Education economics

Education as an investment

Economics distinguishes in addition to physical capital another form of capital that is no less critical as a means of production – human capital. With investments in human capital, such as education, three major economic effects can be expected:

• increased expenses as the accumulation of human capital requires investments just as physical capital does,
• increased productivity as people gain characteristics that enable them to produce more output and hence
• return on investment in the form of higher incomes.

Investment costs

Investments in human capital entail an investment cost, just as any investment does. Typically in European countries, most education expenditure takes the form of government consumption, although some costs are also borne by individuals. These investments can be rather costly. EU governments spent between 3% and 8% of GDP on education in 2005, the average being 5%. However, measuring the spending this way alone greatly underestimates the costs because a more subtle form of costs is completely overlooked: the opportunity cost of forgone wages as students cannot work while they study. It has been estimated that the total costs, including opportunity costs, of education are as much as double the direct costs. Including opportunity costs investments in education can be estimated to have been around 10% of GDP in the EU countries in 2005. In comparison, investments in physical capital were 20% of GDP. Thus, the two are of similar magnitude.

K-12 public education in the United States is primarily funded by state and local governments, while the federal government provides a smaller percentage of funding through grant programs for at-risk youth. In 2018, the US spent approximately 5% of its GDP on K-12 public education, placing the US as the 7th highest spender per student compared to other OECD nations. Schools in the US spend approximately $17,000 per student, but public education spending varies significantly at the state level. At the college level, increasing tuition and out-of-pocket costs have increased the cost of attending college. The opportunity cost of college also increased due to the higher wages of high school graduates. Over the past decade, the cost of in-state tuition for a 4-year education increased by one-third, with tuition inflation rates decreasing in the recent decade. A 2014 study by economists Jaison Abel and Richard Deitz found that the opportunity cost of attending college amounts to $120,000 due to forgone wages, with the total cost of college amounting to an estimated $150,000 when also factoring in out-of-pocket expenses.

Returns on investment

Human capital in the form of education shares many characteristics with physical capital. Both require an investment to create and, once created, both have economic value. Physical capital earns a return because people are willing to pay to use a piece of physical capital in work as it allows them to produce more output. To measure the productive value of physical capital, we can simply measure how much of a return it commands in the market. In the case of human capital calculating returns is more complicated – after all, we cannot separate education from the person to see how much it rents for. To get around this problem, the returns to human capital are generally inferred from differences in wages among people with different levels of education. Hall and Jones have calculated from international data that on average the returns on education are 13.4% per year for first four years of schooling (grades 1–4), 10.1% per year for the next four years (grades 5–8) and 6.8% for each year beyond eight years. Thus someone with 12 years of schooling can be expected to earn, on average, 1.134⁴ × 1.101⁴ × 1.068⁴ = 3.161 times as much as someone with no schooling at all.

Higher levels of educational attainment can increase lifetime earnings, impacting the return on investment (ROI) of education. In the US at the college and university level, each level of degree attainment significantly increases lifetime earnings as more education is achieved. Lifetime ROI is significantly higher at lower levels of educational attainment than at higher levels (1,200.8% for an Associate's degree vs. 287.7% for a Bachelor's degree). While higher levels of degree attainment can increase lifetime earnings, the ROI decreases at the doctoral level compared to a master's degree. In higher education, ROI also varies significantly depending on the degree concentration. Degree concentration matters when examining the ROI of Bachelor's degrees, with choice of major accounting for half of the variation in ROI between majors. College degrees with the highest ROI are in engineering, medicine, business, and other sciences. While nearly 40% of degree programs do not deliver a financial return, a bachelor's degree can also have social benefits that can increase ROI, which is often not accounted for in typical ROI calculations.

Effects on productivity

Economy-wide, the effect of human capital on incomes has been estimated to be rather significant: 65% of wages paid in developed countries is payments to human capital and only 35% to raw labor. The higher productivity of well-educated workers is one of the factors that explain higher GDPs and, therefore, higher incomes in developed countries. A strong correlation between GDP and education is clearly visible among the countries of the world, as is shown by the upper left figure.

Of course, correlation does not imply causation: It's possible that richer countries choose to spend more on education. However, Hanushek found that scores on internationally standardized tests of student achievement do better in explaining economic growth than years of schooling, as discussed further below.

Multiple studies have found that investing in the education of poor children on average substantially reduces their risk of poverty as adults and increases their life expectancy. Children in the 1962 Perry Preschool program and matched controls have been followed for decades since. The Perry Preschool participants had substantially fewer teenage pregnancies, fewer high school dropouts, less crime and higher incomes on average as adults. And the results have been intergenerational: The children of the Perry Preschool children have similarly had fewer school suspensions, higher levels of education and employment, and lower levels of participation in crime, compared with the children of those in the control group.

To distinguish the part of GDP explained with education from other causes, Weil has calculated how much one would expect each country's GDP to be higher based on the data on average schooling. This was based on the above-mentioned calculations of Hall and Jones on the returns on education. GDPs predicted by Weil's calculations can be plotted against actual GDPs, as is done in the figure on the left, demonstrating that the variation in education explains some, but not all, of the variation in GDP.

Finally, the matter of externalities should be considered. Usually when speaking of externalities one thinks of the negative effects of economic activities that are not included in market prices, such as pollution. These are negative externalities. However, there are also positive externalities – that is, positive effects of which someone can benefit without having to pay for it.

Education bears with it major positive externalities: giving one person more education raises not only his or her output but also the output of those around him or her. Educated workers can bring new technologies, methods and information to the consideration of others. They can teach things to others and act as an example. The positive externalities of education include the effects of personal networks and the roles educated workers play in them.

Positive externalities from human capital are one explanation for why governments are involved in education. If people were left on their own, they would not take into account the full social benefit of education – in other words, the rise in the output and wages of others – so the amount they would choose to obtain would be lower than the social optimum.