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THE JOURNAL OF ECONOMIC EDUCATION , VOL. , NO. , – https://doi.org/./..

FEATURES AND INFORMATION

The economics of education and policy: Ideas for a principles course

Cecilia Elena Rouse

Woodrow Wilson School of Public and International Affairs, Princeton University, Princeton, NJ, USA

KEYWORDS Economics of education; educational attainment; returns to schooling; teaching economics principles

JEL CODES A; D; J

ABSTRACT There are many aspects of the “economics of education” that would make excellent examples for introductory economics students. The author presents two topics that are central to the economics of education and to human cap- ital theory: the economic benefit (or “returns”) to schooling and educational attainment as an investment. There are two key concepts the author hopes students get from this discussion. The first is that there are both private and social benefits of schooling whence we derive the rationale for government intervention. The second is that educational attainment is an investment decision with both costs and benefits, and some risk.

There are many aspects of the “economics of education” that would make excellent examples for introductory economics students. One could study, for example, the educational production function (at the elementary, secondary, or even postsecondary level), school vouchers and charter schools, or performance-based pay for teachers. I chose two related topics that are central to the economics of education and to human capital theory: the economic benefit (or “returns”) to schooling and educational attainment as an investment. There are two key concepts I hope students get from this discussion. The first is that there are both private and social benefits of schooling whence we derive one of the key rationales for government intervention. The second is that educational attainment is an investment decision with costs and benefits, and some risk.

The economic benefit of education

The relationship between education and labor market outcomes

One of the best documented relationships in economics is that between annual income (or hourly wages) and educational attainment. Figure 1 shows average annual earnings graphed against years of schooling completed using data from the United States collected in 2016. At years of schooling below about the 11th grade, there is not much of a relationship, but beginning with the 11th grade, there is nearly a linear relationship between education and income. The close ties between income and education are important because in a perfectly competitive labor market, workers are paid according to their marginal productivity. As such, the fact that employers are willing to pay more for workers with more education suggests that they find the workers more “productive” or otherwise “worthwhile” for their enterprise.

Figure 2 illustrates another way in which we see that more highly educated workers have better labor market outcomes. This figure shows the overall unemployment rate (4.1 percent) in March 2016, as well as the unemployment rate by the education level of the unemployed worker. Those who had completed

CONTACT Cecilia Elena Rouse [email protected] Katzman and Ernst Professor in the Economics of Education, Woodrow Wilson School of Public and International Affairs,  Robertson Hall, Princeton University, Princeton, NJ , USA. Color versions of one or more of the figures in this article can be found online at www.tandfonline.com/vece.

©  Taylor & Francis

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Figure . Average annual earnings, by years of completed schooling. Source: Bureau of Labor Statistics, Current Population Survey, March  (BLS ).

fewer than 12 years of schooling (whom we typically believe to be high school dropouts) had an aver- age unemployment rate of 7.4 percent, those who had completed high school but no further education had an unemployment rate of 5.4 percent, and those who had attained a bachelor’s degree or more had an unemployment rate of 2.6 percent. In the United States, this inverse relationship between years of schooling completed and the likelihood of being unemployed holds in both strong and weak labor mar- kets. In fact, in October 2009, when unemployment was at its highest rate during the “Great Recession,” the unemployment rate for those without a high school degree was 15.5 percent compared to 4.7 percent for those with at least a bachelor’s degree.

Figure . Unemployment rate by educational attainment (March ). Source: U.S. Department of Labor, Bureau of Labor Statistics. Data are seasonally adjusted (BLS ).

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Why do more highly educated workers earn more?

Figures 1 and 2 show only two examples of the better labor market outcomes for more educated workers. They also work in jobs with better nonwage compensation, better retirement benefits, and generally more job “flexibility” in terms of hours. Importantly, while there is ample evidence that employers pay higher wages to more educated workers, presumably because more educated workers are more “productive,” it does not necessarily mean that education makes someone productive. In fact, two Nobel Prizes in Economics have been awarded to economists who have theorized why this relationship holds.

The first Nobel Prize was awarded to Gary Becker in 1992. Becker developed “Human Capital The- ory,” which posits that workers who complete more education are more productive because they learn valuable skills through their classes or in their training programs. Because the workers obtain skills that are important in the labor market, they are more employable, and employers are willing to pay them more. Human Capital Theory, therefore, suggests there is a causal relationship between education and labor market outcomes.

The second Nobel Prize that attempts to understand the relationship between education and earnings went to A. Michael Spence in 2001. Spence developed “Signaling Theory,” which hypothesizes that edu- cation acts as a “signal” to employers as to an employee’s innate (unobserved) “ability” but that education may not (causally) increase a worker’s level of productivity. The reasoning is as follows. Suppose that those individuals who are more “able” or more “motivated” (or have some other inherent and hard-to- observe abilities) find obtaining additional schooling less costly (perhaps because it is easier for them). As a result, those who have higher ability obtain more schooling. Suppose that this inherent ability makes workers more productive, but schooling does not. We will still observe that workers with more schooling earn more in the labor market but not because they obtained valuable skills while in school. Rather, employers will know that more able workers find it easier to obtain more schooling, and therefore employers can use the level of education as a “signal” that the worker has a high level of the unobserved characteristic.

Signaling Theory is related to other potential explanations for why the observed relationship between education and earnings is not causal. For example, there may be other “omitted variables” that would explain a student’s future success that are related to education but not due to what a student learned in school, per se, such as their family background. Or perhaps while in school students develop valuable social networks. That is, while in school, students meet other people who help to facilitate future labor market success and develop contacts, mannerisms, and other social/soft skills that allow them to be suc- cessful in high-paying professions. The problem highlighted by Signaling Theory and omitted variables is that the student may have done well in the labor market without going to school. An analogy to phys- ical fitness can help elucidate this principle. If you want to improve your health, you may think about exercising. Before you buy a yoga mat, however, you would want to know that exercising actually makes you healthier. People who exercise more may be healthier on average, but it may actually be because they are more likely to eat heathier or be wealthier, and so on. Before you start exercising, you would want to know that exercising is effective, or has “value added,” to your health. The same is true for education and other social programs: we want to know that people’s lives are changed because of the education or program.

Estimating the private and social returns to education

An important focus of research in the economics of education has been to sort out whether the economic return to schooling is causal or not. If education, itself, does not causally improve productivity, then there may be less expensive ways to distinguish more productive from less productive workers. Additionally, if schooling does not improve productivity, we should figure out that “other factor” that does affect out- comes and education. It is also important to determine if taxpayer dollars that are spent on education may be better directed elsewhere.

The way researchers estimate the causal impact of education is to attempt to determine what would have happened had the individual not obtained more education. That is, they attempt to establish the

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“counterfactual.” The ideal way to do so would be to construct a time machine. With the time machine, one would first have the person live his or her life without further schooling and observe the labor mar- ket outcomes. One would then turn back time (and all the circumstances) and have the person complete more schooling and then observe the outcomes again. The (average) difference between the two out- comes (over many individuals) would give us an estimate of the average impact of schooling. Sadly, we have yet to invent a viable time machine. Researchers, however, have developed alternative methods for trying to determine the counterfactual.

The next-best method (to a time machine) is a randomized experiment. In such an experiment, one group of individuals is randomly assigned to attend school (the “treatment” group), and the other group is assigned to a “control” group that (in theory) does not attend school.1 The researcher then waits for an appropriate period of time (in the case of education, the members of the treatment group must complete their schooling and ideally have a few years in the labor market), and then compares the outcomes of the treatment group to the outcomes of those in the control group. Because, on average, there should be no observed or unobserved differences between the two groups, this research design should gener- ate a causal estimate of the effect of education on outcomes. There are, of course, many ways in which this strategy can break down, but in theory it is the “gold standard” approach to evaluating programs. Understanding this approach, which can be expensive and difficult to actually implement, also helps to understand other methods that researchers have employed to estimate the return to schooling.

Third-best approaches include estimating the impact of compulsory schooling laws (in which stu- dents are required to remain in school until a certain age), using variation in access to educational insti- tutions (e.g., a nearby college), or comparing outcomes of identical twins. The basic conclusion from these approaches is that each additional year of schooling is associated with about a 10-percent gain in wages (Ashenfelter and Rouse 2000). Importantly, this evidence also suggests that much of the impact of education is “causal.”

When considering the impact of education, economists have long speculated that there are “private” and “social” benefits. Private benefits are those that accrue to the individual and perhaps to his or her fam- ily. These benefits include better labor market outcomes (e.g., higher income, greater likelihood of being employed), improved health, greater marital stability, increased financial market participation, lower chances of bankruptcy, and better outcomes for the next generation.2 These benefits make the individ- ual personally better off. If the benefits from education are purely private in nature, from an efficiency standpoint, there would be no role for the government to get involved because individuals would make the decision to pursue education, or not, and would both bear the costs and reap the benefits themselves.

We also believe that society is made better off when individuals attain higher levels of schooling; that is, we also believe there is a “social” benefit to education. These benefits come in the form of a more literate population that is able to fully participate in our democratic system of government and individuals who, with their valuable skills, are able to earn a good living to take care of themselves and their families, reducing their (economic) dependence on others and the government. For example, because they typically have lower earnings and lower quality jobs, which are less likely to provide health insurance, those who have not completed a high school education are more likely to use public insurance programs such as Medicaid. Further, researchers have documented that schooling appears to reduce participation in crime, and increase the likelihood of voting, being politically informed, and believing in the freedom of speech. There is also recent evidence that educated workers are more likely to engage in environmentally-friendly behavior and to have positive spillovers to other workers, making their coworkers more productive as well.3

Educational attainment is an investment

The basic idea and rationale for government involvement

A second key concept for students is that acquiring additional schooling is an investment. Schooling requires that an individual pay costs upfront in the form of tuition and fees, books, and forgone activities (which at the postsecondary level largely involves forgone income). These costs are borne in exchange

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Table . Degree attainment within  years for – beginning postsecondary students, by type of first college.

Highest degree attained All Public two-year Public four-year Private not-for-profit

Bachelor’s . . . . Associate’s . . . . Certificate . . . . No degree, still enrolled . . . . No degree, not enrolled . . . .

Source: U.S. Department of Education, National Center for Education Statistics, Beginning Postsecondary Survey,  (NCES ).

for future benefits as discussed above. This decision is dependent on one’s utility function (including how much one values today vs. tomorrow), the level of one’s innate “ability,” environmental factors (e.g., the quality of prior schooling), the cost of obtaining the schooling (including the opportunity cost), and the anticipated future benefits. Importantly, like all investments, it carries some risk. The labor market may not be as strong when one graduates as it is when one decides to invest in the schooling, obtaining any one job is not guaranteed, and one cannot fully anticipate one’s future health and ability to work.

How much education will an individual obtain given the considerations above? In the most basic model, an individual will compare the present discounted value of the stream of future benefits to obtain- ing the additional schooling to the present discounted value of the costs of obtaining it.4 An individual will invest to the point where the marginal (present discounted) benefit is equal to the marginal (present discounted) cost.

So, what is the role of government in education? Whenever we think of such a potential role, it is useful to begin by identifying the potential market failure. In our educational example, ideally the individual would invest to the point that the marginal total (private plus social) benefits are equal to the marginal total (private plus social) costs. However, an individual will invest to the point that the marginal private benefits are equal to the marginal private costs. Thus, to the extent there are also positive social benefits, individuals will underinvest in their education relative to what would be optimal from the social point of view.5 Because of the social benefits, the government has an incentive to help individuals acquire more education by subsidizing its cost, although many countries go further by actually providing the schooling as well, particularly at the elementary and secondary grade levels.

Another potential market failure, which is particularly salient at the postsecondary school level in the United States, is that the simple investment model described above also assumes that capital markets are perfect. That is, the model assumes individuals can borrow as much as they need to finance their schooling in the near-term with the understanding that they will repay the loans out of the increase in their income in the future. Borrowing to finance schooling can be tricky because there is not necessarily an asset to serve as collateral that the lender can seize in the event the borrower does not repay his or her loan, as is the case with home mortgages and car loans. Therefore, in the private market, student loans are often unavailable for low-income students without government intervention. A final role for government stems from the fact that our simple model assumes individuals have perfect information: they perfectly understand the costs, and they understand the potential benefits (including the risk) of investing in their education. As such, an important role for the public sector can be to improve information available to individuals making schooling decisions, whether it is for the parents choosing where to live or where to send their child at the elementary and secondary school levels or for students selecting a postsecondary institution.6

Educational attainment at the postsecondary education level

Table 1 provides a look at educational attainment at the postsecondary level in the United States. The table gives the percentage of students who have attained each level of educational attainment within six years of starting at a postsecondary institution in 2003–4. The table shows that among all students, about 31 percent had completed a bachelor’s degree within six years, 9 percent had completed an associate’s degree, and 9 percent had completed a certificate (often a one-year program). Note that 50 percent of students had not completed a degree, although 15 percent were still enrolled in school. Note, as well, the difference

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Table . Degree attainment by goal in first year by type of first college attended.

Highest degree attained Initial degree goal Outcome for those who wanted a BA

Outcome for those who wanted an Associate’s

Outcome for those who wanted some

college

Two-year college students Some college . . . . Associate’s . . . . Bachelor’s . . . .

Four-year college students Some college . . . . Associate’s . . . . Bachelor’s . . . .

Source: Author’s calculations from U.S. Department of Education, National Center for Education Statistics, Beginning Postsecondary Sur- vey,  (NCES ).

in attainment by type of first institution attended. At least about 60 percent of students who first enrolled in a four-year institution (either public or not-for-profit) completed a bachelor’s degree within six years, and about one-third had not completed a degree. In contrast, only 35 percent of students who started in a two-year college had completed any degree or certificate within six years; the remainder (nearly two-thirds) had not.

Readers familiar with two-year institutions might argue that the lower rates of educational attainment among students who started at a two-year college reflect the preferences of those students: they may not have aspired to higher levels of educational attainment in the first place. Table 2 shows educational attainment by first institution attended and by the stated educational aspirations of the students when they first enrolled in a postsecondary institution. Among students who started in a four-year institution, 89 percent aspired to complete a bachelor’s degree as their highest degree, and six years later 62 percent had done so. By comparison, 58 percent of students who started in a two-year institution also aspired to complete a bachelor’s degree, and yet six years later only 17 percent had actually done so. Further, only 20 percent of those who started in a two-year college and aspired to complete an associate’s degree as their highest degree had done so.

Why do so few students actually attain the level of schooling they set out to complete, particularly among those that start in a two-year institution? There are many factors that would contribute to the difference based on our basic model of educational investment. First, their prior schooling may not have adequately prepared them for postsecondary level school work. By some estimates, only between one- quarter and one-third of high school seniors have completed course work in high school that is rigor- ous enough to prepare them for postsecondary classes (Bettinger, Boatman, and Long 2013). Further, a growing number of students have “complicated lives” and are not traditionally-aged college students (i.e., 18–22 years old) who have no dependents, are not working, and are still dependent on their parents for support. Third, those students who choose lower levels of educational attainment may place a higher value on “today” relative to “tomorrow” in their utility function (they have a high discount rate) such that the costs today get magnified in comparison to the future benefits.

In addition, as would be expected from the basic model, cost is also a factor. As such, it is not a surprise that subsidizing the cost of a postsecondary education is one of the most important ways the federal government intervenes at this level of education. In fact, in 2015–16 the federal government spent $28 billion on the Pell Grant program that provides funding for 7.6 million students to attend postsecondary education based on family income (College Board 2017). Because these are grants and therefore must not be repaid, the federal government is truly lowering the cost of postsecondary school attendance through this program. In addition, the federal government also provides subsidized student loans; while these loans must be repaid, they address the problem that capital markets are not perfect, especially for students from low-income families.

Modeling Pell Grants

What do Pell Grants do? There are many ways one could potentially model the impact of Pell Grants on educational attainment; figures 3a–3d provide one setup. In this framework, an individual chooses

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Figure a. Starting with budget constraints ….

between consuming education and “all other goods.” The individual has a fixed level of income and faces a budget constraint. The Pell Grant is a fixed amount of additional income (that can be spent on education or other goods) that is provided for those who consume greater than “Emin” level of education (which might be considered “college attendance”); see figure 3a. This framework reveals that grants will not increase educational attainment for all individuals. Let us consider different types of individuals and how the introduction of a grant program will likely impact their educational choices.

Consider Individual #1 in figure 3b. Before the grant was made available, the student planned to attain a level of education below Emin. Given the individual’s preferences and the size of the grant, the grant induces him to increase his level of educational attainment to Emin. As a result, the grant program actually induced this individual to attend college. The situation is somewhat different for Individual #2 (figure 3c). In the absence of the program, this student would have attended college and attained a level of educational attainment higher than Emin. With the introduction of the program, the individual stays in school even longer. As such, there is an overall increase in, say, years of college attended or perhaps degree completion, but not in college attendance. Finally, we have Individual #3 (figure 3d). Individual #3’s level of educational attainment would not be affected at all by the introduction of the grant program. The reason is that Individual #3’s optimal level of schooling in the absence of the program is so far below Emin (perhaps this individual would have dropped out of high school in the 9th or 10th grade) that the level of the Pell Grant is not enough to induce her to change her behavior.

Figure b. Individual #: Educational attainment is substantially increased.

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Figure c. Individual #: Educational attainment is somewhat increased, but ….

Figure d. Individual #: Educational attainment is unaffected.

The point of this exercise is to highlight that just making college more affordable (at least by the levels we have conventionally seen) will not induce “everyone” to attend college. Overall, the evidence suggests that $1,000 of grant aid increases college enrollment by 4 percentage points; though, we know less about who is affected.7

Conclusion

In this article, I have attempted to highlight two important insights from economics for education policy. First, there is a well-documented relationship between education and later adult outcomes, including increased income, health, and better child outcomes. There are also spillovers to society in the form of reduced crime and reliance on social welfare programs and to other workers. Importantly, the best evidence suggests that much of this relationship is likely causal.

Second, we can model education as an investment with costs in the near-term and benefits in the future, but there is also risk. While individuals have an incentive to invest in their education based on anticipated private benefits, the spillovers to others suggest there is a role for the government to encourage even greater investment. Pell Grants, which provide additional income to help lower the cost of postsec- ondary education, are one way the federal government attempts to increase educational attainment, at least for some.

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Acknowledgments

The author thanks Amy Wickett for expert research assistance.

Notes

1. More generally, the control group does whatever one would do in the absence of school. In actual randomized research studies, the fact that members of the control group can sometimes get access to similar programs to those in the treatment group complicates things.

2. See, e.g., Cole and Paulson (2014); Cutler and Lleras-Muney (2006); Heckman, Humphries, and Veramendi (2016); Isen and Stevenson (2010); Lundborg, Nilsson, and Rooth (2014); and Muennig (2007).

3. See, e.g., Dee (2004); Levin (2005); Meyer (2015); Milligan, Moretti, and Oreopoulos (2004); and Moretti (2012). 4. The “present discounted value” is the current value of income that a worker may earn in the future taking account

of the fact that dollars earned in the future are worth less than dollars earned today. The future income is therefore “discounted” at the discount rate. The higher the discount rate, the less future income is worth today.

5. Notice that an individual may under- (or over-) invest in education if she over- (or under-) estimates the costs to herself and society as well.

6. Of course, equity is also a compelling reason for government intervention in education, but the point of this discussion is to highlight that there are also important efficiency reasons.

7. This framework also can be used to understand the potential impact of “performance-based” scholarships (those that are awarded based on a student having achieved academic milestones rather than just based on college enrollment).

References

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  • Abstract
  • Acknowledgments
  • Notes
  • References