Introduction to the economics of

education
Craig Holmes
Higher Education and the Economy seminar
13th October 2014

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 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?

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 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

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 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
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 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?

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 Consumption
Value

Marginal costs

Marginal benefits

Amount of consumption

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 Consumption
Value
Benefits

Costs

Undergraduate Master’s PhD

Education
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 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?

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

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 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

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 Investment
Value
MC (high course
costs)

MC (low course
costs)

Marginal benefits
(immediate +
delayed)

Amount of education

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 Demand for education
Price

Individual
demand

Amount of education

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 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.

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A market for education
Price Supply of places

Total demand

Amount of education

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

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

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 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

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 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?

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 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?

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

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 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?

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 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?

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 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?

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

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 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

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 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?

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Correcting market failure
Value

Marginal costs

Social marginal
benefits
Private marginal
benefits

Amount of investment

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 Correcting market failure
Value

Marginal costs

Subsidy
Social marginal
benefits
Private marginal
benefits

Amount of investment

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

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 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

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 Signalling
Wage,
output

Cost (low)

200
Wage
150
Cost (high)
100

Education

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 Signalling
Wage,
output

Cost (low)

200 Wage

Cost (high)
100

E*
Education

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 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

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 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.

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 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.

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 Exercise
• Many countries have seen an increase in higher education
participation in recent years:

• Consider explanations and consequences of this trend from

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 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

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