Is Human Capital Theory Compatible with the Strategy Literature?

7 May 2014 at 5:37 pm 3 comments

[Another Becker-themed guest post, this one from former guest blogger Russ Coff, a leader in the emerging field of Strategic Human Capital.]

| Russ Coff |

Human capital theory (HCT) has brought a lot to the strategy literature. It has also held it back as scholars import logic that is inconsistent with core assumptions of the literature.

Before I launch into my heretical rant, let me acknowledge, as others have said so eloquently, Gary Becker was a truly innovative thinker. The most unique part was that, while he was firmly grounded in economic logic, he did not hesitate to venture into new terrain. Though he is most known for his work in HCT, his thoughtful explorations of marriage, discrimination, crime, and many other topics demonstrate the breadth and depth of his intellect.

However, strategy represents new terrain that is often inconsistent with the logic of HCT. In this sense, I think Becker would have relished the opportunity to examine this context as a new problem. Human capital challenges the strategy literature in the most fundamental ways possible – if we go beyond a cursory integration with Becker’s world. Here are some examples:

How much does firm-specific human capital (FSHC) matter? Drawing on HCT, scholars often assume firm specificity is important since it hinders mobility and allows the firm to capture rent. However, recent work suggests that this effect may be overstated. It requires strong information about human capital as opposed to the coarse signals that employers often rely upon. Thus, a worker moving from a successful firm may have ample opportunities as the firm’s success serves as a signal of the worker’s capabilities – FSHC investments are ignored. Even with strong information, individuals who invest in FSHC may be in demand by firms seeking employees who are willing and able to make such investments. When we consider such market imperfections (at the core of strategy theory), some of the classical HCT logic breaks down.

General human capital as a source of competitive advantage? Recent work in economics (Lazear’s skill-weights model) and the literature on stars focuses on workers who have skills that are valuable across firms. Both literatures point out how valuable and rare such skills can be (at very high levels). The scarcity and imperfect markets suggest that general human capital can be a source of advantage. Such people may be much more scarce and much less mobile than is assumed in classical HCT. Practitioners focus extensively on this type of knowledge. Can it lead to an advantage?

What is competitive advantage? From this, we might ask some more fundamental questions about competitive advantage, firms, and ownership. Most scholars implicitly adopt an agency theoretic view where shareholders are the only residual claimant and competitive advantage is therefore rent that flows to shareholders. Any value that flows to employees is considered not to have been captured by the firm. Joe Mahoney points out that shareholders would be the sole residual claimants if all factors are traded in perfectly competitive markets (e.g., wage = MRP). For this to be true, firms would have to be homogeneous and human capital would need to be a commodity. As such, this logic assumes away the possibility of competitive advantage altogether. If firms are heterogeneous and there are factor market failures, shareholders would not generally be sole residual claimants. What, then, is competitive advantage?

Who is a firm? This leads us to the question of who is considered to be part of the firm and who is not. As suggested above, the competitive advantage literature largely treats employees as external suppliers. This is an interesting contrast to the internal labor market literature which draws a key distinction between hiring on spot markets (external) and internal hierarchies. The vertical integration literature might lead us to conclude that integrated units are part of the firm but their employees are not. Do the boundaries of the firm only refer to physical assets that can be owned? If not, which individuals are part of the firm?

Ownership and control rights? Finally we arrive at the problem that the firm cannot own human assets – can it be an asset? HCT is unambiguous that workers own their human capital – research focuses on returns to investments in human capital for employees. Ironically, it can only be an asset to the firm if employees are part of the firm (above) or they willingly provide their services. Thus, implicit contracts transfer “control rights” to the firm; allowing them to direct employee effort. The boundaries of these control rights may be defined by Barnard’s “zone of indifference” or perhaps, the psychological contract literature. This clearly makes human capital a unique asset. Have scholars fully explored the implications of these unusual attributes for strategy theory? While economic theory suggests that we would see the partnership form where human capital is critical, the munificence of human capital intensive corporations appears inconsistent with this theory.

This is an exciting time – a turning point, perhaps. It is clear to me that there is much work yet to be done. Some of the assumptions in HCT must be re-examined for a strategy context. At the same time, human assets challenge many of the core constructs in the strategy literature.

Becker started a revolution but it is we who are charged with finishing it. The journey will require us to question what we think we know from HCT as well as strategic management. Who knows where it will take us.

HumCapLivestock

Entry filed under: Former Guest Bloggers, Management Theory, Strategic Management, Theory of the Firm. Tags: .

A Note on “Human Capital” The New Empirical Economics of Management

3 Comments Add your own

  • 1. Charlie Williams  |  8 May 2014 at 12:52 am

    Great post, Russ. Not all that controversial, I hope.

    The crux seemed to be this, which still left me a bit confused:

    “While economic theory suggests that we would see the partnership form where human capital is critical, the munificence of human capital intensive corporations appears inconsistent with this theory.”

  • 2. RussCoff  |  8 May 2014 at 7:02 am

    Hi Charlie. Of course as a corporate researcher, it would stand out that R&D oriented corporations (biotech, etc.) are not partnerships as economists would predict for human capital intensive firms. However, I think the implications for competitive advantage and what a firm is are actually more fundamental (and radical) for the field. They are so fundamental that I think it is hard for many people to get their arms around (including me).

  • 3. Aija Leiponen  |  8 May 2014 at 8:44 am

    Thanks for the post, certainly thought-provoking if not controversial. One possible solution to the biotech vs. partnership dilemma seems to be the role of teams and whether key resources and outputs are jointly owned. We see partnerships in industries where human capital is extremely important but “stars” work largely alone and can control key aspects of their work (including clients): law, medical, other types of professional services. However, the star scientists in biotech work in teams, using essential inputs and creating outputs that are owned jointly/by the organization. It would be much more difficult to sort out their exact contribution to the performance of the organization. Contrast this to professional services where it’s all about billable hours from proprietary clients. I guess the team production theories (Alchian & Demsetz and others) appeared after Becker’s HCT contributions… I’m not sure if anyone has integrated these perspectives though.

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