Marina Souyioultzis                                                                                                             For Dr. Ryan

Peterhouse Part II

Lent 1999

MICROECONOMICS SUPERVISION TOPIC 4: EDUCATION

Does the UK under-invest in higher education?

It has been pointed-out that the British university sector is too small, with Britain having a lower proportion of the relevant age group at university than any other advanced country. Farmer and Barrell (1983) argue that this is inefficient and inequitable, citing as evidence the fact that the earnings differential between graduates and non-graduates, though reduced by the expansion following the Robbins Report (UK, 1963), is large by international standards. Such differentials are the result of entry restrictions to university education. This evidence lends at least qualified support to the view that the British university sector is too small. In addition, Ryan (1992) suggests that fiscal rules adopted to restrict public spending may have resulted in under-allocation of resources to higher education, particularly in Denmark, New Zealand and the UK, where fiscal restraint was most severe.  Concerned about inflation given slow productivity growth, youth unemployment and the actual or impending glut of highly educated people, governments cut back on educational expenditure after the mid-1970s, threatening efficiency in the allocation of resources to the higher education sector. The UK government used the argument that private rates of return are above social rates in order to justify policies which reduce the element of state subsidy to higher education. The introduction of student loans reflects this. Yet if education confers benefits to society at large, which are not reflected in the incomes of those who have been educated, attempts to justify more of higher education to the marketplace would be gravely misplaced. Indeed, there is good evidence that investment in higher education offers a social return at least as good as that on physical capital, providing a strong justification for expansion of the system. 

Both equity and efficiency reasons can be advanced for the policy of subsidising education. Equity is involved because education is not good collateral for loans, so those from poor families would be disadvantaged in making such investment. It might be thought equitable to direct money away from the better-off so as to equalise opportunity. Economic efficiency is involved because education might have external benefits. Since such benefits are not captured by the student, there will be under-investment in education in the absence of subsidies.

While there is an equity case for an increase in education expenditures made by poor families, this is in fact quite difficult, because the subsidies might not be appropriated by the poor. Free education is not means-tested. Moreover, those eligible for subsidised higher education are only those who have successfully completed the lower education courses – who tend to be middle-class. There is also the fact that some families spend less on education after the state introduces an education subsidy (the ‘Peltzman effect’). Looking at higher education in particular, the subsidy system seems inequitable as presently organised. Each year the CSO publishes estimates of taxes paid and benefits in cash and in kind received by families according to family income. The richer families receive the higher education benefits. Thus it seems that subsidising education by providing it free at government-run schools and universities, is not a very effective means of reducing education inequality.

Grants are costly, and university places are therefore rationed by controls on public spending. Maintenance grants are now capped in nominal terms, but students have access to loans at a zero real rate of interest. Loan schemes fall broadly into the following categories: a loan repayable over a fixed period, an income-contingent loan (whereby the rate of repayment depends on the graduate’s attained level of income in any year), or a graduate tax (whereby graduates pay over their lifetime an additional and possibly progressive income tax). The current UK scheme lies somewhere between the first and second types of loan – the full debt is repayable, but repayments cease if income drops below a specified level, and the debt lapses if income remains low for a long period. The essence of the loans strategy is that individuals are charged for the private benefits of their university education, but are subsidised to the extent of the external benefit conferred on others. This is a valid approach to efficient resource allocation only where consumers have perfect information about the long-run value of education, and where capital markets are perfect. Loans bring about the latter condition; whether the first holds sufficiently is one of the central issues in the loans vs. grants debate.

What is the effect of loans on the quantity of university education consumed? It is argued that grants distort the individual decision to acquire a university education by making it too cheap, thereby causing over-consumption (in the absence of budget constraints on the number university places). A subsidy may well be justified if university education creates external benefits but, so long as private benefits are positive, this is no argument for a 100% subsidy. (Of course, with the introduction of fees, university education is no longer fully subsidised.) Loan schemes, it is argued, avoid the tendency to over-consumption associated with grants. A logically incompatible view is that loans avoid under-consumption. It has been suggested that the expense of the grants system has kept the university sector below its optimal size. Loans relax the budget constraint, thereby enabling an expansion of university education at no additional public cost. Nevertheless, a public loan scheme, even if self-financing in the long run, is likely to increase public spending in the short term, when the state will be issuing many loans and receiving few repayments. Moreover, the need to repay loans, even is repayments are income-related, might well increase inequality of university attendance by social class[1]. If education is the engine of economic prosperity, we should be concerned about its distribution on efficiency as well as on equity grounds. If post-compulsory education has no social benefits, the importance of the efficiency question is diminished, though the equity issue remains.

It should not be presumed that higher education necessarily has a positive social economic return. Some commentators argue that a negative social return appears to be a feature of some types of undergraduate education, and of many more types of postgraduate education. The most obvious way of measuring the consequence of higher education is by looking at the effect on the incomes of those who have experienced higher education. The private rate of return exceeds the social rate of return in the UK because students receive a grant to cover part of their living expenses, though they now have to pay tuition fees. Against this must be set the fact that society benefits from increases in income gross of income tax, while individuals only benefit from post-tax enhancement of their incomes.

External benefits will not be captured by a mere comparison of the earnings of more with less educated individuals. Such a comparison would understate the social benefits of education. The argument is that since individuals are necessarily only interested in the private benefits of education when making education decisions, there will therefore be too little education investment from society’s point of view. The idea that there may be external benefits from education returned to the fore with the work of Lucas (1988). Any static link between tertiary training and productivity has direct implications for economic growth. A high level of education is likely to accelerate the rate of technical progress, perhaps because the extent to which a country can catch up with others through the import of technical knowledge is likely to depend on the level of education and training. Education thus raises the economy’s growth rate by improving its ability to exploit new technologies. Consequently, an increase in the corps of educated people would be expected to raise the rate of growth of the output of the uneducated, as well as increasing the amount of product as a direct result of education (Weale, 1992).

In a growing economy, a higher rate of growth (or even of income), benefits future generations as well as the current generation, provided that at least some of the skills acquired by one generation are passed on to their successors. A consequence of this inter-temporal externality is that a generation concerned only about its own welfare would provide a lower level of education than one which is also concerned about the welfare of future generations. A well-tried method of imposing a burden on a future generation, is for the government to finance the excess of the socially desirable level of education over the privately desirable level by borrowing. The maintenance of a national debt at an appropriate level will impose on future generations a burden equal to the benefit they gain from the education of the current generation through a higher rate of growth.

Is it true that education is causally related to increases in individual income through increases in individual productivity? The screening hypothesis argues that education is associated with increases, but does not cause them. The distribution of earnings is the result of a complex interaction of factors including sex, race, family circumstances, natural ability and the quantity and quality of education. The screening hypothesis is a special case which argues that education beyond a basic level does not increase individual productivity. Instead, it is assumed that firms seek high-ability workers, but are unable, prior to employing them, to distinguish them from those with low ability. (Analytically the problem is identical to adverse selection). It is necessary to posit a large amount of employer ignorance. Then those who are uneducated will be passed over, even if they are able, in favour of those who are educated. Everyone will thus be caught up in a competitive race for qualifications, with the associated waste (Polachek and Siebert, 1993). Since high-ability individuals tend to perform well in the educational system, educational achievement is correlated with higher productivity but does not cause it. Education is hence no more than a screening or signalling device to prospective employers, which it is in the individual’s (though not necessarily in society’s) interests to acquire. To the extent that it is true, the screening hypothesis has profound implications for the socially optimal level of investment in education: it would suggest that there has been too much education investment. 

One way of testing the screening hypothesis is to consider situations where employer ignorance is low, and see if there is then less education over-investment. One such situation is where a person is self-employed: individuals have an advantage in gauging their own abilities. In fact, the self-employed do have lower levels of educational attainment than the employees, ceteris paribus. While this appears to support the screening idea, it should be borne in mind that the self-employed usually undergo a long-period of on-the-job training. This easy test of the screening argument is therefore inconclusive.  

The screening hypothesis neatly accounts for the notion that earnings rise with additional education, which would conform to everyone’s expectations, and which is well supported by the data. It also helps to explain why the educational explosion of the last fourty years has had so little effect on equalising the distribution of income. If education acts merely as a filter to separate the more able from the less able individuals, the steady expansion of higher education dilutes the significance of a degree and induces employers to upgrade the hiring standards of jobs previously filled by university graduates (Blaug, 1983). But if secondary schooling is expanding at the same time, so that secondary-school leavers are likewise being squeezed into lower-level jobs, earnings differentials between the two groups may nevertheless remain largely the same. The expansion of university education thus ends up in a chronic core of unemployed school leavers, with no significant effect on the distribution of labour income. The effect of education on earnings at the point of recruitment persists even after employers have had the opportunity to assess graduates’ productivity on the job, due to the existence of  ‘internal labour markets’; most vacancies in large organisations are filled by internal promotion. Hence, any advantages at the point of recruitment become permanent advantages throughout a working life with the company. The use of screening on the basis of education and the presence of internal labour markets can thus jointly explain why highly educated people on average earn more than less educated people even though they may not be inherently more productive.

Spence (1973) introduced the idea of signalling in the context of education. A prerequisite for effective job-market signalling is that the costs of acquiring the signal are negatively correlated with the individual’s productive capability with respect to some job. There are multiple signalling equilibria, with different efficiency properties. When education is used as a signal, there are again likely to be differences between private and social returns to investment in education. If the social return to education were to be estimated by comparing wages and various levels of education in the labour force, the contribution of education to output might be seriously over-estimated. Nevertheless, the social return is not zero. Education as a signalling device helps to allocate the right people to the right jobs. Moreover, signalling keeps talented workers from moving to jobs where their productivity is lower, but their talent is known. If ability is endogenous – moral hazard rather than adverse selection – signalling also encourages workers to acquire ability and all workers might acquire a positive amount of the signal. Systematic over-investment in education is still a distinct possibility, however, because of the element of arbitrariness in the equilibrium configuration in the market. 

The education sector suffers from the ‘cost disease’ – slow productivity growth implies trend increases in relative costs and prices. If the demand for education is more responsive to income than to price, an optimal growth pattern will also involve increases in the sector’s output and its shares of national income. Yet Ryan (1993) points out that fiscal rules such as ‘level funding’, which are potentially inconsistent with the requirements of unbalanced growth, have abounded since the mid-1970s, and fiscal restriction has been particularly severe to higher education. Conflict between fiscal restraint and the cost disease gives rise to the possibility of resource misallocation. The higher the income elasticity of demand, the larger the productivity growth gap between the education sector and the rest of the economy, and the lower the price elasticity, the greater is the growth of excess demand; and the more severe and durable the fiscal restriction, the greater the likelihood of positive excess demand.

Having said that, it is difficult to assess the degree to which productivity growth in higher education lags behind that in the rest of the economy, due to the multi-dimensionality and intangibility of its output. The two principal dimensions are student learning and faculty research, each of which has various sub-dimensions, which are generally difficult to measure even in physical terms. Studies of productivity growth in higher education consequently rely on partial and unreliable measures of output, such as first degrees awarded. Given this limitation, it is suggested that the rate of productivity growth is low even by the standards of public services, though it is not zero. The shortfall in sectoral labour productivity growth may be reduced by increases in other inputs, including technical change or in the internal efficiency of universities and colleges. The latter is of particular interest in the UK, where the government has claimed that efficiency savings permit cuts in real funding without damage to output. Moreover, cuts in public funding may be replaced by increases in private funding, as when participants receive lower maintenance subsidies and pay increased tuition fees. Finally, even if output falls, allocative efficiency may not be damaged if demand for higher education falls as well.

Such intervening variables offset to some extent the potential effects of fiscal restriction during 1970-87. However, some influences operated in the reverse direction, intensifying the effects of the cost disease. For example, unit costs have been raised in Britain by the increasing enrollment shares of science, technology and engineering courses, with their higher current and capital costs. Nor can increases in technical change have raised productivity growth during the period: in most countries, increasing enrollments were accompanied by declining gross investment, implying that both capital inputs per student and embodied technical change declined. In the most restrictive cases (Denmark, New Zealand, the UK, France, Germany) public investment had fallen by 1985-87 to between 20% and 60% of 1970-72 levels. There remains the prospect of increased private finance, however, especially with the introduction of tuition fees.

It is most likely that allocative inefficiency occurred in those fiscally restrictive countries whose education systems remain dependent on public provision and finance. UK universities responded to funding cuts in the 1980s initially by reducing enrollments and then by refusing to compete for extra enrollments at reduced per capita funding levels. The extent of under-spending on higher education remains, however, uncertain, ultimately reflecting the difficulty of determining the link between fiscal policy and taxpayer preferences. The latter constitute a further source of fiscal restriction. It is difficult to defend increased public spending on a service whose benefits are amongst the least public of all. The participants in university education in the UK have remained overwhelmingly middle- and upper-class, and show little willingness to pay more tax in order to extend public subsidies to less favoured groups. The inclination of governments to increase student numbers but not public spending threatens further quality losses in education and research unless appropriate long-term technological or financial policies are pursued.