Human capital is the accumulation of prior investments in education, training, health, and other factors that increase productivity and earnings. It is the cumulative knowledge, know-how, and skills that enable individuals to earn income. A valuable stock of human capital, together with strong demand for one’s services, can add up to a large capacity to earn income. For some people, high earnings have little to do with actual hours of work and much to do with their cumulated human capital. This point is demonstrated in the following story. It is said that a tourist once spotted the famous Spanish artist Pablo Picasso (1881-1973) in a Paris café. The tourist asked Picasso if he would do a sketch of his wife for pay. Picasso sketched the wife in a matter of minutes and said "That will be 10,000 francs [roughly $2,000]." Hearing this high price, the tourist became irritated, saying "But that took you only a few minutes." "No," replied Picasso, "it took me my entire life."

15.2 Efficiency wages button

Ford Motor Company made headlines in 1914 by offering autoworkers $5 per day, up from $2.50 per day. The wage payment was newsworthy because the typical market wage in manufacturing at that time was just $2 to $3 per day.(1) What was Ford’s rationale for offering a higher-than-competitive wage? Statistics indicate that the firm was suffering from high rates of job quitting and absenteeism. It reasoned that a high wage rate would increase worker productivity by increasing morale and reducing employment turnover. Only workers who worked at Ford for at least six months were eligible for the $5 per day wage. Nevertheless, 10,000 workers sought jobs with Ford in the immediate period following the announcement of the wage increase. According to historians, the Ford strategy succeeded. The $5 wage raised the value of the job to Ford workers. That created worker incentives to maintain employment at Ford and show up for work each day. It also encouraged laborers to work energetically so as not to be fired from a job that paid much more than alternative employment. The rates of job quitting and absenteeism both plummeted, and labor productivity at Ford rose by an estimated 51 percent that year. The $5 wage was an efficiency wage—one that raised the marginal revenue product of Ford workers. Ford’s pay plan addressed its principal-agent problem. The $2.50 wage hike "paid for itself" by more closely aligning the interests of Ford workers and owners. This application is from Campbell R. McConnell, Stanley L. Brue, and David A. Macpherson, Contemporary Labor Economics, 5th ed. (New York: McGraw-Hill, 1999), p. 233. It is based in part on Daniel M. G. Raff and Lawrence Summers, "Did Henry Ford Pay Efficiency Wages?" Journal of Labor Economics, pt. 2, October 1987, pp. S57-S86.

Photograph courtesy of: Courtesy of Ford Motor Company;