Economics has been defined as science of man in relation to his ‘wealth getting‘ and ‘wealth spending‘ activities. It is related to wants of man and means to satisfy them. The problem is that man‘s wants are unlimited and the means are limited. So he has to make a wise choice according to the priorities. The same is the case with the nations.
A democracy has to be a welfare state. The states resources are limited and so has to make allocations of funds according to its predetermined policies and priorities it has decided upon democratically. Education is one of the most important areas of development where any welfare state has to pay attention if it has to progress and keep pace with other developing and developed nations. Education of the citizens influences economic growth of a nation and reciprocally, the economic policies and allocation of funds for education affects the educational progress of the citizens. Let us see the mutual relationship between the two in detail.


Philosophy, Sociology and Psychology have been considered as the three foundations of education. But of late, Economics is no less connected with education than these three branches of knowledge. Briefly speaking, the common areas of inter-relationship of economics and education are the following.

i. Economics determines some major aims of education.
ii. Economics explains the importance of education in so far as the economic growth of the country is largely based on development of education.
iii. Education itself is an investment in economic terms.
iv. Education alleviates poverty as it produces skilled labour and creates right attitude to work and development. It also creates awareness for better living.
v. Education determines the wage structure, the profile of professional values and guarantees economic security of the people.
vi. Besides the social, moral, cultural and spiritual aims of education, the purely simple ‘bread and butter‘ aim of education cannot be lost sight of. In fact, the aim of education as for earning a living and that too making a good economic living is one of the major aims.


Education as economic goods: Two conditions are to be fulfilled for a ‘goods‘ to become economic goods. 1) Availability should be limited. 2) It should be subject to allocation.

Economic goods are of two types. 1) Material goods – physical or tangible goods. Education plays a vital role in the production of material wealth. It makes a man more intelligent, more ready to change, more trustworthy in his ordinary work. 2) Non-material goods – services that satisfy human wants. Education is non-material economic goods. It satisfies a human want. It is limited in supply and can be allocated. It should be borne in mind that education develops talents and virtues. Higher level of economic welfare depends on mental out-look, technical knowledge and skills. An awakened mind, right knowledge, appropriate skills and desirable attitudes hastens economic development. It enhances dynamism and releases forward flowing energy. The constructive urges of man are aroused through education. The direct results of education are better organized skills and sharp inventiveness. This will help produce integrated personalities and helps them lead a harmonious life.

Education is both a producer‘s goods and consumer‘s goods. It is a producer‘s goods as it is used in the process of producing other goods. Those who are educated can educate others there by producing more number of educated people. It is producer‘s goods as required for becoming a teacher, lawyer, engineer, mechanic, etc. It is a consumer‘s goods if received merely for satisfaction of one‘s wants like enjoyment etc.


In olden times, education was considered an end in itself and unproductive expenditure. Hence, budgetary allocation was always cut in education by developing countries whenever there was a resource crunch. Modern view is that education is an essential expenditure. It is a productive investment. The returns are in the form of useful, dynamic and efficient citizens. They contribute more to the welfare of the country. Education is an investment for national development.

H. G. Wells says, “Investment in education has a unique importance to any nation because the effect of under-investment in this field can never be fully recovered. Human history becomes more and more a race between education and catastrophes”. Education has numerous consequences for individuals and society. For many people, there is some "consumption value" from the educational process as human beings are curious creatures, and they enjoy learning and acquiring new knowledge. Education also has considerable "investment value." Those who acquire additional schooling generally earn more over their lifetimes, achieve higher levels of employment, and enjoy more satisfying careers. Education may also enable people to more fully enjoy life, appreciate literature and culture, and be more informed and socially involved citizens.


Gross National Income (GNI) is spent on various sectors like agriculture, industry and education for more returns year after year.

Education is a growth industry and provides employment and produces services needed by the total economy as any other industry contributes to the G. N. P. of the country. It thus contributes substantially to the total economy of the country; and without it the economy would be all too poor. It is to be noted that education produces no-material goods which satisfy human wants. All these suggest that education is an industry. It is evident that education is amenable to supply-demand analysis. As students, parents and employees, and the government demand education at different prices and this demand is met by the education output as educated manpower, well trained citizens, literate people, etc., the theory of demand and supply becomes applicable to education also. The supply of different kinds and quantities of education involves corresponding costs. All these once again suggest that education can be treated in terms of economic analysis. Education produces a society with productive capacity to satisfy the material and non-material wants of the population.

Investment in education is considered as a long term investment as its returns start coming only after a certain period of time, say, after the education is over and they start earning. Of late, due to the influence of

‘Globalization‘, education is commercialized, especially, higher and technical education. In fact, education has become a business. The various education providers‘ interest is mainly in profit making. Many terms used in business like ‘stake-holders‘ and ‘entrepreneurs‘ for educational providers, ‘customers‘ or ‘clients’ to students are widely used in educational system. The fees and allied expenses have gone through the roof making it unreachable to the marginalized and common man. The WTO and GATT agreements have played the decisive role in reducing education in to a service that can be traded across the nations of the world. Many European countries, USA and Australia have major share of their GNP coming from third world countries by selling education there.

Education ideally should acts as an important factor in reducing the gap between the rich and poor. Education provides better opportunities for better jobs. Better jobs enable one to have better income. Better income leads to higher standard of living as well as better savings. Better savings help one to have more investments both in capital goods and education. This allows them to get their children quality education. The cycle continues. This is one of the strongest justifications for providing reservation to socially and economically backward people in educational institutions by the Constitution of India. Yet, a majority of the population remain outside the fold of education especially higher and technical education, thanks to the policy of liberalization, privatisation and globalization which has made quality education beyond the reach of most of the middle class and lower class due to the high cost of education. Only the upper class who can afford to invest in their children‘s education can avail quality education there by perpetuating and often widening the gap between the rich and poor. Indians are said to be great planners, but poor executers. Various schemes and programmes have been mooted to overcome the problem, but largely remained ineffective in getting the desired results. One should not forget the benefits brought by Globalization. But it is a fact that the benefits have not percolated to the lowest strata, instead, it has enabled the rich to become richer and the poor poorer. Only suitable and effective intervention by the government can save the situation. More and more state funding of education can save this situation to a greater extent.


Anything that yields a stream of income over time is capital. As such, capital plays a vital role in the process of economic development which consists largely in its power to produce or accumulate income immediately or in the long run. In this context H. G. Johnson categorised capital as follows.

i) Capital goods which provide specific services to production or consumption by the owner.
ii) Human capital (conveniently known as labour). The distinguishing characteristic of which is that both inherently and by legal tradition, control over the use of the capital is vested in the individual embodying the capital regardless of the source of finance or the investment in it.
iii) Social capital or collective capital. Due to its inherent necessity or administrative convenience, its services to production or consumption are not charged to individual users but are paid for by the taxation of community at large.
iv) Intellectual capital. The underlying characteristic is that once created it is a free good, in the sense that use of it by any one individual does not diminish its availability to others. Education is necessarily a human capital as it directly promotes the quality and capability of human beings. It also contributes to intellectual and partly at least makes social capital. The quality of human beings count a good deal, for it is the human brain and power that makes physical capital what it is worth. Economists consider human beings as a form of capital due to the following reasons.

1. Formation and development of human capital demands cost.
2. Skilled human resources add to national product.
3. Expenditure on human resources is concurrent with National wealth.

The factors which affect human capital formation are investment in formal education, improved health, on the job training, manpower rehabilitation, migration, etc. chief among the factors is formal education for it raises the economic value of human capital by raising earning power and current asset value of human beings. Education is important since it makes man to be a better producer. Education also acts as a guarantee of economic security as education determines professional values, the wage structure etc. It is also an established fact that economic prosperity of the country is directly proportional to the educational development.
Knowledge is Capital:

Intellectual capital, knowledge or professional competence is one of the four capitals. Capital is the key to the production of income and consequently to economic growth. Capital is anything that involves costs but yields a strain of income over time. Schultz says that an educated man invests a lot of himself in acquiring education and that investment is also in capital. Educational expenditure is thus, not consumption, or expenditure but investment expenditure.


Economic growth of a country is largely based on educational development. Economic growth is identical with prosperity and better life. Faster economic growth helps the citizens of the nation to enjoy higher standards of living. This also leads to better social services. Some economists believe economic development means the proportion of national income that is devoted to physical investment. According to this, developed countries continuously increase their capital stock by way of huge investment and the developing countries accumulate relatively less capital stock due to their low level of national income. Another argument is that it is not the quantum of investment which is the clue to growth, but it is the technical knowhow which should come from education.

Yet another group of economists consider that the per-capita income is an indicator of economic growth. In that sense, the rich oil producing countries like Iran, Saudi Arabia and Kuwait which have a high rate may boast of sound economies. Still some other economists are of the view that a well oriented labour force can increase the income of a country. But a labour surplus with limited capital or no tools and place to work can only stand in the way of development. Considering the above views, John Vaizey redefines economic development as the total effect of “development of the labour force, the accumulation of physical capital, and additions to the stock of knowledge and the skill available in the community”.


Adam Smith, the philosopher–economist and Marshall, the most versatile contributors to the discipline of economics had long back identified the relationship between education and development. Adam

Smith in his book ‘Enquiry into the Nature and Causes of Wealth of Nations‘ said, “Education confers great indirect benefits even on the ordinary workman. It stimulates his mental activity, it fosters in him a habit of wise inquisitiveness; it makes him more intelligent, more ready, more trustworthy in his ordinary work; it raises the time of his life in working hours; it is an important means towards the production of material wealth”. Adam Smith observed that the acquisition of talents through education cost a real expense, which formed a capital fixed and realized in the persons concerned; further, those talents made a part of their fortune as well as that of their society.

Recent perceptions into the field have provided the insight that the economic contribution of education could be interpreted in terms of human capital formation through education. Schumpeter while upholding the effect of organization and innovation in the context of economic growth emphasized ‘nothing but improving available resources which is possible among other things, through education‘. Karl Marx pleaded for education on the ground that ‘it is a counter balance to the inhuman results of the division of labour‘. The potentialities of education for economic growth were clearly stressed by Theodore Shultz also.

Economic development through human resource development is very significant in underdeveloped and developing countries. Harbison and Mysers hold the view that the educational process is of human resource development, is necessary for the transformation of social and political institutions, for which the people of modernizing countries strive.

However it should be noted that the system of education and economic growth in a given social set-up are interrelated in such a way, that one cannot exist without the other. Deterioration in education therefore will affect economic development and slow economic development will affect educational system and standards.

The economists and educationists have joined hands to attack one of the most complicated of all social problems, the planning of a country‘s whole educational system as an integrated part of the economy.

The economist wants the educationists to produce engineers, doctors, teachers and other technical personnel with the least cost. The economist goes by the quantitative considerations while the educationists are concerned with quality. John Vaizey says “in order to produce one graduate in a given system there have to be ten people in the secondary school and a hundred people in the primary school”. The point of interest in the partnership between the economist and educationist is that both are not concerned so much with provision of funds for the educational programme as with some reduction in cost without affecting the rise in production. The economists wish the educators come out with some innovation by which the productivity of schools is increased with little or no rise in cost. To enhance quantity and quality in education it is necessary to have quality labour, efficient administrators, well trained teachers, educational innovations and research. But this needs further support with finance. The allocation for education is strained too much under the argument that funds are scarce and the available funds are diverted to other developmental activities. In the words of Dean Rusk, “Education is not something which is a luxury which can be afforded after development has occurred. It is an integral part, of the development process itself”.

Education has the power to improve quality and make human resource more productive. The USSR of 1920‘s is a valid example for the above statement. “It was estimated that the work of the people who had received primary education was almost one and a half times more productive than that of illiterate workers of the same age doing the same work, and that the work of those who had received secondary education was twice as productive, while that of graduates was four times as productive”. Japan of twentieth century is another example. It could make very rapid economic progress even though it had serious problems like paucity of natural resources, large density of population and a late entry in the field. The reason; at least partly, could be due to the stepping up of her public expenditure on education after World War II.

Literacy in developing countries is far below than that in the developed countries. Illiteracy is thus concomitant with underdevelopment. India could gain only 6 per cent increase in literacy during the period 1961-71. As illiteracy is a common feature of underdeveloped countries and is common among low income groups, it acts as a barrier in economic development. It is found that uneducated people are neither motivated nor qualified to make full use of the facilities created for economic growth in the field of agriculture, family welfare programmes, and adoption of new technology in rural areas or the efficient use of credit for increasing production.

A positive attitude towards practical work and manual work counts much in economic growth. There is always the danger of a situation in which education entitles one to have white hands, avoiding practical work and enjoy the fruits of belonging to the intelligentsia. Education has a prominent role to play in effecting changes in the attitudes and habits of the people as well.

Economic growth becomes really meaningful when the people participate extensively in the production process. The real challenge of growth is to provide full employment. The small scale sector is the symbol of that fact of our economy which reflects production by masses rather than means to production.


An important distinction can be made between the private and the social returns to education. Private returns refer to benefits received by the individual who acquires the additional schooling. These include economic benefits such as higher lifetime earnings, lower levels of unemployment, and greater job satisfaction. They may also include consequences such as improved health and longevity. Social returns refer to positive (or possibly negative) consequences that accrue to individuals other than the individual or family making the decision about how much schooling to acquire. They are therefore benefits (possibly also costs) that are not taken into account by the decision-maker. If such "external benefits" are substantial, they could result in significant under-investment in education in the absence of government intervention.

Many observers have suggested that schooling has substantial social benefits, and on this basis has advocated government involvement in the financing and provision of education. Indeed, when discussing education policy, many classical economists departed from their usual

laissez faire position on the appropriate role of government. For example, in The Wealth of Nations, Adam Smith states: "The state derives no inconsiderable advantage from the education of the common people. If instructed they ... are less liable to the delusions of enthusiasm and superstition, which among ignorant nations, frequently occasion the most dreadful disorders" A more contemporary illustration of this point is Milton Friedman's position on the role of government in schooling: "A stable and democratic society is impossible without widespread acceptance of some common set of values and without a minimum degree of literacy and knowledge on the part of most citizens. Education contributes to both. In consequence, the gain from the education of a child accrues not only to the child or to his parents but to other members of the society; the education of my child contributes to other people's welfare by promoting a stable and democratic society." (Friedman, 1955).

Governments typically have strong direct involvement in the financing and provision of schooling at various levels. Hence, public policies in these areas have major effects on a country‘s accumulation of human capital. For a given level of initial per capita GDP, a higher initial stock of human capital signifies a higher ratio of human to physical capital. This higher ratio tends to generate higher economic growth through at least two channels. First, more human capital facilitates the absorption of superior technologies from leading countries. This channel is likely to be especially important for schooling at the secondary and higher levels.

Second, human capital tends to be more difficult to adjust than physical capital. Therefore, a country that starts with a high ratio of human to physical capital — such as in the aftermath of a war that destroys primarily physical capital — tends to grow rapidly by adjusting upward the quantity of physical capital. Upper-level schooling in the growth panel is that many countries follow discriminatory practices that prevent the efficient exploitation of well-educated females in the formal labour market. Given these practices, it is not surprising that more resources devoted to upper-level female education would not show up as enhanced growth. Female primary education promotes growth indirectly by encouraging lower fertility.


There are different theories which are widely used to explain the labour market outcomes. These models put forward different approaches to the study of impact of education on employment prospects and productivity. Given below are three such models.

(i) Human Capital Model:
Human capital theory is widely used to explain labour market outcomes. The essence of the theory is that investments are made in human resources in order to improve productivity, and therefore employment prospects and earnings. Individuals acquire skills through formal schooling and/or work experience, and these skills increase the individual's value to employers and therefore their future earnings. Several key elements of human capital theory are worth noting. First, it is a theory of investment decisions: individuals incur costs at the present time in return for benefits in the future. This investment dimension is particularly important because the benefits of human capital acquisition typically accrue over a long period, in the form of a higher earnings stream over many years. Second, because the benefits accrue in the future there will typically be uncertainty about the extent to which the investments will pay off. Human capital investments are generally risky investments. Third, a major component of the costs of acquiring human capital is typically the opportunity cost -- the income foregone by not working. Decisions about education -- both the amount of time to devote to schooling and choice of educational programs -- will be influenced by both the "investment" and "consumption" components of human capital formation. The latter refers to the fact that learning may be a very enjoyable activity for some, but a less enjoyable or even unpleasant activity for others. Other factors being equal, individuals who enjoy learning are more likely to remain in school longer. Similarly, other things being equal, students are more likely to choose educational programs that they regard as interesting and stimulating. An important distinction is that between private and social returns to human capital formation. Private returns are those based on the costs incurred by and benefits received by the individual acquiring the education. These benefits include both the consumption and investment consequences of schooling. Social returns are based on the costs incurred by and benefits received by society as a whole. There may be differences between private costs and social costs, as well as between private and social benefits. This distinction is important because individuals can be expected to base their schooling the lifetime earnings profile of more educated workers lies above the equivalent earnings profile of less- educated workers.

(ii) Signalling / Screening Model:
Human capital theory emphasizes the role of education as enhancing the productive capacities of individuals. A contrasting view of education, where it has no effect on individual productivity, is the signalling/screening model. According to this theory, education may act as a signal of the productive capacity of individuals. Central to this theory is the importance of imperfect information. In their hiring decisions, employers are imperfectly informed about the capabilities of potential employees. They therefore may use education as a signal of a new hire's future productivity. If employers' beliefs are subsequently confirmed by actual experience (that is, if more educated workers turn out to be more productive), employers will continue to use education as a signal. Employers will thus offer higher wages to more educated workers. Facing a positive relationship between education (which is costly to acquire) and wages, individuals will have an incentive to invest in education. A central assumption of the signalling model is that education is less costly to acquire for individuals who are innately more skilled or able. If this assumption holds, higher ability individuals will invest more in education than will lower ability individuals. Both high and low ability individuals face the same potential benefits from investing in schooling, but low ability workers face higher costs and therefore will acquire less education. In these circumstances, employers' beliefs about the relationship between education and worker productivity will be confirmed. Even though schooling has (by assumption) no effect on worker productivity, employers have an incentive to offer higher wages to more highly educated workers and higher ability individuals have an incentive to invest in education. In this model, education serves as a "sorting device", separating the high from the low ability workers. Like human capital theory, the signalling/screening model can explain the positive relationship that exists between schooling and labour market outcomes such as earnings. However, there are important differences between the two theories. In the human capital model, education is privately and socially productive. In contrast, in the signalling model education is privately productive (high ability individuals benefit from investing in education) but not socially productive because education has no effect on the total goods and services produced by society. Another important difference is that in the human capital model, schooling exerts a causal influence on worker productivity and thus earnings. In the signalling theory, education has no effect on worker productivity so there is no causal influence of education on earnings. Rather, the positive relationship between schooling and earnings arises because both variables are related to a third factor – worker ability. In many circumstances, worker ability is unobserved so it is difficult to determine whether the positive relationship between education and earnings arises because schooling enhances workers' productive capacities (the human capital explanation) or because schooling sorts out high and low capacity individuals.

(iii) Job-Matching or Information-Based Model
In the human capital model, individuals choose among alternative educational programs according to the costs of these programs and the associated lifetime earnings streams (and other benefits) that they generate. Information may play a role in helping to identify or forecast the benefits of alternative educational choices. An alternative view of the educational process is that it helps individuals to determine what types of careers they are most suited for. In this case, education plays the role of providing individuals with information about their comparative advantages -- the types of occupations and jobs they are likely to do well in. This mechanism is characteristic of job-matching and information-based models. The perspective is similar to human capital theory in several ways, including the implication that education has both private and social benefits. However, the emphasis is different. Human capital theory emphasizes the acquisition of skills that are valued by the labour market, while job-matching models emphasize the acquisition of information about one's abilities and aptitudes. Human capital theory focuses on the direct increase in skills provided by schooling, whereas information-based models highlight the role of education in identifying the most productive applications of a given set of skills. The job matching approach also has important implications for the interpretation of returns to work experience. It views jobs as having an idiosyncratic, or firm-worker


Many individuals invest in education in the belief that doing so will yield future benefits such as greater employment opportunities, higher earnings and more interesting and varied careers. Similarly, many public policies encourage individual citizens to increase their educational attainment and enhance their skills and knowledge. Increased educational attainment and skills are not necessarily valued for their own sake but often because they are believed to result in better labour market and social outcomes.

Schooling may have numerous consequences for individuals and society. For many people, there is some consumption value from the educational process. Human beings are curious creatures and enjoy learning and acquiring new knowledge. Even focusing on the investment aspects, education may enable people to more fully enjoy life, appreciate literature and culture, and be more informed and socially-involved citizens. Although these and other potential consequences of schooling are important and should not be ignored, the consequences of education for employability, productivity, and earnings are also of substantial importance. As many studies have documented, schooling is one of the best predictors of “who gets ahead”. Better-educated workers earn higher wages; have greater earnings growth over their lifetimes, experience less unemployment, and work longer. Higher Education is also associated with longer life expectancy, better health, and reduced participation in crime. As many studies have documented, schooling is one of the best predictors of “who gets ahead”. Better-educated workers earn higher wages; have greater earnings growth over their lifetimes, experience less unemployment, and work longer.

Higher Education is also associated with longer life expectancy, better health, and reduced participation in crime. Estimates of life-cycle earnings profiles from data on groups of individuals with different levels of education. Combining these estimated earnings profiles with information on the costs of acquiring additional education -- both the direct costs and the opportunity costs associated with the income foregone by not working -- allows the implied rate of return on the investment in additional education to be estimated. For example, the rate of return to a university degree compared to a high school diploma is estimated using the life-cycle earnings profiles for these two groups together with information on the direct and opportunity costs of attending university compared to entering the labour force after completing high school.

The second approach is based on estimation of an earnings function in which a measure of earnings is regressed on years of completed schooling (or highest level of educational attainment), years of labour market experience, and additional variables that control for other influences on earnings. This earnings function approach is widely used because it readily provides estimates of the rate of return to education, as well as yielding insights into the relative magnitudes of other influences on earnings.

The strong positive relationship between education and earnings is one of the most well established relationships in social science. Many social scientists have, however, been reluctant to interpret this correlation as evidence that education exerts a causal effect on earnings. According to human capital theory, schooling raises earnings because it enhances workers' skills, thus making employees more productive and more valuable to employers. However, as discussed previously, the positive relationship between earnings and schooling could arise because both education and earnings are correlated with unobserved factors such as ability, perseverance, and ambition (hereafter simply referred to as “ability”). If there are systematic differences between the less-educated and the well-educated that affect both schooling decisions and labour market success, then the correlation between education and earnings may reflect these other factors as well. According to signalling/screening theory, such differences could arise if employers use education as a signal of unobserved productivity-related factors such as ability or perseverance. In these circumstances, standard estimates of the return to schooling are likely to be biased upwards because they do not take into account unobserved “ability”. More generally, those with greater ability or motivation may be more likely to be successful, even in the absence of additional education. That is, the Correlation that exists between earnings and education, after controlling for other observed influences on earnings, may reflect the contribution of unobserved influences rather than a causal impact of education on earnings. This “omitted ability bias” issue is of fundamental importance not only for the question of how we should interpret the positive relationship between earnings and schooling, but also for the emphasis that should be placed on education in public policies. The marginal return—the impact of additional schooling for someone with low levels of education—may be substantially below the average return. In these circumstances, education may not be very effective in improving the employment or earnings prospects of relatively disadvantaged groups.

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