31
Aug
09

the capital problem

Pretend you’re poor. Actually, you have absolutely no money, but you know a really good investment to make. In fact, the investment is a sure thing.

If capital markets are working properly, you should be able to overcome the fact that you currently have no money and get some lent to you so that you can make the investment (assuming you can demonstrate to the bank or other capital holding institution that there are clear cut benefit accruing to your investment).

So, given the relationship between education and wages, why do we need public financing of education? Why won’t people just make the sure fire investment in human capital?

The reason is that capital markets cannot be accessed. Here’s Hoxby.

In the classic statement of how much schooling an individual should choose, an individual should invest in the level of schooling that equates that individual’s personal discount rate to the internal rate of return from the marginal year of schooling (Becker, 1964; Rosen, 1977). In deciding on the privately optimal investment, an individual will mainly think of the returns to schooling due to higher lifetime earnings. For the socially optimal investment, the individual should also internalize any additional returns that may occur if that person’s decision provides positive spillovers for others. For instance, human capital might provide positive spillovers if people learn from one another in the course of everyday contact or if people who are more educated are better citizens.

School finance faces three challenges in getting people to make such optimal investments. The first challenge, and by far the most serious, is to motivate people to make privately optimal investments in the face of a severely imperfect capital market. A small child cannot commit to repaying debts assumed for investments in schooling, and parents cannot commit a child’s future earnings to repay debt they might assume for investments in that child’s schooling. Even if family relationships could be used to enforce repayment, liquidity constraints would likely prevent many parents from making optimal schooling investments using their own funds. Children are biologically timed to need schooling when parents’ income and wealth are low, and much value would be lost if parents were forced to spread schooling out in smaller chunks over more years.

Education is most effective when kids are young, but this is most often when parents are relatively poor, and kids can’t promise to pay back with their future earnings, and the parents can’t commit their increased further income (the “payoff” to the investment) for their kids. Parents can’t make binding contracts for the mature future versions of their children.

In the classic statement of how much schooling an individual should choose,
an individual should invest in the level of schooling that equates that individual’s
personal discount rate to the internal rate of return from the marginal year of
schooling (Becker, 1964; Rosen, 1977). In deciding on the privately optimal investment,
an individual will mainly think of the returns to schooling due to higher
lifetime earnings. For the socially optimal investment, the individual should also
internalize any additional returns that may occur if that person’s decision provides
positive spillovers for others. For instance, human capital might provide positive
spillovers if people learn from one another in the course of everyday contact or if
people who are more educated are better citizens.
School finance faces three challenges in getting people to make such optimal
investments. The first challenge, and by far the most serious, is to motivate people
to make privately optimal investments in the face of a severely imperfect capital
market. A small child cannot commit to repaying debts assumed for investments in
schooling, and parents cannot commit a child’s future earnings to repay debt they
might assume for investments in that child’s schooling. Even if family relationships
could be used to enforce repayment, liquidity constraints would likely prevent many
parents from making optimal schooling investments using their own funds. Children
are biologically timed to need schooling when parents’ income and wealth
are low, and much value would be lost if parents were forced to spread schooling
out in smaller chunks over more years.

What’s the solution? Hoxby makes a really interesting point about one way to solve the capital problem, but I’ll get to that next time.

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