Introduction to the economics of education Craig Holmes Higher Education and the Economy seminar 13th October 2014

Course introduction What will we study in this course? Who will teach you? Who are you? Before we start, what do think about higher education and its relationship to the economy?

Seminar outline Aims: Understand how economists think about individual decisions, and apply that to the decision to participate in higher education Understand how economists think about social outcomes, to provide a framework for analysing the effectiveness and efficiency of higher education policy

Why do (higher) education? Economists’ focus on two areas: For its own sake – a consumption good For its delayed earnings benefits – an investment good Both connected by a theory: utility maximisation All economic choices produce benefits and costs It is rational to choose something providing the benefits outweigh the costs

Education as a consumption good Benefits (increase utility): Enjoyment of learning Social life Costs (decrease utility): Price of course Effort of studying Opportunity costs – what else could you be doing with your time or spending your money on?

Consumption Value Marginal costs Marginal benefits Amount of consumption

Consumption Value Benefits Costs Undergraduate Master’s PhD Education

Education as an investment Some of the benefits to education arise after the course has been completed Higher wages Greater chance of employment Better jobs (non-monetary in work rewards) Further opportunities to learn or train Any others?

Education as an investment How do you value a delayed benefit?

Education as an investment Like consumption: More investment usually leads to more (delayed) benefits There are diminishing returns to investment These benefits must be weighed against the costs There is an optimal level of investment

Investment Value MC (high course costs) MC (low course costs) Marginal benefits (immediate + delayed) Amount of education

Demand for education Price Individual demand Amount of education

A market for education Total demand for education is the sum of all individual demands at each price level Education providers offer a certain amount of places at each price. In a competitive market, education providers will keep offering places until the cost of adding an extra place exceeds the price paid for that place Like students – marginal benefit equals marginal cost A market is where buyers (demand) and sellers (supply) come together. A market price ensures that supply and demand are equal.

A market for education Price Supply of places Total demand Amount of education

Education as an investment Why do the delayed benefits arise? Two theories: Human capital theory Signalling and screening

Human capital theory What do you understand by the term ‘human capital’

Human capital theory “Laborers have become capitalists not from a diffusion of the ownership of corporation stocks, as folklore would have it, but from the acquisition of knowledge and skill that have economic value” (Schultz, 1961, pg. 3) Human capital represents the qualitative differences in productivity of workers. Like other sorts of capital it: Requires a costly investment up-front Produces a return May depreciate

Human capital theory Investment  Increased productivity  Higher rewards For the worker who receives some education or training Additional skills make workers more productive Workers are employed by firms – their extra output is sold by the firm Firms profits rise Why do workers see higher pay?

Human capital Link between productivity and wages through competition in the labour market Example: There are many firms producing gubbins in a market, which sell for £1 each An uneducated worker produces 100 gubbins each week. How much does a firm pay that worker? An educated worker produces 200 gubbins each week – what would happen if a firm offered her the same wage as her untrained colleagues?

Human capital How does higher education add to a person’s human capital? What sorts of human capital is it best a producing?

Human capital Human capital is not all the same Moreover, the value placed on it can vary from employer to employer Becker distinguished between two sorts of human capital: General human capital: improves productivity of workers regardless of job Specific human capital: improves productivity of workers in a particular job Examples?

Human capital Who pays for a general HC investment? Back to our gubbin market: A worker can produce 100 more gubbins a week if they do a course in the science of gubbins. We saw before that trained workers earned £100 more per week than untrained workers Firm net profit = £0. Therefore, they will not pay for course. Worker benefit from investment = £100 per week. Should they pay for themselves?

Human capital Who pays for a specific HC investment? A firm patents the Gubbin-o-matic, a new machine for making gubbins A worker can produce 100 more gubbins a week if they go to the Gubbin-o-matic Training Seminar Firms would not pay trained workers any more than before. Why? Worker benefit from investment = £0 per week. They will not pay for training Firm net profit = £100 per week. Will they pay for workers to take the course?

Human capital Individuals pay for general human capital, while firms pay for specific human capital? Does higher education produce general or specific human capital?

Human capital and the market for education Why does the state sometimes pay for higher education? Everything we have talked about so far happens through hypothetical competitive markets for education, training and skills Extra wages = extra productivity  private benefits = social benefits Price is set as low as possible  private costs = social costs Price is set to equate supply and demand  marginal benefit = marginal cost. As a result, marginal social benefits = marginal social costs. This outcome is efficient – all socially worthwhile investments take place

Market failures The model has assumed that markets work well: Everyone is well informed about all opportunities to invest. Labour markets are competitive – many firms and many workers, none of whom have any market power Markets for training provision are competitive Finance is readily available to fund investments The decision to invest affects only those involved (e.g. the individual or the employing firm) A breakdown in any of these conditions leads to market failure  an inefficient amount of investment Could any of these apply to a market for higher education?

Correcting market failure Value Marginal costs Social marginal benefits Private marginal benefits Amount of investment

Correcting market failure Value Marginal costs Subsidy Social marginal benefits Private marginal benefits Amount of investment

Correcting market failure How else could the state intervene, other than through direct subsidy?

Signalling Spence (1973): Suppose that individuals differ in productive capabilities, regardless of education Simple case: low ability (100 gubbins per week) and high ability (200 gubbins per week) in a competitive market. Individuals know their ability. Employers can not directly observe this ability. High ability workers want to ‘signal’ their ability. Education can act as a signal if more costly to low ability workers to acquire Employers have beliefs about education-ability link

Signalling Wage, output Cost (low) 200 Wage 150 Cost (high) 100 Education

Signalling Wage, output Cost (low) 200 Wage Cost (high) 100 E* Education

Signalling What is the socially optimal level of education in this model? Zero! Total output is the same regardless of educational choice. Social benefits = 0 Education uses resources: social costs > 0

Job competition A related, but separate theory, posits that productivity (and wages) are determined by jobs themselves, not workers Workers compete for the best job they can get – education is one way they position themselves (as it signals certain characteristics that employers like ability to learn the job) This does not exclude elements of human capital theory – for example, some jobs require skills to be present at the point of entry. Unlike HCT, this is a zero-sum game – if an individual move up the job queue, it pushes someone else down.

Job competition Unlike HCT and signalling, job competition allows for overeducation - a particular concern for university leavers Job competition emphasises that the demand side of the labour market (employers) is as important as the supply side of the labour market (workers) – policy tends to focus on the latter.

Exercise Many countries have seen an increase in higher education participation in recent years: Consider explanations and consequences of this trend from the perspective of (a) human capital theory (b) signalling, and (c) job competition

How does this relate to the rest of the course? Next week: measuring the returns to investing in higher education – quantifying the private benefits Transitions into the labour market – keep in mind human capital, signalling and job competition Who pays? Remember private vs. social benefits HE and economic growth – productivity and externalities Too big? All about finding the social optimum