Capital, Human Capital, and Knowledge: Drivers of Economic Growth

Exam Tip: Remember that the growth rate of the capital stock depends on three things: the amount of investment, the current size of the capital stock, and the depreciation rate. A larger existing capital stock actually results in a lower growth rate, even if the absolute change is the same.

The Return on Capital and Global Flows

Capital tends to flow toward locations offering the highest return on capital, which is defined as the marginal product of capital—the extra output generated by increasing the capital input by one unit.

In theory, this should lead to massive flows from rich countries to poor countries because the marginal product of capital is higher when the capital stock is low. However, we often see divergence rather than convergence. This is because capital is hard to move physically, and poor countries often lack the human capital (skilled workers to operate machines) or social infrastructure (legal systems and lack of corruption) necessary to make those investments profitable.

Human Capital: The Value of Skills

Human capital represents the skills, education, and training embodied in a workforce. This includes technical skills, such as those of a software designer, and managerial skills, such as leadership.

Like physical capital, human capital requires investment in the form of time (schooling) and money (tuition). It is also subject to depreciation; workers can forget skills, or those skills can become obsolete as technology advances.

A critical distinction between physical and human capital is mobility. While physical capital can be shipped across borders, human capital is not easily mobile due to barriers to cross-country migration, such as legal visa requirements, language barriers, and cultural differences. This explains why wages remain so different between countries like Australia and Mexico.

Knowledge and Research & Development

While human capital refers to the effort individuals expend to acquire skills, knowledge refers to society’s collective understanding of the best ways to produce goods and services. Knowledge can be "common" (known by everyone, like the assembly line) or "proprietary" (known only by a specific company, like SpaceX).

Knowledge is generated through Research and Development (R&D), which typically falls into two categories:

1. Product development: Creating entirely new products (e.g., a Covid-19 vaccine).
2. Process development: Improving operations to reduce costs (e.g., using GPS to optimize truck routes).

Knowledge possesses two unique economic characteristics that distinguish it from other inputs:

• Nonrival: One person's use of knowledge does not prevent others from using it.
• Nonexcludable: It is often difficult to selectively deny access to knowledge once it exists.

Because nonexcludability reduces the incentive for firms to spend money on R&D (since others can copy the idea), societies use patents to grant creators the legal right to exclude others for a specific period, thereby incentivizing innovation.

Summary: Driving Long-Run Growth

To understand long-run economic growth, economists use growth accounting to decompose GDP growth into the contributions of capital, labor, and technology (which includes knowledge and social infrastructure).

Ultimately, while accumulating physical capital can help a country "catch up" to richer nations, relying solely on capital accumulation leads to diminishing returns. Sustained, long-term prosperity requires continuous improvements in human capital and the constant advancement of knowledge through technological progress.