmy John's for the term of their employment, plus several months after. Many workers in the IT field are unable to use their "human capital" for years after they leave a job. It's ownership with a deadline sure, but the owner of the capital is probably not the person who isn't allowed to use it.

    1. He's not selling it in that case, he's renting it!

    2. Semantics. You can absolutely sell human capital.

  18. o. nate10:15 AM

    An older but still quite relevant Steve Waldman post on the topic of capital vs. labor in the context of optimal taxation theory:

  19. Good job coming up with such a weird and elaborate metaphor to explain the issue, though I have to admit it took me a while to get it.

    In a nutshell, you're answering Branko's complaint that human capital is different because it requires the owner of human capital to work to earn from it.

    But actually, physical capital also requires somebody to work to earn from it. The only difference in that respect is that with physical capital, the owner and the worker can be different people.

    Unless of course the physical capital happens to be grafted on to your arm.

    I always thought of human capital as a progressive concept, which acknowledges for example that education spending is an investment not consumption. But anyway.

    1. With human capital, the owner and worker can be separate as well. This is not a distinction.

    2. It is a distinction. The owner of human capital is always the particular human in whom it resides. And it can't be monetized without that particular human working. You can invest in a taxi and hire somebody else to drive it. You can't invest in a law degree and hire somebody else to use your expertise while you sleep.

      Maybe you're talking about organization capital, or the sort of capital an agent has in a relationship with an actor. Those aren't the same as human capital. The agent doesn't own the actor's human capital, he just has a contract to get a cut from it. And the agent can't get that cut unless that particular actor works.

      Or maybe you mean slavery or child labor.

    3. Anonymous1:01 PM

      Again, let us take the example of a non-compete agreement. For the duration of the agreement, the human in which the capital resides is unable to monetize it except how their employer tells them to. If we extent the duration of the agreement to be "lifetime" then what pray tell, is the difference between the non-compete agreement and selling the capital? In both cases, the new "owner" (or lifetime renter if you prefer) is the only person who can have it monetized. It seems the only difference is how you name the agreement, the terms and outcome are the same.

      You might claim that the person in which the capital resides remains the owner, even though he has agreed to renounce all control over it, but then in what way does he have any ownership to it? If you sign agreement with someone where they pay you for a house, and you agree to never live in, use, modify, or resell the house to another party, and have no way to cancel the agreement, then in what way do you own the house?

      Indeed, let us carry the example to the extreme, and someone signs an agreement to utilize their human capital exclusivity for one employer for their entire lives, for applications of their capital, and to do so whenever the employer requests. What is the difference between this agreement and selling ones self into slavery? Only semantics, as The Donk pointed out.

    4. This is getting dumb. You're missing the simple point over and over. Human capital can only be utilized by the person in whom it resides.

      It doesn't matter if that person is doing it on another's behalf and giving all the profits to somebody else, or even if we're talking about Rome and he's a slave. The point is that human capital is inseparable from the particular human in whom it resides. Even if you could legally own him, he's different from physical capital because his capital can only be utilized by one person, himself. Even if you own the fruit, he and only he has to do the work. Do you get it finally? Geeeez.

  20. Admit it: you were just dying to use an Army of Darkness reference! Well played.

  21. "'Human capital' is an option you can't resell"

    No, that is what intellectual property is about. If I figure out a great way to do something faster/cheaper, I can patent it, and earn a fee for re-selling (licensing) it.

    If Bruce Campbell owns the process for grafting a chainsaw onto an arm, because he thought of it, he can license it for money and retire, much the way an owner of regular capital could.

    There is a special kind of human capital called technology - processes that I own exclusively, that make allow things to go faster or be made cheaper.

    The difference between human capital (e.g. skills) and physical capital is that I do not destroy human capital when I resell it or license it. Human capital probably has positive returns to scale.

    Education is the process of replicating human capital. Shouldn't teachers be paid a licensing fee? The way IP business work is that they build annuity licensing revenue. Should that be how we pay teachers (a % of the wages of your students, forever), or colleges?

    "But suppose I also had coding skills with which I could make money, but really hated to sit around coding. Well, in that case, the cost of extracting value from my human capital would be very high, and it wouldn't really represent much wealth."

    Hate to quibble here (ok not really), but the wealth of human capital is the net present value of the difference between what people [the market] are willing to pay to extract value [wages] the reservation price [disutility of coding].

    Coding skills could represent a lot of wealth, or a little wealth, depending on wages vs dis-utility.

    In terms of your finance analogy, the strike of an option [here: disutility of coding] does not represent the value of the option [wealth]- it is a function of the difference between the market price and strike.

  22. "especially because in the future, AIs will be able to learn skills too."

    Really, this is true today, and it's interesting. A huge reason for the recent leap forward is the ability to learn from massive data. The new facial recognition software that's as good or better than humans (at least in some important ways), gets good by being fed millions of examples and learning patterns and ways of "thinking" from them. Same with the Google (and soon to be Apple?) car. It has been fed massive information on what occurs when driving, massive data, that it learns from and gets far better as a result.

    In a way, though, it's hard for people to think of this as skills-capital, becasue the computer does it so quickly and effortlessly. For us, years of hard work and massive money, or opportunity cost, to gain these skills. For the new AI computers, hours or day, and a relatively trivial amount of electricity.

  23. Trolling, trolling, over the bounding main . . .

  24. It has occurred to me that I might be able to get my points across better if I didn't come off as so angry. The anger is not entirely about any particular thing but rather my predicament. So sorry for the ways it has squirted out at people. I'm working on it.

    I wan't to post something on this that will make sense as it ties into my criticism of our calculations for total factor productivity, particularly as it relates to recent technological shifts and offshoring. I hope I find enough time to make the point sufficiently well in the next couple of days…

  25. Ok, so I spent an hour on this and I wanted to give you a very quick way to think about this.

    Year 1 we have capital input K1 and labor input L1 and produce GDP of Y1.

    Year 2 we find that we can substitute all of L1 using foreign labor at 1/10 the cost, but due to the shipping costs of materials and resulting capital inputs, let's say it is actually 1/5 the cost.

    In year 2 we have K2 = K1 + .2(L1) and L2 is zero.

    In this case we have a huge excess of capital in year 2 compared to year 1. If that capital is not reinvested, GDP, Y actually decreases. If, however, that excess capital is reinvested, it can theoretically add a new L2 term utilizing only that new capital.

    Think about this for a while. I have to run, but it is an extreme example of the problem.
    More later.

  26. So now look at the above example and assume that prices don't go down due to the increased efficiency of capital. Of course, if L2 is zero, sales are going to slump due to low demand, but if the people of L2 can borrow some money from the owners of K to prop up demand, and if prices keep rising according to inflation, GDP does in fact rise.

    In this case total factor productivity rises significantly due to no technological innovation, but only due to the sudden availability of cheap, foreign labor that doesn't buy many imports from the US.

    What would this productivity increase look like on a graph? It would rise from a baseline to a new level, hold as the shift occurred and then drop back to the baseline after the shift equalized.

    Precisely what the graph of total factor productivity for the US looks like in the 90s.

    No, it wasn't IT.

    The next argument, why couldn't IT create this same pattern? Next time…

  27. Anonymous8:42 AM

    Isn't "different than" bad English?

  28. Ok, so here is a bit if leading premise to get into the argument about IT and total factor productivity.

    IT innovation was spread across the economy fairly evenly, such that the increased efficiencies were shared by almost every industry and every company. It made many processes of businesses more efficient, and this far outweighs the size of the IT industry as a whole. IT in and of itself is a profitable business, but why would this show up in total factor productivity calculations? In order to do so, it would have to create GDP increases that weren't accountable to the industry itself. In other words, these new efficiencies would have to far outweigh the cost of supporting an IT industry.

    The problem here is that the efficiencies were so widespread and evenly spread that competition prevented any major capital extraction from these efficiencies. You either adopted these new, expensive technologies or you fell behind and perhaps went out of businesses.

    When we look at the residual calculation for total factor productivity, the primary effect we're looking for is an increase in GDP not accountable to any new capital outlays or labor increases.

    Many business processes increased efficiency enormously. Workers were displaced, they mostly found new jobs, and certainly the objective measure of productivity would show this. But is total factor productivity objective in this way?

    Only if GDP increases faster because of it. And it didn't. GDP didn't grow at an extraordinary rate. A new industry grew, IT, but that isn't what TFP is supposed to measure.

    People really need to think about this, I think.

    I'll get some numbers together to make the case stronger and more scientific in the next couple of days…

  29. I know that Noah once pointed out that our current measures of productivity were not very accurate, or at least that we didn't understand fully what was being measured. I think he alluded to it having to do with the service sectors.

    I think that is probably valid. However, when it comes to modern technology, there's an even bigger problem I think. The main problem is that modern technology costs decrease very rapidly as compared to older technology costs which were tied more tightly to natural resource costs.

  30. What is the math behind this?

    It isn't even math. GDP doesn't measure quality of life in an aggregate manner. If the increase in quality of life cannot be quantified in GDP, it doesn't matter to economists.

    Economists are living in a world of their own. It doesn't matter to us.