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

2. 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?

3. 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

4. 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

5. 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?

6. Consumption Value Marginal costs Marginal benefits
Amount of consumption

7. Consumption
Value
Benefits
Costs
Undergraduate
Master’s
PhD
Education

8. 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?

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

10. 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

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

12. Demand for education
Price
Individual demand
Amount of education

13. 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.

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

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

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

17. 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

18. 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?

19. 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?

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

21. 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?

22. 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?

23. 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?

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

25. 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

26. 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?

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

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

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

30. 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

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

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

33. 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

34. 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.

35. 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.

36. 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

37. 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