Unit 1 Introduction to the Economics of Education

1.1 Economics of education

The World over investment in education has been recognized as having an array of
economic and social benefits ranging from potential for higher earnings, improved
occupational attainment, social mobility and improved health standards (cf. Becker, 1993;
Johnes, 1993; Schultz, 1972). Therefore, individuals and society invest in education because
of its expected benefits. Individuals benefit from education because schooling increases
their stock of knowledge and skills, leads to acquisition of new attitudes and values, and
improves their communication and critical thinking skills. These traits are thought to make
individuals more productive and their demand in the labour market increases which also
leads to higher life time earnings.

On the other hand society benefits from the individual’s stock of knowledge when many
individuals have higher earnings; there is increased consumption which leads to increased
aggregate demand for goods and services inducing more production and eventually leading
to economic growth and development. This thinking is supported by early classical
economists like Schultz, (1961) and Denison, (1962) who showed that education contributes
directly to the growth of national income by improving the skills and productive capacities
of the labour force. Therefore investing in education is an investment in human capital (cf.
e.g. Psacharopoulos, 1997).

In the process of individuals acquiring education and society providing education costs are
incurred. Individuals and households directly incur costs of paying tuition fees, boarding
costs, transport costs, and costs of buying scholastic materials. On the other hand society
incurs direct costs of the value of the resource of land where educational institutions are
established, the cost oflaborr and the cost of capital in terms of buildings and other
educational equipment. Economists also agree that production of a particular commodity
will have costs in the form of other goods and services that could have been produced with
the resources it uses up and this is called the opportunity cost (cf. LeGrand et al, 1992).
When individuals, households and governments spend on education they forego investment
in other ventures. For example, what an individual household spends on education could be

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spent on a family business or farm or buying a household asset and what the government
spends on education could be invested in other sectors like health, road construction or
provision of other services. This means that besides the direct costs incurred by individuals
and governments on education there is also an opportunity cost in terms of the alternative
investment foregone. The study of economics of education is therefore important because it
analyses the ways in which scarce educational resources are used to provide education
which benefits individuals and nations.

1.2 The Meaning of Economics of Education

Economics of education is concerned with the analysis of the ways in which scarce resources
are used to provide education which satisfies individuals’ educational needs and also
contributes to national development. Like any other resources, educational resources are
scarce yet educational needs are ever increasing both for the individuals and for nations.
This scarcity of resources means that policy makers must decide on the fundamental
questions of:

1. What to produce (i.e. How much to spend on each stage of education?)

2. How to produce (i.e. How to provide education efficiently?)
3. For whom to produce (i.e. who will benefit from the given level and type of
education?)

Economic theory is therefore able to guide educational policy makers and planners by
providing both facts about the education system and values to inform decision making. The
part of economics that is concerned with establishing facts about the world is called positive
economics. It asks questions such as ‘can we improve the quality of teachers by increasing
pay’ or ‘will smaller class sizes raise pupil attainment’? On the other hand normative
economics asks questions that require value judgments such as ‘is it fair to charge higher
education students tuition fees’, of what value is increasing expenditure on primary
education?

Individuals and governments often face hard choices because of the scarce resources they
possess. For example, expanding higher education and increasing provision of basic
education might both appear to be policies that have the potential to improve the well-
being of society, but which of the two should the government prioritize? This causes the

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economic problem in education which is characterised by scarce resources, unlimited wants,
choice and opportunity cost.

• Educational resources are scarce because they are competed for by other sectors
and also within the education sector itself there is competition for these same
resources. At the household level, educational resources are also competed for by
other family wants like health, shelter, food and investment.

• Educational wants/needs are insatiable/un-limited because they are

complementary and recurrent. Complementary means one educational need
supports the acquisition of another need. Recurrent means acquisition of one
educational need raises the appetite/desire to acquire/provide another. This is also
due to increased technological changes and globalization.

• Choice in education means that households and governments have to select the
best educational alternatives that satisfy their educational needs. Choice has to be
done in education because of the many educational wants and the limited
educational resources both at household and national/society level.

• Opportunity cost in education is the best alternative foregone by individual

household and government when they choose to invest in one type/level of
education instead of the other. Opportunity cost also means the alternative
foregone by households and government when they choose to commit resources to
education other than investing these resources in something else.

Economists describe the costs of taking a particular action as opportunity costs, because for
example, the greatest cost of expanding higher education might be the lost benefits of not
undertaking the next best alternative policy, such as increased provision of early years care
(cf. LeGrand et al, 1992; Barr, 2004). Scarcity of educational resources coupled with
unlimited educational wants compels households and government to make choice, and in
the process of choosing there is the best alternative foregone which is the opportunity cost
and these constitute the economic problem in education.

The subject of economics of education is also important because globally education is given
special recognition as a vehicle to the development process. Whereas developed nations are

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strengthening their education systems, developing nations are urged by the World Bank,
IMF and other donor agencies to invest in certain types and levels of education which are
relevant to development objectives. As a result, there is tremendous growth in school
enrolment globally and significant proportions of national budgets are allocated to the
education sector by most nations. The United nations development report, (2000) indicated
that while there were still about 875 million illiterate people aged 15 or older in the world
80% were literate compared to just 63% in the 1970s.

This indicates the tremendous efforts which have paid to education due to the recognition
of the fact that education is an important factor in social and economic development.
Therefore, when individuals and governments invest in education, there is need to assess
the viability and profitability of the investment. If this is not done, there is likely to be a
waste in the allocation of resources which justifies the economics of education.

1.3 Origins of Economics of Education

Economics of education has a long history dating back from the days of classical economists
like Adam Smith, Alfred Marshal and John Stuart Mill who focused attention on education as
a form of investment. In the early 1960s, education was considered a ‘basic human right’
associated primarily with consumption but its economic benefits were ignored. Given this
consideration, education as a right would not need to be subject to economic debate.
Subjecting education to principles of economic analysis like the cost benefit analysis would
exclude some individuals from getting what is considered their fundamental right. Besides
this, educational institutions, most especially those owned by government are considered to
be non-profit making organizations and as such they fall outside the economic arena.

This kind of debate went on until the late 1960s when Theodore Schulz, (1961) and Denison
(1962), showed that education contributes directly to the growth of national income by
improving the skills and productive capacities of the labour force. To demonstrate this,
Schultz did a study in the USA between 1929 and 1957. He calculated the total value of the
stock of education and obtained the figure for the increase in stock. He then made
estimates of the rates of return on the investment in education and combined the
calculations to give the figure for the growth in national income from schooling. His results
suggested that between 16.5% and 20% of the total growth in the American economy was

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caused by the additional schooling of the labour force (cf. Atkinson, 1983). Although this
approach may have its own shortcomings, it suggests that besides the social benefits,
education also has economic benefits both to the nation and to the individuals who attain it.

Besides the fact that education has national/societal economic benefits, there are also costs
incurred by individuals and nations in the process of acquiring and providing education. For
example, Education planners and policy makers have a task of satisfying the demands of
teachers, parents, administrators and the government. In doing this, they have to ensure
that minimal resources are efficiently used to attain the best in education without
compromising its quality. This also means that planners and policy makers have to set
priorities and select the best alternatives in order to ensure that the scarce resources are
well allocated among the competing educational needs.

Nations also have to select that type of education which has economic benefits for
individuals but also addresses national development needs. This would help nations to train
the work force which is relevant to their labour market which will in turn boost the
production of the required goods and services and reduce on the problem of unemployment
with its related vices. Therefore, economics of education provides a good basis for
developing education policy ideas from the application of economic theory. Economic
analysis of educational matters would also ensure that maximum benefits are attained by
the nation at the lowest cost of inputs.

Unit 2 The Market Theory of Education

2.1 The Concept of the Market

A market can be described as a situation in which buyers and sellers or producers and
consumers interact in the exchange of goods and services. Economic decisions (on what,
how and for whom to produce) in the market situation are determined by the forces of
demand and supply in relation to price and this happens in a perfect market. Economists
define a perfect market as one characterized by many buyers and many sellers dealing in a
homogeneous product (cf. Barr, 2004; Douma and Schreuder, 2002). In a perfect market,
there is perfect information for both the buyers and the sellers and there is free entry and
exit with no limitations.

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A perfect market is in equilibrium or is achieving an efficient level of output when demand is
equal to supply. This means that producers are able to sell all their products and consumers
are able to get all that they want and there is no excess demand and excess supply. In
education, this efficient condition is achieved when the demand for school places is equal to
their supply. This means that all learners are able to get the level and type of education that
they need and education providers are able to supply this education and there is no excess
or shortage of school places.

2.2 Costs and Benefits in the Education Market

This equilibrium condition is also determined by the costs and benefits in the context of
education. The total social costs (TSC) of education are all the expenses which society incurs
to provide a given type and level of education. On the other hand, the total social benefits
(TSB) represent total utility derived by consumers of education as well as the benefits
derived by society in terms of economic development. Such benefits also include positive
externalities which are the spillover effects of education for which no money is paid by the
beneficiaries.
The marginal social costs (MSC) in education are the extra costs for producing an extra unit
of education for example the extra cost of enrolling one more student in the school which
has an effect on the cost per student. The Marginal social benefits (MSB) are the extra utility
to society derived from individuals consuming extra units of education. The total social costs
(TSC) and the marginal social costs (MSC) increase as the level of output increases and in the
same way the total social benefits (TSB) and the marginal social benefits (MSB) increase as
more output is consumed until a point where they begin to decrease following the
economic principle of diminishing returns.

Therefore, an efficient education system is achieved according to market conditions when

the marginal social benefits are equal to the marginal social costs also meaning that demand
for education is equal to supply. This is what (Ghosh, 2001:19) calls ‘the marginal condition
of efficient resource allocation’ which is the same as the equilibrium level of output. The
above scenario is illustrated in Figure 1.

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Figure 1a: Maximum net benefit
TSC
TSB TSB
TSC
Maximum net benefit

N Output

Figure 1b: Efficient level of output

MSC S = marginal costs
MSB

P E

D=marginal benefits
N Output/Amount of education
From Figure 1a, the efficient level of output is attained at a point where there is an excess of
TSB over TSC that is the point of Maximum net benefits. In the corresponding MSC/MSB
curve the efficient level of output is attained at point E where the MSB=MSC. At the
equilibrium point E, educational resources are efficiently allocated.

Therefore, an education market exists whenever parents are able to choose between
schools and where parents have a choice, they will have preference for schools with a
higher ranking in terms of quality measured by students’ grades in national exams. Naturally
high quality schools charge high fees which mean that the cost of education will be high for
parents depending on their levels of income which affects the demand for education. If we
can use the case of Uganda as an example to illustrate this point of change in demand for
education as a result of changes in costs for education; when primary education was paid
for by parents before the introduction of universal primary education the cost of primary
education was high and as such its demand was law. For example, by 1997 when UPE was

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introduced only 2.5 million children were enrolled in primary schools but after the
introduction of UPE, primary school enrolment grown to about 7.7 million children by 2008
(cf. Uganda Ministry of Education and Sports, 2008). This is an indicator that subsidizing the
cost of primary education by the public sector could have increased its demand in Uganda.
On the contrary, when the private cost of tertiary education increased with the gradual
withdrawal of government scholarships for university students, the demand for University
places kept on increasing. This trend is illustrated in Table 1:

Table 1: Growth in tertiary enrolment in Uganda between 2000 and 2005

2000 2001 2002 2003 2004 2005 2006/2007

Male 34,441 40,366 49,179 53,932 40,400 69,558 79,469

Female 20,003 23,850 30,678 34,990 63,574 50,587 57,721

Total
enrolment 54,444 64,216 79,857 88,922 108,295 124,313 137,190
Source: Uganda Ministry of Education and Sports, (2008)

Table 1 shows that tertiary enrolment in Uganda grew from 54,444 students to 137,190
students in a period of just seven years yet this is the period when the government reduced
sponsorship for university students and encouraged private sponsorship. This means that
the private cost of tertiary education went high with the reduction of government
scholarships but its demand also kept on increasing. This suggests that like in the market for
other goods and services the demand for education is affected by other factors besides
changes in the cost for education. Factors such as the value attached to education by the
society, employment opportunities available for the educated, government policies like the
liberalization of the education sector, demographic characteristics including growth in
population, and changes in the levels of income in the population also affect changes in the
demand for education.

The other important factor to note is that the market for schooling is generally described as
‘a quasi-market’ because in most countries the world over the public sector controls the
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supply side of education with regulated intervention of the private sector. This means that
education matters are not entirely determined only by the market forces of demand and
supply much as these play a key role. There is always market failure in education production
which requires the intervention of government.

2.3 Causes of Market Failure in Education Production

Ideally, perfectly competitive markets would be efficient in allocating resources to
education. However, in the education sector markets fail because:
In the first place, education is a quasi-public good (Barr, 2004; Ghosh, 2001) which implies
non-rivalry such that its being consumed by one individual does not diminish the benefit to
others for example one extra student in the classroom may not diminish the benefits
derived by other students. Education is also partly non-exclusive because once it has been
provided to a few individuals its benefits may spill over to other members of the community
who may not have paid for it. For example, studies have found out that workers are more
productive when they learn from their more educated co-workers (cf. Barth, 2002); and that
children who have not attended early childhood education programmes may benefit from
these programmes through peer interaction with those who have attended (cf. Waldfogel
and Neidell, 2006).

The issue of non-exclusiveness may therefore lead to the free raider problem where there
are individuals who benefit from education without necessarily paying for it and this
certainly makes the marginal social benefits (MSB) to be higher than the marginal social
costs (MSC).

At the same time education may also have negative externalities (negative spillover effects)
in terms of the opportunity cost which may also make the marginal social costs (MSC) to be
higher than the marginal social benefits (MSB) (cf. Ghosh, 2001; Levacic, 1993) also making
market operations inefficient. Education is also heterogeneous because there are different
levels and types of education and besides that there is usually no perfect information for
both the students and the producers of education (schools) which makes assumptions of
perfect markets unrealistic in the context of education. Therefore, even if markets can

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provide education efficiently there are imperfections because of the above shortcomings
which will require government intervention.

2.4 Government intervention for efficiency reasons

Because of the imperfections in the market to ensure full efficiency in education
governments intervene in the following ways:
In the first place, governments often intervene by setting maximum prices or price ceilings
(Bellinger, 2007) which in education include school fees and tuition. Price ceiling ensures
that the price of education is not over and above the marginal benefit to the learners who
are the consumers of education.
Secondly, governments may also set minimum prices for education or price floor which is
intended to protect schools. Minimum prices are set to ensure that the fees or tuition paid
by students is not far below the marginal cost of providing that education.

Finally, governments may give subsidies to educational institutions which offer education
which is in short supply like in the areas of science and technology. It may levy tax to
institutions which offer courses which have less demand in the labour market leading to
excess supply of graduates and eventually causing unemployment. These measures are
intended to increase productive and allocative efficiency.

2.5 Government intervention for equity reasons

Governments also have to intervene to ensure distributive equity which concerns both
horizontal and vertical equity. Governments can apply the theories of equity in the following
ways:
In the first place, governments can use the concept of horizontal equity which is about
‘equal treatment for equals’ (Monk, 1990), to treat schools of the same standard in the
same way. For example, deprived schools should be given more resources to construct
classrooms in order to catch up with those which already have better structures.

Secondly, from the point of view of vertical equity which is about ‘unequal treatment of the
unequal’ governments can apply both the benefit and minimum standards (Monk, 1990) to
allocate resources to education. Research has found out that higher education has more
private benefits than social benefits (Psacharopoulos, 1993), and as such the beneficiaries

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(the students and households) should meet the biggest proportion of the cost which
conforms to the benefits standard of equity.

Basing on the ability standard, if governments are using the voucher system, parents with
ability to pay for their children should be given less funding and more given to the deprived
parents. The minimum standard (cf. Le Grand, Robinson and Propper, 1992:18) can also be
applied by governments whereby a minimum standard of education should be set for
everyone for example basic education which should be free for all up to a given age.

Governments can apply the utilitarian and welfare principle to ensure equity. This principle
holds that social welfare is the sum of the wellbeing of all individuals (Ghosh, 2001; Monk,
1990). Its proponents include Bentham (1789) who emphasized the greatest good for the
greatest number and Vilfredo Pareto (1848), who held that a fair distribution of resources is
that where there is no relocation to make one individual better off without making another
worse off (Barr, 2004; Monk, 1990).

A lighter version of Pareto optimality was given by Nicolas Kaldor, (1908 – 1986) and John
Hicks, (1904 – 19890). The Hicks-Kalder compensation principle refers to a transfer
mechanism by which total economic welfare would be maximized when individuals who
gain from a change in the economy compensates those who have suffered because of the
change. Governments can apply the utilitarian theory, for example, by implementing basic
education for all that equips children with practical skills for social and economic welfare.

The second is the principle of equity and need or egalitarianism which is concerned with
the wellbeing of the least well off in society. This is supported by Rawl’s difference principle
which is based on the idea that goods should be distributed equally unless an unequal
distribution is to the advantage of the least favoured (Konow, 2003). Karl Marx communists’
distributive principle summarized in the slogan ‘‘from each according to his ability and to
each according to his need’ (Marx, 1972:18) also falls in this line. This principle can be
implemented by governments for instance by allocating more educational resources to
communities that have been deprived.

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Finally, governments can also apply the principle of equity and desert in the distribution of
educational resources. This principle holds that full allocation depends on individual action.
Its advocates are Nozick (1974) who emphasizes that ‘justice is concerned with rights that
are determined by the historical acquisition’ (Nozick, 1974:33). Buchannan (1986) had the
same line of thinking and observed that the four factors that determine an allocation are
luck, choice, effort and birth. Applying this principle, for example, teachers who achieve
better grades in students should be rewarded for their better actions.

However, much as government intervention in education is necessary for ensuring more

efficiency and equity in education production and distribution it may also have weaknesses.
Economists argue that government failure arises when inefficiencies and inequities are
created instead of being solved (cf. e.g. Ghosh, 2001; Winston, 2006). In that circumstance,
economic welfare is actually reduced and resources are allocated in ways that deviate from
efficiency principles. The major causes of government failure are rent seeking behavior
where politicians and bureaucrats may want to preserve inefficient firms for positive private
benefits, majority voting which may lead to inefficient allocations, neglect of market
principles which may lead to government monopolies and inefficient bureaucracies with
their associated delays in project implementation. Such operations by the government may
affect the provision of efficient and equitable provision of education.

Unit 3 Economic Analysis of Education

3.1 The concepts of Investment and Consumption

Individuals spend on goods and services with the objective of present and future utility or
satisfaction. Goods and services which yield immediate satisfaction are called consumer
goods. There are two types of consumer goods which include the durable and non-durable
consumer goods. The durable consumer goods yield satisfaction both in the present and in
the future. On the other hand non-durable consumer goods yield immediate and short lived
utility or satisfaction.

Investment goods are those used in the production of other goods and services in future.
Whereas consumer goods are an end in themselves, investment goods are a means to an
end because they facilitate the production of other goods and services from which the

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producer derives satisfaction. The difference between durable consumer goods and
investment goods is that investment goods yield satisfaction through their ability to
influence consumption in the future; durable consumer goods yield direct satisfaction and
they are an end in themselves. Therefore, investment expenditure refers to the acquisition
of assets which yield benefits over a long period of time and economists consider
expenditure on education to be an investment because through education individuals
acquire skills and knowledge which increase their value in the labour market (cf. Joint
Economic Committee U.S. Congress, 2000). Generally, investment is characterised by:

1. Increase in the stock of capital assets which are used in the production of other
goods and services. For example, a business man who buys a truck does not
necessarily derive immediate satisfaction from the truck but rather from the use of
the truck to deliver his goods.

2. Secondly, investment enhances ‘productive capacity’ which is the ability to produce

goods and services by the individual or society as a whole. This improved productive
capacity is reflected by the increased output of various goods and services.

3. Thirdly, investment leads to increased aggregate demand for other goods and
services. This is because with increased production individuals earn extra income
which they can spend on other consumer goods thus stimulating further demand.

3.2 Education as an Investment for the Individual

Like any other investment, education helps to create income in the future by providing
educated workers with skills and knowledge which enable them to increase their productive
capacities and thus receive higher earnings. The specific attributes that make education an
investment for the individual include the following:

In the first place, education increases the level of earnings for the individual who has gone
through formal schooling. Economists like Shultz, (1961); Becker, (1964); Bartel and
Lichtenberg, (1991), agree that the amount of education acquired by workers has an
important impact on their labour market experience. The most direct way that education
affects the labour market experience of workers is by increasing their productivity, thus
increasing their demand in the labour market and their earnings. The more education

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individuals acquire, the better they are able to absorb new information, acquire new skills
and are receptive to new technologies which increases their value in the labour market.

There is evidence to suggest that a positive relationship exists between educational

attainment and earnings. For example, the U.S. Census Bureau collected data on the
earnings of all persons by educational attainment and earnings (cf. United States Congress,
2000), and their findings suggest that individuals with higher qualifications earn higher than
their counterparts who have lower qualifications. Statistics of the findings in that study are
presented in Figure 2.

Source: Joint Economic Committee United States Congress, (2000)

Figure 2: Median Earnings of all Full-Time Workers in U.S. by Educational attainment 1998

Figure 2 shows that in terms of annual median income, the levels of earnings for individuals
increase with their levels of qualification. From the report, the average baccalaureate earns
nearly $ 20,000 more than the average high school graduate (cf. United States Congress,
2000). Although these findings seem to be incomplete because the analysis ignores the
investment costs of education in terms of the individuals’ contributions through direct costs
and time spent acquiring additional schooling, there is evidence to suggest that earnings
increase with additional schooling.

Despite the methodological and data limitations, several studies done both in the U.S. and
the U.K. (see e.g. Dearden, 1999; Psacharopoulos, 1994; Bennel, 1996; Rumberger and

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Daymont, 1994; Alexander and Pallas, 1983; Bishop, 1996) are also consistent in their
findings suggesting that returns to an extra year of schooling are high. It is reasonable to
conclude that the amount of education that individuals receives directly affects their
earnings and this should be a motivation for individuals’ decisions when they invest in
education.

Secondly, highly educated individuals have higher chances of getting gainful employment
compared to their counterparts with lower education. Economists agree that increased
education increases labour force participation, decreases the probability of unemployment,
and decreases job turn over (cf. Mincer, 1993). Studies done in the U.S. in 1996 suggest that
possession of a college degree increased the probability of being in the labour force by
nearly 23 percent over high school graduates and that labour force participation is strongly
associated with education even after controlling for other factors such as age and marital
status (United States Congress, 2000). Individuals with higher levels of education (human
capital) tend to be very efficient at their employment search, which increases their
likelihood of remaining with the same firm. Workers with higher education and training are
also less likely to experience involuntary job changes.

Other studies for example by Walker and Zhu, (2001) which used a Labour Force Survey
dataset in the UK found out that there is a strong relationship between education,
employment and earnings. Their findings also suggest that the subjects that individuals
chose to do play an important role on the time they take to get employment. The estimates
found a substantial variation in employment potential between arts and humanities subjects
compared to science and business subjects. These findings also concur with other studies
by Eide, (1990); Kehm and Teichler, (1995); Neave and Jenkinson, (1983) which also suggest
that social science and humanities graduates have lower potential for employment relative
to their engineering and medicine counterparts.

Whereas there is a lot of evidence that the type of subjects students chose to do have an
effect on their potential for employment and earnings, there is also evidence which suggests
that the type of school, college or university where the student does such subjects also
matters. For example, Brewer, Eide and Ehrenberg, 1999) used longitudinal data from the
National Centre for Education Statistics of the U.S. Department of Education to estimate the
effects of college quality on employment and earnings and how this varied across time in

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the U.S. They found evidence of large market premium to attending an elite private
institution and a smaller premium to attending a middle-rated private institution relative to
a bottom-rated public college.

Although available evidence is mainly from the developed world due to data limitation
problems in the developing world, it is clear that formal schooling increases the potential of
an individual for gainful employment whether this individual is from the developed country
or the developing country. This is because employers whether from the private or the public
sector consider formal schooling to be the major mechanism of developing individuals’
productivity. Therefore, it is reasonable to suggest that education is an investment for the
individuals and their households because it increases their potential for future gainful
employment and incremental earnings.

3.3 Consumer Benefits of Education

Economists also believe that besides the market benefits of education that accrue to an
individual in terms of increased probability for employment and earnings, education also
has non-market benefits which are not necessarily determined by the earning of money.
This is because education often affects the quality of life for an individual in ways that may
not be reflected in employment or earnings. Such benefits include better health for
individual with higher levels of education compared to those with lower levels. Wolfe and
Zuvekas, (1995) did a study for the Institute of Research and Poverty and found considerable
evidence that higher levels of schooling increase individuals health status and that of their
families. This is probably because such individuals believe that they have made an
investment in themselves in form of education and as such they take preventive measures
to increase the probability of better health.

In the early 1960s education was considered a ‘basic human right’ associated primarily with
consumption. Expenditure on education was not seen as having economic benefits and
provision of education was viewed as a national obligation. Viewed this way, education is
seen as an end in itself and beneficiaries of education would just enjoy being in school.
Knowledge would be acquired for its own sake without looking at its economic value.
Education may also give its consumers immediate utility just like that derived from other
consumer goods. This can be demonstrated by the following examples:

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1. Education improves the social status of its consumers. The possession of a higher
qualification like a degree or a diploma gives the bearer social recognition and
respect.

2. Education enables its consumers to enjoy a variety of other goods and services. This
is because in the process of acquiring education, these individuals are exposed to a
wide range of luxuries compared to their counterparts with less education.

3. Individuals who have gone through schooling enjoy a psychologically satisfying

memory of their olden school days. This psychologically satisfying memory motivates
individuals to be in school.

4. Finally there are individual who enjoy learning for the sake of it. There are individuals
who go to school just for the sake of getting a qualification which may not
necessarily be for earning them a job or earnings. The same applies to individuals
who have an insatiable appetite for credentials in which case credentials become an
end in themselves.

It is important to note that, economist are not so much interested in these consumption
benefits of education but are interested in looking at education as an investment.
Acquiring education in the present should increase the individuals’ ability to earn more
in the future which will necessarily influence the consumption trends and in turn induce
production leading to economic development. Therefore, if viewed as a consumption
item, the supply of education can be reduced during the period of financial hardships
and resources should be spent on the investment aspects of it which affect the rate of
economic growth.

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Unit 4 The Human Capital Theory

4.1 Background of the Theory

The human capital theory introduced by Theodore Schultz in 1961 and elaborated by Gary
Becker in 1964 suggests that individuals acquire skills and knowledge to increase their value
in the labour market. The theory holds that individuals and society as a whole consider
prospective returns when they choose to invest in a given type or level of education. It is
generally accepted that both the quantity and quality of education are important
mechanisms for increasing human capital (cf. Becker, 1993; Johnes, 1993; Schultz, 1972).
This is because education increases an individual’s stock of knowledge and skills, leads to
acquisition of new attitudes and values, and improves communication skills and critical
thinking skills. These traits are thought to make individuals more productive and the
individual’s demand in the labour market increases which also leads to higher life time
earnings. On the other hand society benefits from the individuals stock of knowledge when
many individuals have higher earnings; there is increased consumption which leads to
increased aggregate demand for goods and services inducing more production and
eventually economic growth and development (cf. Schultz, 1972).

Besides the market effects of education on human capital development, studies have also
suggested that education and training can contribute to the productivity of farmers. The
most detailed analysis of education as a physical measure of productivity was carried out
among farmers in low income countries by the World Bank in the 1970’s (cf. Psacharopoulos
and Woodhall, 1997). These studies explored the relationship between education and
agricultural efficiency or productivity, measured in terms of crop production. The findings
revealed that farmers who had completed four years of elementary education their
productivity was on the average 8.7 percent higher than that of their counterparts with no
education.

Therefore, apart from wages being considered a measure of increased productivity as a

result of education or formal schooling, the above study also demonstrates productivity
increase as a result of education for farmers who are not wage earners. The study also
shows that as suggested by Schultz, (1961) education is much more likely to have a positive

18
effect in more progressive, modern agricultural environments, rather than in traditional
ones.

The fact that farmers’ education is positively linked with their physical productivity and
choice of technology shows that education provides benefits in rural as well as in urban
environments. Education as a form of investment does not depend only on the use of wages
as a measure of productivity but it can also depend on other measures like the level of
agricultural output for educated farmers compared to the uneducated farmers.

4.2 The Human Capital Model

Some economists agree that the human capital model suggests that an individual’s decision
to invest in training or education is based upon an examination of the net present value of
the costs and benefits of such an investment (cf. Backer, 1964; Veum, J.R. 1995; Hansson,
B.2004). This is also based on the idea that education and training makes workers more
productive, they collect the returns from their investment in later periods through higher
marginal products and higher wages.

In this model, the stock of human capital includes: human capital investment; depreciation
or losses of value; time investment needed to acquire the human capital; and investment in
goods needed for human capital investment. These constitute the independent variable. On
the other hand, wages earned by educated individuals are considered as dependent
variables mainly because they vary according to the stock of human capital and the rate of
returns to investment in human capital. The relationship is illustrated in Figure 3.

19
 Figure 3: The Human Capital Model:

Incremental Earnings in Terms of

Wages

Increased Demand for other

Investment in Development of Goods and Services
Education Human Capital
Assets

Increased National Wealth

(Measured in GDP)

Figure 3 Indicates that individuals invest in Education with prospects of future returns. This
is because investment in education leads to the acquisition and development of human
capital assets in form of useful knowledge and skills. These make workers more productive
which in turn leads to increased earnings by the workers. Increased productive capacity
among the educated workers contributes to national development in two major ways. In the
first place educated workers directly contribute to the production process by being
employed in different sectors of the economy. Secondly, educated workers who are in
gainful employment earn high ways which influences their consumption trends and if there
are many such individuals in the population, there is likely to be increased demand for other
goods and services. This induces further production and eventually increases national
wealth or economic growth measured in terms of GDP. Therefore, education is potentially
important both for the individual who benefits in terms of employment end better earnings
and for the nation which benefits in terms of social economic development.

4.3 Assumptions of the human capital theory

The human capital theory is based on the following assumptions:

1. Expenditure on education can be clearly sub-divided into investment and

consumption elements. This means that while spending on education, an individual
can desegregate what are consumption elements of education and investment

20
 elements and in the time of scarcity possibly avoid spending on consumption
aspects.

2. The other assumption is that an educated population is a more productive work

force. This is based on the idea that education always enhances the productive
capacity of individuals through the knowledge and skills acquired from education.

3. Formal education is the major mechanism for the formation of human capital. That it
is only through formal education that productive attributes are acquired which are
important in the formation of human capital assets.

4. The theory also assumes that the labour market in which the educated workers must
compete is perfect. This means that all who go through formal education will always
get gainful employment.

5. Workers are paid according to their productivity. This also means that the more
educated an individual is the more productive he becomes and the more he earns.

6. Finally the theory assumes that it is easy or possible to specify the relationship
between educational inputs and outputs. So that one can easily measure the
productivity of any given investment in education.

4.4 Critique of the human capital theory

Some critics have argued that the Human Capital Theory is a poor concept of capital in that
it is unable to explain human activity other than as the exchange of commodities and the
notion of capital employed is a purely quantitative one (cf. e.g. Block, 1990). It is also easy to
deduce the weaknesses of the theory from its assumptions which include the following:

1. It is difficult to clearly distinguish between the investment and consumption

elements of education. It is true that people demand education for purposes of
attaining skills in order to earn a living which constitutes an investment component.
However in the process of acquiring this education, the individual has some social
benefits like meeting new people, learning social etiquette, and the general
exposure which is consumption. In this context, it is hard to distinguish the gains
which are basically investment and those that are of consumption in nature.

21
2. It has been argued that education doesn’t improve productivity by imparting the
necessary knowledge and skills but all it does is simply to serve a screening device by
which employers identify individuals who possess certain characteristics and
qualities that they value (the screening hypothesis). These qualities are in turn
rewarded by employers by means of higher incomes.

3. The theory underestimates the contribution of non-formal educational approaches

to the development of human capital. It emphasizes formal education as the only
key mechanism for improving the quality of human resources. As human capital is
found within the members of the labor force, the return on human capital is mixed
up with the return on the quality of labor which is difficult to isolate. In other words.
Both the educated and non educated are productive.

4. The labor market in which the educated workers compete for jobs is not a perfect
one. Suitable jobs are not easily available and there is lack of perfect information on
where and when the educated people’s skills are required, the employers at times
don’t know where they can get individuals with appropriate skills. They rely on
interviews which are not genuine measures of competence. Recruitment into jobs is
not done on merit; the labor market is characterized by rigidities and imperfections
such as corruption, nepotism, favoritism and trade union demands.

5. The theory underestimates the role of other factors besides human resources like
land and physical capital as also contributing to national development. It also ignores
the role played by external factors such as the nature of international relations,
international trade, peace and security as factors in development. Fair trade
between nations favors development as much as peace and security. For example in
Uganda in the 1970s and early 1980s there was breakdown in peace and stability and
international relations and trade. Much as there were educated individuals their
contribution to the development process was less significant.

6. The theory makes a wrong assumption about the direct cause effect relationship
between education on one hand and development on the other. It is important to
recognize that much as there may be a correlation between education and
development it does not necessarily mean that education causes development. For

22
 example if a country doubled the volume of investment in education (human
capital), that country would have not necessarily doubled the rate of development in
that country.

Having noted the above shortcomings, the relatively simple model of human capital should
not be dismissed entirely. This is because individuals and nations alike consider education as
an investment that promises future returns. Some scholars have also suggested that
alongside the human capital theory, social contacts also affect the productivity of individuals
and groups and therefore, the social capital theory is also important (cf. Coleman, 1988;
White 2002). These scholars have gone further to suggest that it is all about establishing
relationships purposefully and employing them to generate intangible and tangible benefits
in short term or long term and therefore, just as physical capital and human capital facilitate
productive activity, so does social capital.

This view also seems logical because, much education enhances individuals’ possibilities of
getting employment and higher earnings, in some circumstances these may not be fulfilled
when not backed by social networks. This applies much more in the developing countries
where employment is not necessarily acquired on merit but on linkages that an individual
has. Therefore, much as the human capital theory is critical in relating education to
increased productivity and earnings, this works hand in hand with other attributes such as
the social attributes.

23
Unit 5 Analysis of Educational Costs and Benefits

5.1 Educational Costs

Costs of Education refer to the amount of money spent either by the individual to acquire
education or by the government to impart education. From the point of view of the
individual, costs refer to the amount of money spent by the individual during a particular
period to acquire education. From the point of view of the state or government it refers to
the amount of money spent by the state on education during a year. Costs incurred by the
state also called social/public costs of education include expenditures incurred on staff
salaries, equipment and buildings, maintenance costs of apparatus, library books, and
sports. Costs incurred by individuals or their households also called private costs of
education include expenditure on books and stationery, school fees, travel cost and in case
of students making use of hostels, it will also include rent of hostel accommodation, and
mess charges.3

In economics, costs are used when reference is made to the production of goods and
services. It implies the cost of resources utilised in the production of goods and services. It
can be expressed in monetary terms. It has always to be with reference to an economic
transactor such as a producer, or seller, or buyer/consumer. Literature in economics has
distinguished between real costs and money costs. Real costs are said to correspond to the
sacrifice of resources or inputs needed to produce goods and services. Therefore, real cost
corresponds to opportunity cost; because opportunity cost refers to the foregone output
that could have been produced had the input been utilised in the next best way. In
education, real costs are the alternative foregone by governments and individual
households when they invest in education.

5.1.1 The Direct Private Costs of Education

Households with children in both private and public schools incur direct and indirect costs to
keep these children in school. These are also called private costs of education. Direct costs
include fares for uniforms, school supplies, books, and transportation, contribution to
parent groups, and even tuition or school fees and building fund. In the era of the
liberalization of the education sector in the developing world where the private sector is
becoming dominant in education, the direct private costs of education have increased. Even
24
in situations where there is government intervention, for example, where there is universal
primary education where government meets the biggest proportion of expenditure,
households still have to incur direct costs such as buying books, uniform and catering for the
feeding of children. It is also important to note that in the developing world the private
costs are low at lower levels of education because of government policies of spending more
at this level. Private costs are high at higher levels of education because of the low
government subsidies and the privatisation of the higher education sector. It should also be
noted that resources spent by the government on education could be used in other sectors
like health, roads, or industry and therefore that alternative investment foregone by the
government is an indirect cost.

5.1.2 The Indirect Private Costs of Education

The indirect private costs of education are costs not directly paid for by the individual but
they are incurred as tradeoffs for investing in education. The Indirect costs of education for
the individual for example may include the foregone income of the child’s work in the
labour market, the foregone contribution of the child to home or farm production, and the
value of parents’ time contributed to school activities. In developing countries, the
opportunity cost of basic education seems to be higher compared to alternatives like
contributing family labour in the gardens, farms and as such school dropout rates have been
increasing at the lower levels. The opportunity cost of higher education is also high because
high school and university students are of working age. Parents also sacrifice income and
time to the education of their children which income could have had alternative uses.

5.1.3 The direct Social Costs of Education

Social costs are incurred by the government from the tax payer to facilitate the running of
education programmes. For most governments education takes the biggest proportion of
the national budget and this covers the private costs of education. From society’s
perspective, the direct costs of education include the value of the time of teachers
measured in terms of salaries paid to them and the value of the physical resources such as
books, scholastic materials, rental value of buildings and any other equipment used in the
education process. There are other costs incurred in designing educational programs and
curricula and paying educational staff at different levels in the education sector.

25
5.1.4 The Indirect Social costs of Education
From both the social and private perspectives, indirect costs are the value of the student’s
time, typically measured as earnings foregone which would benefit both the students and
the nation. Student’s time is a cost because a student could be earning an income or
performing other activities if he or she were not spending time studying. In economic terms,
the value of the student’s time is called an opportunity cost since it is not a direct out-of-
pocket expense. Some scholars (see e.g. Ray, 1984; Psacharopoulos, 1981; Murphy, 1993)
suggest that even though indirect, the opportunity cost of time is a very important cost to
consider in evaluating investments in education. If, for example, a student studying full-time
in a university course could have been earning a salary of $5,000 per year, then the $5,000
must be counted as part of the total cost of the student’s investment.

5.2 Educational Benefits

Education yields direct and indirect benefits both to individuals and to society. The private
educational benefits are the expected direct and indirect returns that accrue to the
educated and their families as a result of attaining a given level of education. Economists
measure the direct private benefits as the incremental life time earnings attributed to the
extra-education received. If a graduate teacher earns 50% more than a grade five teacher,
then the 50% increment measured in shillings per year constitutes the private direct
benefits of attending school up to university. Other direct benefits include increased
opportunity for employment, work related benefits like good offices, housing and health
insurance. The knowledge and improved productivity are advantages that directly go to the
individual who acquires education.

5.2.1 Indirect private benefits:

Education also creates indirect benefits to individuals. Such benefits for the educated
include the following:
- Early childhood education benefits the child and family in that the child receives
both education and child care services. This happens in circumstances where the
parents especially the mother is free to earn some income.
- Intergenerational benefits arising from the link between education of parents and
the education attainment of their off springs.

26
 - The utility derived from the improved social status and prestige is an indirect benefit
that goes to the individual who acquires education.
- Improved health status and hygiene. Educated individuals live in more hygienic
environment.

5.2.2 Social Educational Benefits

These are direct and indirect benefits to society as a result of its members acquiring a given
level of education. The direct social benefits include the higher productivity of educated
workers and their additional contribution to national income over their entire working life
span. The higher life time earnings of educated man power may be used to measure the
direct benefits of education to society under the assumption that the relative earnings of
workers reflect their productivity. Therefore, additional earnings are a proxy measure of the
high output of the educated. Education also yields indirect benefits to society (externalities
or spill over benefits). This means that benefits of education spill over to those who
neighbor with them. Examples of these include: crime reduction; social cohesion and
learning new ways of life; democratic governance (mass education for example is thought to
be a threat to dictatorship); reduction of fertility rate and affordable families.

27
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