Education represents perhaps the most important means of human capital accumulation. An individual's education level is often the key determinant of his/her income level, and for a country, the overall education level of its residents is an important driving force of economic growth. However, the significant role education plays in promoting economic growth and other dimensions of human development cannot be a good reason for the government to intervene in education through public policies. From an economic viewpoint, human capital investment in education is a matter of personal decision. If private returns to education equal the social returns, then the individual (or family) will achieve a socially optimal level of investment in education. However, market failures in education, as well as the demands of equity, make government intervention in education necessary. In what follows, we explore the rationale for government‘s intervention in the education market more closely, from both the efficiency and equity points of view.
Market Failures and Education Policy
To begin with, education has an externality which causes the returns to the person investing in education to be less than its social returns. Education not only helps to raise the income level of the educated but also, through promoting technological innovation and dissemination, boost overall economic development, thereby benefiting other individuals and families.
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Similarly, the enhancement of a person's educational level can also promote the social welfare in other non-economic fields. For example, education can improve a person's health awareness and enable him to have more health information, thereby reducing the possibility of, say, and infectious diseases. Individuals and families will make investment decisions on education solely on the basis of private returns, ignoring other social benefits. Thus, presence of positive externality makes private investment in education below its socially optimal level.
Secondly, imperfections in credit markets also tend to undermine individuals' and families' ability to invest in education, while the lack of adequate information and uncertainty about future returns further decrease their willingness to invest. As an influential World Bank (1993, p.197) report points out: ―The difficulty of borrowing to send children to school affects the poor especially. Creditors cannot easily stake a future claim on embodied human capital (as they can for other types of collateral). Even poor families, who might be willing to borrow, because schooling has high private returns, usually cannot. The poor are also likely to be less aware of future returns on education—and therefore invest less in their children‘s schooling than would make sense even from a strictly private point of view.‖
It is noteworthy that, in addition to the above-mentioned market failures, the lack of social security will further inhibit private investment in education by some individuals and families, and this phenomenon is quite common in developing economies. As another more recent report by ADB (2007b, p.84) observes, for those families lacking social security, ―[r]isk
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aversion and vulnerability to income shocks can curtail other kinds of investments with potentially high returns. Vulnerable households tend to discount the future highly, and investment decisions of a longer-term nature are likely to be negatively affected by this discounting. Households sometimes hesitate to invest in the education of their children, or may pull them out of school as a result of economic shocks. This can have a detrimental impact on the economy in the long run where human capital investments are suboptimal.‖
―Inequality Trap‖ and Public Policy on Education
From the equity point of view, education is about a person‘s basic capability. Equal access to education can help ensure that individuals will be able to take advantage of economic opportunities provided on a level-playing field. However, due to the mutual feedback loops between education and income, income inequality may likely be translated into inequality in education, which in turn can further exacerbate income inequality, thus creating a vicious circle, known as the "inequality trap" (World Bank, 2005). Government bears a responsibility for helping people in this trap to escape from it through public policy.
The mutual feedback loop between education and income has been confirmed by many studies. In many developing economies, children's access to education is often closely related to their family‘s income. For low-income families, the previously mentioned imperfections of the credit market, lack of adequate information and uncertainty about the returns, and lack of social security, can all conspire to inhibit their investment in education for their children. Even if a free compulsory education system is introduced, the economic
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opportunity cost of receiving education can cause children from poor families easily to drop out. As can be seen from Figure 4.6.1, domestic economic conditions causes males‘
completion rates of the fifth grade to differ significantly in four ESA economies, Indonesia, Cambodia, Vietnam and the Philippines.
Figure 4.6.1 Proportions of Males Who Have Completed Fifth Grade by Wealth Quintiles, Various Years (% of Males in the Household Aged 15–49 Who Have
Completed Fifth Grade)
Source: ADB, Key Indicators 2007b, p.5
The effect of a person's education on his/her income is even more obvious. According to a recent World Bank (2009b) study, in China differences in human capital endowments associated with differences in education attainment are the most important explanatory factor behind each of the three major components of income inequality: between urban and rural areas, within urban areas and within rural areas. Figure4.6.2 shows income differences between individuals of different educational status. In urban and rural areas, respectively, income for people with the highest educational attainment (more than 12 years) is on average 1.85 and 3.56 times higher than for people with the lowest educational attainment (less than
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6 years). In another study by Sicular et al. (2007), a decomposition of the rural-urban income differences in 1995 and in 2002 using a nationally representative sample reveals that differences in the educational attainment of a household's workers explains 25% of the mean difference in rural-urban incomes in both years.
Figure 4.6.2 Differences in Per-Capita Incomes by Educational Achievement In Rural and Urban China, 2003 (RMB)
Source: World Bank (2009b).
In sum, therefore, income inequalities combined with credit market failures and governmental failures in service delivery translate into inequalities in human capital endowments. In an environment where incomes increasingly reflect the level of human capital endowments, these inequalities in turn reproduce income inequalities and propagate their inter-generational persistence, resulting in an ―inequality trap‖ (World Bank, 2005).
Once caught in it, things can only get worse over time for those in it.35 In order to prevent
35 In terms of our two sector labor market model developed in Section 3.4.1 (for skilled and unskilled labor), the idea of an inequality trap can be seen as a case where unskilled labor's income is so depressed that workers cannot make adequate private investment in their (or their children's) education. There is no possibility to borrow to finance such investment, and there is also no government support for them to undertake such education. That is, these workers are 'trapped' to the SA
supply curve, at a wage equal to WAR, which is too low for them to save and to make private investment in education, even if they want to.
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people from falling into this trap, government should implement public policies to ensure basic education equity, thereby ensuring that everyone can have an equal chance to take advantage of the economic opportunities provided.