Information Problems

Information Problems
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School of Economi cs and Pol i ti cal Sci ence; date: 31 May 2014
University Press Scholarship Online
Oxford Scholarship Online
The Welfare State as Piggy Bank: Information, Risk,
Uncertainty, and the Role of the State
Nicholas Barr
Print publication date: 2001
Print ISBN-13: 9780199246595
Published to Oxford Scholarship Online: November 2003
DOI: 10.1093/0199246599.001.0001
Nicholas Barr (Contributor Webpage)
DOI:10.1093/0199246599.003.0011
Abstract and Keywords
Information problems constrain the usefulness of consumer choice about school
education, suggesting that the state will continue to provide the bulk of finance for school
education and, separately, will continue to be the major provider. In contrast, consumer
choice is useful for tertiary education, where consumers are better informed than
central planners. This argument is strengthened by the growing diversity of post
compulsory education and training. These arguments underpin the case for market
forces in higher education discussed in detail in Ch. 13. Imperfect information is also a
problem in capital markets. Conventional loans (for example, to buy a house), when
applied to investment in human capital, present borrowers and, for different reasons,
lenders with significant risk and uncertainty.
Keywords: borrowers, capital markets, central planning, consumer choice, human capital, imperfect
information, lenders, market forces, school education, tertiary education
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Information is central to arguments about education. The previous chapter explained why
measures of the benefits of education are problematicalan aspect of imperfect
information that applies to everyone, including government. This chapter considers
(Section 1 ) whether consumers are well informed in the separate cases of school
education and postcompulsory education. A different type of imperfect informationthat
facing borrowers and, separately, lenders of student loansis discussed in Section 2 .
1. Information Problems in the Market for Education
1.1. School Education: The Case Against the Market
As discussed in Chapter 2, Section 4 , markets are more efficient (a) the better is
consumer information, (b) the more cheaply and effectively information can be improved,
(c) the easier it is for consumers to understand available information, (d) the lower are
the costs if someone chooses badly, and (e) the more diverse are consumer tastes.
Are consumers well informed about school education? Can information be improved cost
effectively? Will any such information be understood? Children (the immediate
consumers) are not well informed. Decisions are therefore generally left to parents.
However, parents might themselves not be well informed; in addition, they are likely to
differ in the extent of their confidence and articulateness. Parental information can and
should be improved, but it does not follow that this approach is necessarily a complete
solution. The cost of improving information and its effectiveness in aiding choice will vary
considerably across parents. Furthermore, even parents who are generally well
informed can be wrong: it is sometimes suggested, for example, that middleclass parents
seek out for their children the sort of education they experienced, and thus
systematically make outofdate choices. These problems all suggest that market allocation
at a school level will not result in all parents making efficient decisions on behalf of their
children.
At least as important, these problems disproportionately affect people from less welloff
backgrounds. Thus the case for intervention also rests strongly on (p.172) equity
grounds, in the sense that we might contemplate a very different school system in a
world in which all parents were well informed, articulate, and deeply concerned about
their children's education.
How high are the costs of choosing badly? A restaurant that provides bad service will go
out of business; its former clientele will have suffered nothing worse than a bad meal, and
can spend the rest of their lives going out for better meals. School education, in contrast,
is largely a onceandforall experience. A child who has had a year of bad education may
never recover. In addition, a child may face high emotional costs (changing friends, for
example) in changing school. A more apt analogy is a restaurant whose food is so bad that
it might cause permanent ill health.
All these arguments underpin the case for extensive regulation of school education; the
case for public provision is completed if we believe that an important task of the school
system is to develop social cohesiona process that is enhanced if children go through a
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common educational experience.
The last of the five criteria, however, argues in the opposite direction. There is
considerable diversity in consumer tastes. As discussed in the previous chapter, families
have different views about subject matter, the role of discipline, and the place of religion.
Thus, the education package (and hence the meaning of a good education) will depend
on the economic, political, and social structure of the country concerned, and will vary
considerably. Thus there are inescapable tensions:
In efficiency terms, what are the respective claims of (a) parental choice, given
that a good education can mean very different things, and (b) public provision
aimed at providing a relatively homogenous package of school education in
pursuit of common values and social cohesion?
What is the tradeoff between efficiency and equity objectives? If some parents
are well informed, what are the respective claims of parental freedom, on the one
hand, and equity objectives, on the other? Specifically, should middleclass
parents be allowed to make better choices on behalf of their children?
Neither dilemma has a complete solution.
Though these arguments do not lead to a definitive conclusion, a number of factors point
towards public production at school level: there are information problems and,
separately, informationprocessing problems, leading to inefficient choices;
1
such
problems have a socioeconomic gradient, creating equity (p.173) problems; and a
strong case can be made for a significant common element in the school education
package to foster social cohesion.
1.2. Tertiary Education: The Case for the Market
The same criteria lead to very different conclusions when applied to tertiary education.
The argument is illustrated here in terms of universities but also applies to post
compulsory education more generally, and to vocational training.
First, information is available, and more can be made available. There are already good
university guides, and universities publish detailed information on the Internet. Secondly,
the information, for the most part, is sufficiently simple for the student to understand and
evaluate. This process is easier because the need to make an educational choice (which
course, which subject) can normally be anticipated, so that the student has time to
acquire the information she needs, and time to seek advice. The nonurgency of the
decision contrasts with finding a doctor to deal with an injury after a road accident.
The costs of mistaken choice are potentially significant, but there are three lines of
argument suggesting that individual choice, together with advice and suitable consumer
protection, is less inefficient than any alternative. First, the costs of mistaken choice are
reduced by modular degrees, which allow students to change subjects and, increasingly,
institutions. The costs are also lower because students are older than schoolchildren and,
for that reason, the emotional costs of changing subject or institution will generally be
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less, or at least less longlasting. Secondly, whatever the costs of mistaken individual
choice, a central planner is likely to do even worse. In this respect, too, there is a contrast
with school education, which is deliberately designed to be relatively homogenous, as
manifested, for example, by a national curriculum of some sort in many countries. Post
compulsory education, in contrast, is properly highly diverseindeed its diversity is a
sign of richness of culture and openness to social and technical innovation. Thirdly,
students make choices already.
Though the matter is controversial, it can be argued that the assumption of wellinformed
(or potentially wellinformed) consumers holds for higher education. The many students I
have met have generally been impressively well informeda savvy, streetwise consumer
group.
2
Finally, consumer tastes are diverse, education and training courses are becoming more
diverse, and change is increasingly rapid, and global. For all these reasons, students are
more capable than central planners of making choices that conform with their own needs
and those of the economy. In contrast, attempts at (p.174) manpower planning are even
more likely than in the past to be wrong, largely (though not wholly) because of the
increasing complexity of industrial and postindustrial society.
1.3. Implications for Policy
Two very different strategies for allocating food and health care were outlined in Chapter
2, Section 4. In the case of food, people are generally sufficiently well informed to make
choices; nor are there other major market imperfections. This suggests that efficiency
should be pursued by market allocation and equity objectives through income transfers
for example, paying pensions to the elderly, who then buy food in the same shops as
the rest of us, and at the same prices. With health care, in contrast, there are major
information problems in the market for medical care and, separately, the market for
medical insurance, suggesting a much greater role for the state.
In considering whether education is more like food or more like health care, there are
two important gradients to consider.
Age. As students get older they become better informed. It is clearly right that
someone makes educational choices on behalf of a small child. A university
student, in contrast, is better informed about his or her needs than anyone else.
At some stage in between the balance tips, arguably at the age at which education
stops being compulsory.
Diversity. As discussed in Section 1 , there are strong arguments for a
significant element of homogeneity in what schools offer. Such homogeneity applies
both to technical matters (all children should acquire a common package of basic
knowledge and skills) and to attitudes and values, to strengthen social cohesion.
The higher up the education scale one goes, the weaker the claims for uniformity
and the greater the desirability of diversity, particularly of subject matter.
These two gradients both point in the same direction. The capacity of younger children to
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make choices is limited and the case for uniformity of educational experience stronger,
adding weight to the case for a centrally planned package with space for local, cultural,
and religious diversity. School education, it can therefore be argued, has more in
common with health care than with food.
In contrast, the capacity of young adults to make choices is good and the case for
diversity strong. Postcompulsory education is more like food than health care. It is thus
completely compatible to oppose excessive reliance on market forces in school education
but to support market mechanisms in combination with income transfers for tertiary
education and training.
(p.175) 2. Information Problems, Risk, and Uncertainty in Capital Markets
Information problems arise not only in the market for education itself, but also in capital
markets. As discussed in subsequent chapters, loans are an important source of finance
for investment in human capital. In the world of certainty analysed at the start of Chapter
2 , the market provides loans efficiently, and people make voluntary individual choices
about how much to invest in their own human capital and how much of that investment to
finance by borrowing. This section discusses the major differences that result from
relaxing the assumption of certainty, in particular the fact that both borrowers and
lenders face risk and uncertainty.
2.1. Risk and Uncertainty Facing Borrowers
Students face risk and uncertainty in borrowing to finance investment in human capital. To
explain why, it is helpful to start with the example of borrowing to buy a house, a loan that
comes close to that in the simple Fisher model in Chapter 2 . Such a loan will have a fixed
duration (say twentyfive years) and a positive interest rate. A key feature is that a
person's monthly repayment is entirely determined by three variables: the size of his
loan, its duration, and the interest rate. Apart from adjustments owing to changes in the
interest rate, the monthly repayment rate is fixed.
Buying a house is a relatively lowrisk activity for an individual.
(a) A person who buys a house knows what he is buying, having lived in a house
all his life.
(b) The house is unlikely to fall down.
(c) The real value of the house will generally increase.
(d) If his income falls, making repayments burdensome, he has the option to sell
the house.
(e) Because the house acts as security for the loan, he can get a loan on good
terms.
For all these reasons, the market provides loans for house purchase with little if any role
for the state beyond the regulation of financial markets. The contrast with lending to
finance investment in human capitalfor example, a university degreeis sharp, with
problems of imperfect information, risk and uncertainty.
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Imperfect Information.
The question behind the discussion in Section 1 is who should be the prime mover in
choices about school or university attended, subjects studied, and course content? One
of the conclusions is that there is an (p.176) age gradient, with older studentsfor
example, university studentsbest placed to make educational choices because they are
better informed than anyone else about their own aptitudes and preferences. That line of
argument is strengthened by the second gradient, that of diversity, which is much
greater at more advanced levels of education, making efficient central planning impossible.
Thus a major conclusion of earlier discussion is that university students are well informed
consumers. That conclusion now needs slightly to be qualified by the existence of a third
gradient: some schoolchildren (or other potential university students) may not know the
benefits of getting a degree. This is particularly a problem for students from poor
backgroundsthe very people for whom access is the most fragile, and the very people
whose participation governments want actively to foster. Thus the extent to which a
person is well informed (element (a)) can have a significant socioeconomic gradient.
RISK AND UNCERTAINTY arise because (b), (c), and (d), though true for housing, are
much less true for investment in skills. First, a qualification can fall down, in the sense
that a borrower may fail his exams. Thus he ends up having to make loan repayments but
without the qualification that would have led to increased earnings from which to make
those repayments. Secondly, even wellinformed students face risk: though the average
private return to investment in human capital is positive,
3
there is considerable variance
about that average. In addition, as discussed in Chapter 10 , even the private benefits of
education are hard to quantify, so that the borrower faces uncertainty as well as risk
about the return to a particular qualification. Thirdly (element (d)), someone who has
borrowed to pay for a qualification and subsequently has low earnings and high
repayments does not have the option to sell the qualification, further increasing the
borrower's exposure to risk.
For all these reasons, borrowing to finance investment in human capital exposes the
borrower to more risk and more uncertainty than borrowing to buy a house. The
problem arises for all students, and most acutely for those from poorer backgrounds.
2.2. Risk and Uncertainty Facing Lenders
Because of (d), the lender has no security for the loan, leading to a further problem,
adverse selection. The effect of these twin problems, in contrast with home loans, is to
face lenders with significant risk and uncertainty.
No Security.
If I borrow to buy a house, the house acts as security. If I am unable to repay, the
lender can repossess the house, sell it, and take what he is owed. Separately, (p.177)
deliberate default on repayments is not a problem; it is true that I could disappear; but I
could not take the house with me. For both reasons, lenders are prepared to offer home
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loans on good terms. An analogous arrangement with human capital would allow the
lender, if I default on my repayments, to repossess my brain, sell it, and take what he is
owed. Since slavery is illegal, that is not an option. Thus lenders for human capital have no
security. In contrast with lenders for house purchase, they face risk and uncertainty
connected with (a) whether I will acquire the qualification and (b) whether my
subsequent earnings record will allow me to repay the loan.
Adverse Selection.
The average rate of return varies across professions; and the variance in the rate of
return is much larger in some professions than others. A borrower who wants to become
an actor presents considerable risk to the lender: since a large part of the return is job
satisfaction rather than money, the average return is low; and the variation in income is
considerable, both between one actor and another, and for a given actor over time. For
an accountant, in contrast, the mean return is higher and the variance lower. In that
sense, from the lender's perspective, an aspiring actor is a bad risk and an intending
accountant a good risk. Adverse selection arises because the borrower is better
informed than the lender about whether he aspires to a career in acting or accounting.
In principle, insurers can ask questions that elicit the relevant information. A travel
insurance company can ask whether my holiday involves skiing or whitewater rafting,
charge a premium accordingly, and refuse to pay benefit if my answers were not truthful.
The analogue for student loans is to ask people what career they would like, to charge a
higher interest rate for aspiring actors, and, quite possibly, to withdraw the loan from a
person who said he or she wanted to become an accountant but who subsequently
dropped out of his or her degree to become a musician. The analogue is clearly
horrendous: it comes close to reintroducing slavery by the back door, since it effectively
locks a student into a career; it interferes with student choice and, importantly, with
students changing direction over the course of their studies and early career; it also
makes the lender, in effect, final arbiter of a person's career choices. The last is deeply
damaging, since it is in the interests of the lender to make lowrisk loans, while it is in the
national interest to encourage the development of flexible skills and new skills.
Thus the case against allowing lenders to seek information about a borrower's career
intentions is overwhelming. But that means that the borrower is better informed than the
lender about his true career intentions, thus exposing the lender to adverse selection.
The resulting inefficiencies, discussed in Chapter 2 and, in the context of medical
insurance, in Chapter 4 , are well known: there will be an (p.178) inefficiently small
amount of lending, and in the extreme the market may fail entirely.
The implications for policy of risk and uncertainty for both borrowers and lenders are
taken up in the next chapter.
Notes:
(1) Chapter 2, Section 2.2 , sets out the distinction (New 1999 ) between an information
problem, which can be solved by ensuring that the necessary information is provided,
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and an informationprocessing problem, where, because of complexity or for other
reasons, a person cannot necessarily choose efficiently even if provided with all relevant
information.
(2) It has been suggested that this is true in some university culturesfor example, the
UK and the USAbut that in other countries students are more passive consumers. It
remains the case, however, that young adults (or older adults) will generally make better
choices than any agent acting on their behalf.
(3) See UK National Committee of Inquiry into Higher Education ( 1997d ) for estimates
of rates of return to a degree in the UK.
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