Positive Returns on Investment
Education has positive returns. That claim is certainly not the most extravagant generalization about education that one can make. It is true unless of course hundreds of millions of people over centuries have been systematically paying for education and not fully recovering their investment.
An investment is an expense in the present which pays benefits in the future. The discounted net present value of the future benefits has to exceed the present costs for an investment to be rational. The fact that people invest in education – whether their own or their children’s – strongly indicates that this is so. If it is individually rational to invest in education, then collectively as a society it is also rational to invest in education. These are obviously reasonable propositions. So why do some people and some societies fail to invest in education is a question worth asking.
Discount Factor
One factor that enters the calculus of cost/benefit analysis of activities that have a temporal dimension is the discount factor. A discount factor is like a personal interest rate which is distinct from the interest rate that one gets from, say, putting money in the bank. If the discount factor is greater than the bank interest rate, then it is rational to not put money in the bank and instead just consume it in the present. In other words, the more present consumption is weighed heavily relatively to future consumption, then you can say that the future is discounted heavily. If one faces a very uncertain future, then one has to discount the future. Or if the present needs are extremely pressing, then also one has to discount the future.
Let’s take a concrete example. Should I plant that tree? Suppose it will cost me Rs 100 today to buy the seed and all the resources that will be needed for growing the tree. Suppose further that when fully grown in 20 years, the tree will sell for Rs 1000. Assume that I have only two investment options: plant tree or put the money in a fixed deposit. If the bank interest rate is less than 3.5 percent a year, clearly I should plant the tree. Now let’s introduce uncertainty. What if there is some chance that the tree will die before reaching maturity? What if I were to die before 20 years? Each such factor will increase the discount rate that I will use to calculate whether to plant the tree or not.
Credit Constraint
Someone who is not well-off (however defined) in the present is likely to have a high discount rate for the future. But even when one does not have a high discount rate, it is possible for the person to not make the investment because of what is called a “credit constraint.” Indeed, my definitive test of a poor person is whether the person is credit-constrained or not. The sufficient condition for someone to be poor is to be credit-constrained. Only he is poor who is unable to borrow. You could even be in heavy debt but as long as you have the ability to borrow money (and this will only happen if the lenders know that you will be able to repay the loan), you are not poor.
Back to education and the question of why some don’t invest in education.
Education has positive return on investment as one suspects from just looking around. So if some fail to do so, it could be for a number of reasons. First, incomplete information. That is, one does not know that it pays to invest in education. This is “information failure.” Second, one knows but one does not have the money to invest in education. This is “credit constraint due to incomplete credit markets.” Third, one knows the benefits and has the money but the schools don’t exist. This is “education supply constraint.”
Each of these failures bear a bit of investigation. And I hope to make the case that in the present world, none of these are unsurmountable. Indeed a bit of pondering will reveal that our dismal education system and its pitiable results are quite fixable if only we have the right policies in place. Let me get to that the next time.
Life is a Random Draw 
Great Direction setting, Atanu.
Can’t wait to read your next entry in the series. I liked the positive tone for a change a lot !!
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Yes. Agreed that the three “constraints” are fixable, and the policies matter. But the issue is that the instruments of policy change are unlikely to change the present ones to the desired ones. For instance, is the model of schools designing and implementing their own syllabi given final minimal requirements and hiring teachers acceptable? The policy change to provide choice to schools may not see the light of the day.
Eager to see the “fix it” proposal. Better to discuss that :).
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That education can be economically lucrative (both to the provider and the consumer) is a relatively recent phenomenon. A little more than a century ago, most education in India was provided in “tols” (village schools) where the focus was on writing and arithmetic. The teachers had little economic incentive to teach and the students had little economic incentive to learn. However, our written scripts and arithmetic skills got passed on from generation to generation due to the dedication of a few. Most of the Indian population then did not consider reading/writing/arithmetic economically important enough skills to spend time on.
When the British started providing monetary payments to teachers most capable people left the tols leading to the demise of that institution. Today the government is trying to recreate the tol system in villages. However, any such system depends crucially on the dedication and quality of the teachers. Our social system has changed and the respect people had for teachers (even poor ones) and knowledge no longer exists. That was one fundamental pillar of the tol system. The only way to recreate that system is to recruit talented idealists who are willing to sacrifice their personal economic well being to change things at the village and town level (similar to the daughters of highly educated families in the Boston area who created schools all over the roudy western US in the last century). I don’t see that happening any time soon.
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Atanu,
You talk about the reasons that one fails to have a positive return from education. I am waiting to have a look at the next 3 in this series of posts.
To your list, I wan’t to add one more. As as one’s credit worthiness improves, has access to better loan products with lower interest rates or has access to portfolio managers who would manage his money better than he can manage himself.
The increase in return can, theoretically, go at a faster rate relative to the increase in your resource base. In any event, you would have access, with an increased resource base, to the experts, more than what a retail investor would have.
I have been discussing the CAT exam with many professors at several IIMs. They seem to back my hypothesis that the number of students who fail the CAT because they cannot meet the cut-off in English is significantly higher than those who don’t because they cannot make the cut-off in Math or DI.
Having taken and done well at the CAT and now as a teacher, I am of the opinion that it is much easier to build skills in English, than it is in Math, as tested by the CAT (it is a different debate that I feel that the Math on the CAT is at odds to that required of a business education). Ineed many students who take the CAT may have had tremendous experience relevant to a career in business management, but little exposure to communicative english (a function of their town/city of upbringing)
Accordingly, the credit worthiness of these students could be increased (making products like the IIMs available to them) quite easily by providing them with a immersion into the English language through a 3 month-residential remedial programme offered either by private players or by the IIMs themselves.
This is a quick post. Hope I have made myself coherent.
Warm regards,
Vivek
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