1. EC-112
Current Issues in Economics
Economics of Education
(continued)
Lecture 4

2. The results from numerous studies of the rate of return
to a graduate education are well above 6% which has
been used by the Treasury in deciding whether a
public investment is appropriate.
This is before making any allowance for benefits which
may arise to the wider economy, some of which may
be difficult to quantify.
However, it should be future returns rather than past
returns which should determine an individual’s
investment decision in a university education.
Historic rates of return may be an imperfect prediction
of prospective rates of return.

3. Future premia to a university education are likely to be
determined by a number of factors:
• growth in the supply of graduates
• growth in the demand for graduates
• the impact of any shift in the balance between supply and
demand on the graduate pay premium
• the impact of any changes to the capability of entrants to Higher
Education
• elasticity of substitution, the flexibility for profitable substituting of
graduates with non-graduate labour
Trying to forecast future labour market needs for highly
qualified workers cannot be done with any precision
Given the recent large increase in students attending
university returns may be lower that for earlier generations

4. However, whilst the supply of graduates is increasing,
so is the demand for graduates as new technologies
are introduced and patterns of work change. There is
an increasing demand for higher level of skills and
forecasts expect this trend to continue.
Changes in industrial structure is also likely to
influence demand for graduates
• decline in manufacturing employment which traditionally employs
relatively few graduates
• increase in employment in business and finance sector which
traditionally employ relatively large numbers of graduates

5. However, changes in occupational structure likely to
be more important
• fewer clerical workers
• more professional workers
Within all occupations demands for skills are
increasing

6. Social Demand for Education
So far we have focused on the individual as the main purchaser
of education. However, some of the reasons why society wants
education are distinct from those of individuals.
• Necessary for the functioning of democracy
• Increase in welfare from technical progress can be
immense
Endogenous growth theory suggests the rate at which the
economy grows will depend on the level of education undertaken
• Robert Barrow finds a 10% increase in education
attainment increases growth by 0.2% per year
• Becker estimated the social rate of return to education at
25%

7. The size of these figures might explain why education is
provided by the state.
But why does education have to be provided by the state.
Couldn’t education not be produced by the private sector and
purchased by consumers on the free market?
Education is likely to be susceptible to market failures:
• Externalities
• Information problems
• Constraints on individual investments
If there were no state intervention in the market for education,
individuals would enter further/higher education only if the
private benefits of education exceed the private costs.
This can be shown in the following diagram.

8. £
pmc
pmb
Np No. of students
In this case, equilibrium number of students is given as Np
where private marginal cost (pmc) is equal to private marginal
benefit (pmb).
However, the possibility arises that social marginal costs and
social marginal benefits may be different from the private shown
above.

9. As a result the private market may result in too few students
entering higher education. Np less than Ns.
A subsidy however could result in the socially optimal number of
students being educated – shifts pmc to the right to pmc’
Capital Constraints
Capital markets allows people to transfer wealth between
different periods by borrowing and lending so that profitable
opportunities for education should be fully exploited.
£
smc
smb
Ns No. of students

11. However, there may be severe problems for many people
due to reluctance on the part of lenders to lend as much as
individuals might want.
• Default especially a problem given the timing of
expenditures
• Long-term financing for house is possible because a
house itself acts as a security for the loan.

12. Signalling
Critics of human capital theory argue that education does
nothing to increase productivity, rather it signals to an
employer that an individual is talented.
To be effective the screening process must separate the
high-ability workers from others.
Important to test human capital and signalling theories.
Both predict that education effects earnings.
What we need to know is – does education determine
productivity? Problem arises because on many occasions
we can’t observe productivity.

13. If schooling is purely a screening device we might
expect that the self-employed would invest less in
education as they are likely to know their own
productivity so do not need to acquire signals to testify
this.
There is evidence in both the USA and UK that the
self-employed do acquire less schooling than
employees.
However, no perfect test as those self-employed may
not know when deciding whether or not to invest in
education that they will become self-employed. So still
may need to acquire a good education – the signal.

14. Also self-employed may need to acquire certificates as
a testimony to their competence.
If schooling is only a screening device would expect
schooling to be less important as years with an
employer increases as they would have more
information on an employee – appears not to be the
case.
If schooling were only a screening device would
expect other cheaper screens than education to come
into existence – IQ testing stations!
If education is only a screening device this would
dramatically reduce the social rate of return to
education but not the private.