There are important implications for the efficiency of education output: if the human capital idea holds, and education creates external benefits, then the amount of education chosen by individuals will be less than the optimal amount of education for society, but it would be sensible to subsidize education by an amount equal to the external benefits it creates. However, if the screening hypothesis holds, then education has only private benefits for the trained individuals, and no external ones for society as a whole, and so there is no case of education subsidies beyond a primary level.
Government will attempt to generate an efficient level of education output in order to improve education outcomes. For society as a whole, the efficient level of output Q* would be when the marginal social cost of education equals its marginal social benefit:
Measuring the cost is easy, while measuring the benefits seems more complicated: while increased future tax payments of trained individuals can certainly be measured, higher productivity and general cultural benefits cannot be expressed in simple figures. Also, it is difficult to measure inputs and outputs: while it is feasible to measure teachers’ and students’ time, equipment and infrastructure, there are problems of measurement with variables sucha s quality of teaching and the natural ability of students. As we have said before, benefits of education, or the output is difficult to measure as well, except for test scores, which do not give a complete or even accurate impression of educational benefits.
Problems of measurement of social benefits are not the only problem policy-makers are faced with when trying to achieve an efficient level of education. As mentioned before, a high-quality mass system of higher education cannot be supported by public funds alone, and so private funds will be needed to supplement the public ones. The willingness of the trainee will depend on his expected future benefit. In a perfect capital market, investment in human capital or education, like other forms of investment, could be undertaken with the aid of a loan at the market interest rate. Then, the optimal amount of investment would occur because trainees would invest in education if and only if the rate of return to human capital was greater than or equal to the interest rate. In practice, however, trainees are very likely to be credit-constrained, as unless other investments in real estate for example, investments in human capital do not provide a collateral for a loan, and so lenders will probably demand a higher rate of interest. Therefore, potentially profitable human capital investments do not occur in an efficient amount, and there will be under-investment in education.
There are two possible sources of education market failure: labor market imperfections and capital market problems. We will consider the market for education. The price of education is paid by trainees to the firms providing the training, which are assumed to be price-takers, as potential trainees can choose freely among all firms offering education. If we assume the labor market to be perfectly competitive, firms will not take over any of the costs of providing education, and will supply education up to the point where the price of education equals its marginal cost. If the capital market is functioning perfectly, trainees will be able to receive loans at the market interest rate. This will drive the demand for education up the point where the price of education is equal to the discounted present value of expected future wage gains. The demand schedule will be sloping downwards, as the wage falls with the number of trained individuals. The intersection of the supply and demand curves when both labor and capital markets are perfectly competitive gives us the first-best amount of education E*. At this point, the marginal cost of education equals the present value of the trainees enhanced productivity.
If we now suppose that the capital market is not perfect, then trainees – which are assumed to be risk averse – now face credit-constraints in the form of a higher interest on loans. Demand for education will thus fall as will the price, while capital market imperfections have no effect on the supply of education, and a new equilibrium is found.
If we now consider the case of an imperfect labor market, we see that this will result in a lower equilibrium outcome as well. In the imperfect labor market, the wage is assumed to be lower than the marginal product of the trained worker, and so trainees will be less willing to invest in education. However, if future employers of trained individuals anticipate this reaction, they are likely to take up some of the costs of education, as they count on employing the trained individual later on for a wage that is less than his marginal product. Still, this will result in lower equilibrium education.
As policy-makers have an incentive to achieve the efficient level of education output, they need to interfere in the market for education. Government can provide a subsidy that is equal to the external benefit that is created by education, although, as we have seen before, there are problems with measuring these benefits. Also, as stated by the screening hypothesis, the issue of causality between education and productivity is not resolved, making the determination of an appropriate level of subsidies even more difficult.
One result of this analysis that is commonly accepted however, is the fact that education undoubtedly creates a private benefit for the individuals receiving it, and this means that some of the costs of education should be borne by trainees or students. Now, the problem with this is that, due to the imperfect capital market, lenders are faced with risk and uncertainty, because borrowers cannot provide a collateral for the investment in human capital, and so the rate of interest or the premium charged will be well above the competitive market level, which will result in trainees or students – who also face risk and uncertainty – being deterred from investing in education, and the efficient level of education output will not be achieved.
So far, our analysis suggests that firms providing education should charge fees, as education cannot be supported by public funds alone, and it is students that should be charged with those fees, as they are the ones that are definitely profiting from the investment in human capital, while there remains some doubt about the extent of social benefit, which is represented by a part-subsidy. However, providing loans results in an inefficient market outcome, if this is handled by private firms, and so government has to take up the task of providing the loans, which should be offered at an interest rate broadly equal to the government’s cost of borrowing. The loans offered should be income-contingent as opposed to mortgage-type, as they reduce the risk and uncertainty that students face, because a certain percentage of their future income is used to pay off the loan, and not a lump-sum amount.
Concluding, we can say that while fees should be paid for students for receiving education, there is a strong case for making it free at the point of use in order to achieve the efficient amount of education.
