Theoretical Concepts in the Economics of Education
                    DJBrewerandGCHentschke,UniversityofSouthernCalifornia, LosAngeles, CA, USA
                    EREide,BrighamYoungUniversity, Provo, UT, USA
                    ã2010Elsevier Ltd. All rights reserved.
                Introduction                                                      as quoted by Walberg and Bast, 2003:182). Economists
                                                                                  study how individuals, organizations, and societies employ
                Over the past two decades, the economics of education             time, money, and effort. In the case of education, econo-
                has grown rapidly as a field. Previously, scholars and            mists are interested in how society organizes and uses
                policymakers tended to view education and economics               scarce resources to produce various types of knowledge
                as separate realms, with economics applied to the study           andskills through formal schooling, and how these types of
                of private goods and education as a public good. Econom-          knowledge and skills are distributed to various groups in
                ics has been characterized as cold and impersonal due to          society. This broad definition means that many social and
                its focus on firms, rational self-interested individuals, and     political issues and topics can fall under the purview of
                cost–benefit decision making, all of which on the surface         economics. John Maynard Keynes once wrote that eco-
                appear to be unrelated to the social and moral values             nomics was a ‘‘way of thinking’’ and it is this lens that has
                associated with educating children. As school systems in          been brought to bear on a wide array of traditionally non-
                developed countries have come under pressure to improve           economics topics, including education policy.
                quality and scale, the distance between the two realms has           Economists typically begin an explanation of observed
                narrowed. It is well documented that better-educatedwork-         phenomena by building a theory or a model in order to
                ers have more favorable labor-market outcomes than those          simplify reality and highlight key characteristics. A model
                withless schooling. Moreover, a well-educated labor force is      contains a set of assumptions, and yields predictions,
                critical for a nation to compete in an increasingly global        ceteris paribus (all other things being equal). Often this
                economythatrewardsknowledgeandskills.Givenconcerns                abstraction causes concern among noneconomists, but
                withtheproductivityof educational institutionsand thefact         such simplifications are essential to understanding real-
                that the study of incentives, choice, and competition lie at      world settings. Economists would argue that what matters
                the heart of economics, economists have become more               is whether the predictions of a model are correct on
                relevant to education-reform debates. They bring increased        average rather than whether the assumptions underlying
                attention to resource allocation and decision making at the       it are realistic. Economics, then, sits firmly within the
                school level, take the view of educational organizations as       tradition of theory–testing scientific method-based disci-
                potentially competitive enterprises, and those running them       plines: a question is framed; a model/theory developed to
                as entrepreneurs. The study of incentives lies at the heart       explain behavior; and the hypotheses or predictions of
                of economics, and an understanding of how actors in large         that model/theory are then tested empirically using
                complex systems respond to incentives, and changes in in-         real-world data. It is often described as concerned with
                centives, helps shed light on how teachers might react to         positive rather than normative issues, where the former
                merit pay incentives or schools might react to increased          are empirically testable and the latter are dependent on
                competition from choice programs and charter schools.             value judgments. The emphasis on hypothesis testing
                    In this article, we briefly review several of the most        makes economists almost always use research designs
                important theoretical concepts in the economics of edu-           that are quantitative in nature, attempting to discern
                cation. First, we define economics and then review three          whether predictions of cause and effect are valid, and
                of the most commonly used ideas – human capital, mar-             the degree to which they are generalizable.
                kets, and education production. We focus here on expli-              Economic theories are typically built on three basic
                cating the major underlying theories (in a nontechnical           foundations: scarcity, rationality, and optimization. Scar-
                manner), rather than their application. All three have            city refers to the assumption that individuals and society
                been utilized in numerous empirical studies. These are            will never have enough resources to completely satisfy
                reviewed in greater depth elsewhere in the encyclopedia.          their unlimitedwants. Rationalityrefersto people’sability
                                                                                  to make decisions in a systematic and purposeful way.
                                                                                  It implies a ‘‘consistency of response to general econo-
                EconomicsDefined                                                  micincentives and an adaptabilityof behavior when those
                                                                                  incentives change’’ (Ehrenberg and Smith, 2006: 4). The
                Economics is often defined as ‘‘the study of the allocation       last assumption is the idea of optimization – either profit
                of scarce means to satisfy competing ends’’ (Gary Becker          or goal maximization with reference to organizations or
                                                                                                                                           193
                   194      EconomicsofEducation
                   utility maximization with reference to individuals. Indi-            Benefits accrue later in life through enhanced earnings in
                   viduals and groups have particular goals – be they happi-            the labor market, access to better jobs, a higher likelihood
                   ness, profit, market share, or some combination of these or          of being employed, and better health. There are also
                   others – and will make choices that will maximize these              psychic benefits from enhanced social status and the pres-
                   benefits, subject to the constraints that they face (e.g., their     tige associated with higher levels of education. Although
                   income). This does not mean, however, that economists                individuals’ motivation for pursuing schooling may differ,
                   only care about selfish individuals; personal values are             and the psychic costs and benefits may be quite varied
                   viewed more broadly, including all that individuals care             depending on personality, expectations of returns, and
                   about. Individuals behave subject to the constraints they            other traits, economists hypothesize that, other things
                   face, the context in which they find themselves, and their           equal, the more the education acquired, the higher the
                   perceptions of the consequences of alternative choices               earnings achieved after the schooling is completed.
                   they make.                                                              Prima facie evidence for human capital theory is to be
                      Economics provides a framework for understanding                  found in the strong positive relationship between educa-
                   the behavior of individuals and organizations as they                tion levels and earnings that exist in almost every devel-
                   generate and allocate human, material, and financial                 oped country. Generally, earnings rise with education
                   resources. Using this perspective, economists have exam-             level and they increase at an increasing rate in the imme-
                   ined a wide range of education-related topics, and in the            diate post educationyears, continue to increaseat a slower
                   remainder of this article we discuss three of the major              pace, and then flatten as individuals approach retirement
                   education questions of interest and the concepts that have           (Ehrenberg and Smith, 2006). This general pattern of
                   been used to shed light on them. First, how much educa-              earningsbyeducationlevelholdsforalmostallsubgroups,
                   tion (does and) should an individual acquire? This entails           including men andwomen,anddifferentracial and ethnic
                   the notion of human capital. Second, how should educa-               groups, but it is the differences among these groups that
                   tion be produced and allocated by a society? This broad              often fuels education policydebates about the distribution
                   question examines conditions, characteristics, and behav-            of education subsidies and services. Economists have
                   ior under alternative organizational forms, including both           devotedconsiderableattentiontothechallengeofestimat-
                   markets and hierarchies. Third, can we be more efficient             ing the returns to schooling taking account of these other
                   and effective in organizing the production of education?             factors. Analysis of such returns generally reveals a consis-
                   Theideaof‘educationproduction’ishelpful in answering                 tentpositiverelationshipbetweeninvestmentineducation
                   this question. We discuss each of these in turn.                     andincreasedearningsfor individuals, with an estimate of
                                                                                        theaveragerateofreturntoanadditionalyearofschooling
                                                                                        of about 10% (Psacharopoulos and Patrinos, 2002). An
                   HumanCapital                                                         overviewof the empirical literature is provided elsewhere
                                                                                        in the encyclopedia.
                   Aprimary research area within the economics of educa-                   Economic research has also found nonmonetary bene-
                   tion is the association between schooling and individual             fits, both private and public, associated with educational
                   outcomes, especially those associated with the labor mar-            attainment. Individuals who have invested in education
                   ket. Education (and training) is modeled as an individual            and job training often have more job stability, improved
                   investment decision that will receive a monetary return in           health (e.g., exercise regularly, smoke less, and eat better),
                   the labor market, typically in the form of higher lifetime           are more likely to receive employer-provided health
                   earnings. This notion of human capital has a rich history,           insurance and pension benefits, are more inclined to
                   with early economists such as Adam Smith, John Stuart                vote, and have generally increased social and cultural
                   Mill, and Alfred Marshall suggesting that individual’s               capital that often enables upward mobility. These benefits
                   skills could contribute to their economic status. In 1776,           are reviewed elsewhere in the encyclopedia.
                   Smith laid the foundation for human capital theory when
                   hewrotethathumaneffortliesattherootof allwealth. In
                   1848, Mill built upon Smith’s notion; he considered                  MarketsandMarketFailure
                   human abilities as means to wealth (Sweetland, 1996).
                   Modern-day human capital theory has further extended                 There is general consensus that national investments in
                   the central insight through the pioneering workof Schultz            education lead to economic growth (for a review of the
                   (1963), Becker (1964), and Mincer (1958, 1962).                      literature, see Sturm, 1993; Hanushek and Kimko, 2000).
                      Knowledge and skills acquired through educational                 Countries spend a sizable percentage of their gross
                   investments increase human productivity. With each                   domestic product (GDP) on education each year. Educa-
                   investment, one may incur costs in the form of out-of-               tional spending can be undertaken by private individuals
                   pocket expenses, foregone earnings, and psychic costs                and by governments through public expenditures. The
                   associatedwiththepressureofstudyingandexaminations.                  decision as to how education at different age levels should
                                                                                          Theoretical Concepts in the Economics of Education                                    195
                     be allocated is at its core an economic decision about how                         best mechanism for allocating education from society’s
                     best to allocate scarce resources in order to maximize                             standpoint.
                     output (i.e., education).                                                              Whenmarketsdonotefficientlyorganize production or
                         Goods and services may get allocated in many differ-                           allocate goods/services to consumers, then market failure
                     ent ways – for example, by tradition, force, or lottery. In                        is said to occur. There are several reasons why markets fail.
                     modern societies, resources are allocated either by mar-                           First, market power may arise when a supplier of a good/
                     kets, by governments, or frequently through the interplay                          service has the ability to control price. A monopoly is an
                     of both. K-12 schooling has traditionally been allocated by                        example of such market power. Perfectly competitive mar-
                     government at the federal, state, and local levels, with                           kets have many buyers and sellers, so no single buyer or
                     postsecondary education allocated by some combination                              seller has a big impact on price. While certain inputs to
                     of markets and government. As concerns about the effec-                            schooling may be more characteristic of perfect markets
                     tiveness of existing schools have risen, policymakers have                         than others (e.g., school supplies), markets in K-12 school-
                     questioned the central role and functions of government                            ing are quite imperfect.
                     in the allocation of educational resources, and turned                                 A second type of market failure is when consumers
                     toward market or market-related mechanisms.                                        have incomplete information about price and product
                         A market is defined in an economic context as a col-                           quality, in which case the market cannot respond effi-
                     lection of buyers who purchase and sellers who produce                             cientlyand correctly. Under incomplete information, par-
                     and sell goods and services; the interaction of buyers and                         ents may or may not choose schools based on outputs
                     sellers results in the possibility of exchange and, hence, in                      important for broader society. (There is some evidence,
                     the allocation of goods and services. The transaction is                           e.g.,  that many parents care not only about student
                     facilitated through agreement on price. A graphical illus-                         achievement but also the social and racial profile of a
                     tration of a market shows a downward-sloping demand                                school’s students, preferring settings where there are
                     curveandanupward-slopingsupplycurve.Sellerswantto                                  most students like their own child.) Hence, although
                     maximizeprofits, while buyers want to maximize satisfac-                           their preferences may be satiated in a market setting,
                     tion based on their preferences and budget constraints.                            some may judge that these preferences are not desirable
                     The higher the market price, the more of a good or                                 from society’s standpoint.
                     service a seller is willing to supply, but the lower quantity                          Third, externalities exist when consumption or pro-
                     of that same good or service a buyer will demand, other                            duction have an indirect effect on others that is not
                     things being equal. The function of a market is to adjust                          reflected in market prices. In the case of education, the
                     price to accommodate changes in supply and demand as                               decision maker (e.g., an individual student) does not bear
                     efficiently as possible. When the price in a market reaches                        all the costs or reap all the rewards from his or her
                     a level where the quantity that buyers want to purchase                            decision about how much education to obtain. Even
                     equals the quantity that sellers want to supply, then the                          though society may benefit more from an educated per-
                     market is said to be in equilibrium. Markets also act to                           son, the person making the educational decisions may not
                     keep prices low. Producers that fail to offer consumers                            see those benefits as his or her own. Thus, the good
                     what they want, or who charge too high a price, will lose                          (education) will be underconsumed from the perspective
                     business and eventually close. The dynamics of markets                             of the market. This presence of social benefits arising from
                     means a continuous process of adjustments that includes                            basic education is perhaps the chief reason why govern-
                     shortages and surpluses, and consumers and producers                               ments have typically made schooling compulsory at ele-
                     entering and exiting the market.                                                   mentary and secondary levels.
                         In many circumstances, markets are the preferred                                   Fourth, markets may fail for public goods – those that
                     method for allocating resources because they are able to                           can be made available to additional people without addi-
                     coordinate many buyers and sellers, give consumers con-                            tional cost (nonrival), and once provided are difficult to
                     siderable influence over price, characteristics, and quan-                         prevent others from consuming (nonexcludable). School-
                     tity, and avoid relying on a handful of arbitrary decision                         ing is to some degree a public good. As with externalities,
                     makers. Under these circumstances, markets are an effi-                            markets will tend to undersupply public goods.
                     cient mechanismforallocatingresources,meaningthatno                                    Thepossibilityof market failure, especially the under-
                     morecouldbeproducedwiththesameresources,andthe                                     consumption of education by private individuals from
                     same output could not be produced with fewer resources.                            society’s standpoint, as well as the importance of educa-
                     Efficiency is a specific criterion for judging an allocation                       tional goals other than efficiency, has historically led to
                     mechanism. It does not say whether the resulting distri-                           significant government intervention in the education sec-
                     bution of resources meets goals other than satisfying                              tor through regulation, financing, and operation. Regula-
                     buyers and sellers (e.g., whether it is fair). Clearly, con-                       tion can take different forms including setting safety
                     sumers of education have multiple goals (Gill et al., 2001)                        standards, mandating curriculum or student assessments,
                     and these need to be considered in deciding what is the                            and requiring teacher credentials. Financing can be in the
                 196     EconomicsofEducation
                 form of direct funding to schools or various forms of          identify and measure all inputs and outputs of schooling.
                 financial aid to individuals. Revenues for schooling may       Multiple outputs (e.g., basic skills, vocational skills, creativ-
                 be generated from general taxation, rather than user fees,     ity, and attitudes) are valued, may accrue in a cumulative
                 such that there is no clear relationship between receipt of    manner, and may only be discernable many years into the
                 the service and the payment for it. The government may         future.Inputscanbehardtomeasure,andthedimensions
                 also directly operate educational enterprises, which           most easily measurable may not capture the important
                 means that the delivery units are embedded within a            features of that input adequately. For example, the way in
                 larger government hierarchical infrastructure controlled       which a teacher interacts with students is important in the
                 bypolitical mechanisms, owned by the state, and in which       students’ learning process; however, the characteristics of
                 the employees are civil servants.                              effective teachers may not be well captured by readily
                    Typically, regulation, finance, and operation have been     available proxies such as years of experience or qualifica-
                 combined in a vertically integrated public sector system.      tions. Nonschool inputs, such as peer influence and family
                 Further, because government-operated schools have been         background clearly affect how much students learn. More-
                 designed to serve all students in a geographic area, in that   over, outputs are themselves joint products (i.e., students
                 locality theyconstitute a virtual monopoly. From a market      experience multiple teachers and carry with them knowl-
                 perspective, this means that schools do not face com-          edge from other classes and from home). The value of
                 petitive pressure to keep quality high and costs down.         the production function approach, however, is as a frame-
                 In addition, many families (particularly low-income and        work for thinking about what resources, in which combina-
                 minority families) do not have much choice over the            tions, make a difference for student outcomes. Many studies
                 schooling options for their children. Recent educational       have attempted to determine the relationship between
                 reforms are to some extent characterized by an attempt         inputs and outputs as currently exists in the United States
                 to unbundle regulation, finance, and operation – ranging       and elsewhere.
                 fromtaxcredit schemes, to magnet schools, to controlled-          The second economics-oriented perspective on orga-
                 choice programs, to charter schools, and voucher pro-          nizations, achieved largely through applied principal–
                 grams. Several of these are discussed in much greater          agent theory, was originally conceived by economist
                 depth elsewhere in the encyclopedia.                           Nobel Laureate Ronald Coase in the early 1930s, who
                                                                                argued that markets and hierarchies, heretofore examined
                                                                                as separate topics, were in effect, substitutes for each
                 EducationProduction                                            other. The factors in a specific firm or division of a firm
                                                                                that made one alternative superior to another were often
                 Economists have sought to understand how education is          associated with the differing costs of coordination (the
                 produced. This has taken two different forms. One is to        costs associated with transactions among individuals).
                 treat education as a production function wherein school-       This perspective has been extended to include a third
                 ing inputs are processes from which outputs are produced.      substitutable form of organization, alliances or networks.
                 In this formulation of schooling, processes occur within a     In agency theory (Moe, 1984; Ferris and Winkler, 1991)
                 black box of the school system. The second approach            principals (superiors in organizations, e.g., school super-
                 explicitly looks inside the black box and examines the         intendents) seek to ensure that agents (subordinates in
                 organization as a web of interpersonal contracts wherein       organizations, e.g., school principals) carry out the princi-
                 individuals seek to coordinate others (and are in turn         pal’s goals, in recognition of four primary factors that
                 coordinated by others) in the performance of work. This        make this difficult. An adverse selection problem occurs
                 latter arena is most often referred to either as transaction   when principals (e.g., school superintendents) are not
                 cost economics (accounting for the newly recognized            fully informed about the abilities and values of the agents
                 costs of coordination or transactions) or as applications      (e.g., school principals) and select agents that are not the
                 of principal–agent theory (seeking to capture the complex      best choice. A diverse objectives problem occurs when
                 issues of delegation of decision rights between bosses or      agents pursue their own objectives at the expense of
                 principals, and their subordinates or agents).                 pursuing the principals’ objectives. This problem is com-
                    Theproductionfunctionapproachuses an input–output           pounded when compliance is achieved only by costly
                 framework to help think about schooling. The main inputs       monitoring and controlling of the agents. An information
                 mayincludeteachers, administrators, supplies, and facilities   asymmetry problem occurs when information within
                 while the main outputs are student achievement (knowl-         the accountability relationship is not evenly distributed.
                 edge, skills). The relation between the educational inputs     The agent typically has the information advantage.
                 and outputs is usually statistically estimated using multiple  Finally, a weak incentives problem occurswhen principals
                 regression techniques. While the education production          lack sufficient decision rights to cause the agents to
                 function is simple in theory, it is very complex in practice   either share principals’ values or to behave as if they did.
                 (Goldhaber and Brewer, 1997). For example, it is hard to       Although the full implications of agency theory and the