Market failure as a source of underinvestment
in further training1
Klaus Schömann, Liuben Siarov
International University Bremen
1.
Introduction
Many studies deal with the issue of market failure in the continuous vocational training (CVT)
market as one element of overall human capital investment and lifelong learning (Layard et al.
1995; Schömann and O’Connell 2002). Market failure is referred to in order to justify government
intervention in the functioning of the market for qualifications and training. CVT has proved to
yield significant benefits to the individual, the enterprise and on the level of society as a whole. If
the supply of CVT fails to respond to the changes in demand for CVT, the market for training will
not clear. In case this is persistently the case, we speak of market failure in CVT. In simple terms:
why is it, that firms require high skilled employees, but seem to train them reluctantly? Even under such favourable labour market conditions many individuals do not invest in training to respond
to such skill shortages. In this situation, market failure in the field of CVT can be defined as having an inadequate supply or demand for lifelong learning (LLL) of a persistent manner.
We provide evidence for the existence of persistent imbalances on the market for qualifications
with a focus on continuous vocational training, rather than the broad field of lifelong learning. We
subsequently outline the reasons for this, according to major labour market theories. In this paper
we focus on market failure in form of “under- investment”, mainly on the side of the lower skilled
persons rather than the potential “over- investment” of the higher skilled. The latter group might
not find an adequate match for their high level of skills in terms of labour market earnings. The
persistent qualification imbalances in the market justify, as a corollary, various forms of government intervention in the CVT market for efficiency and equity purposes. The paper stresses the
efficiency grounds for market intervention rather than the equity perspective, because the equity
concerns involve value judgements, which are even harder to assess.
1
Paper prepared for the Thematic Review Seminar on the European Employment Strategy 28.9.2005 in Brussels:
„Sharing costs and responsibilities for lifelong learning“. The paper provides a summary of a larger background study
and builds on the results of the transitional labour market network, which is co-financed by the DG Research under
the 5th framework programme under the acronym “tlm.net” and a German ministry grant on future skill needs “frequenz.net”.
2.
Indicators show that market failure is a problem
The circumstances that lead to market failure or at least temporary inefficiencies in the market,
are wide in range and broad in scope. It is indeed mainly the function of a market to coordinate
the process of further training, which has caused most concerns. With the growth of the knowledge economy and the increased demand for more qualified employees across most sectors of
the economy (not just the knowledge-intensive ones), it is obvious, that the low percentage (9.9%
in 2004 in the EU25) of people engaged in the process of lifelong learning is widely seen as insufficient (further training in the Eurostat labour force survey, measures participation 4 weeks prior to
the survey only, the ad hoc module of the ELFS 2003 on lifelong learning provides remarkable
higher figures for all year round participation).
According to Eurostat, further training participation for the European Union as a whole is not rising rapidly, but has steadily increased. Although the increase between 1995 and 2000, as well as
the increase between 2000 and 2004 are 2.5 percentage points, the Lisbon target of 2010 standing at 15% for the EU15 countries, is probably hard to achieve (see table 1).
Table 1: Participation Rates Further Training 1995-2003 in the European Union
EU-15
Male
Female
EU-25
1995*
1996*
1997*
1998*
1999*
2000*
2001
2002
2003
2004
5.7
5.9
5.4
6.5
6.6
6.3
6.6
6.6
6.5
5.8
5.9
5.7
7.8
7.5
8.1
8.2
7.8
8.5
7.9
8.4
7.3
8.4
7.9
8.5
7.4
8.6
8.0
10.0
8.6
10.0
9.3
10.7
9.2
10.7
9.9
* gender data refer to EU-15, otherwise to EU-25, Source: Eurostat
ƒ
It is encouraging, that overall participation has almost doubled in the course of the past 10 years.
However, the growing difference in participation between men and women provides an early indication of market imperfection. In order to identify in more detail the extent of market failure, we
look at the distribution of lifelong learning across major socio-economic groups (Table 2). The
extent of the market failure can be summarised as follows:
the young receive almost five times more training than older persons (aged 55-64)
ƒ
the employed receive almost 2 percentage points more training than the inactive
ƒ
the high-skilled receive more than six times more training than the low-skilled
It is especially disconcerting to observe the persistent 13 percentage point difference between
participation rates of the low- versus the high-skilled in education and training. The selectivity of
further training according to previous full-time education, remains strong across Europe.
Table 2: Participation Rates in Education and Training, EU-15, by:
AGE
Gender
All
Male
Female
1995
11.2
12.0
10.4
1996
12.1
12.9
11.4
1997
12.5
12.9
12.0
1998
11.1
11.6
10.5
1999
13.6
13.7
13.5
2000
14.2
14.2
14.2
35-44
All
Male
Female
5.4
5.3
5.4
6.4
6.1
6.7
6.4
6.1
6.7
5.6
5.5
5.7
7.9
7.2
8.5
8.2
7.6
8.8
45-54
All
Male
Female
3.3
3.2
3.4
4.1
3.9
4.3
4.2
4.0
4.4
3.8
3.6
3.9
5.8
5.2
6.5
6.0
5.3
6.8
55-64
All
Male
Female
1.1
1.2
1.0
1.4
1.4
1.3
1.4
1.4
1.4
1.2
1.3
1.1
2.4
2.3
2.5
2.8
2.6
3.0
WORK STATUS
All
Employed
Male
Female
5.7
5.3
6.3
6.6
5.9
7.5
6.7
6.0
7.7
6.1
5.6
6.8
8.3
7.2
9.9
8.6
7.4
10.3
Unemployed
All
Male
Female
6.6
5.7
7.6
7.2
6.4
8.0
6.8
6.1
7.7
5.9
4.8
7.0
8.0
7.1
8.9
8.3
7.3
9.3
Inactive
All
Male
Female
5.4
9.2
3.9
5.9
9.8
4.4
6.0
9.6
4.6
5.1
8.1
3.8
6.5
9.4
5.2
6.9
9.8
5.6
EDUCATIONAL LEVEL
All
2.0
Low
Male
2.0
Female
2.0
2.6
2.6
2.6
2.6
2.7
2.6
1.6
1.6
1.5
2.3
2.3
2.3
2.4
2.3
2.5
25-34
Medium
All
Male
Female
6.7
6.8
6.5
8.0
8.2
7.8
7.8
7.7
7.9
6.7
6.5
6.9
9.3
8.8
9.9
9.7
9.2
10.2
High
All
Male
Female
11.4
10.4
12.5
13.0
11.7
14.8
13.3
11.9
14.9
10.4
9.8
11.0
15.5
13.7
17.8
15.7
13.7
18.0
Source European Commission
Of course, one may ask whether this is just the normal functioning of the market, that this distribution of learning, reflects the true distribution of benefits according to training in the labour market.
However, by observing unemployment rates by levels of educational attainment across the European Union, the higher risk of unemployment for the lower skilled is evident (table 3). The market
for qualifications in labour market terms, favours in a clear fashion the higher skilled over those
with lower qualification levels. Over the last ten years at least this pattern is rather stable.
Table 3: Unemployment rates by levels of educational attainment, age groups and sex, 2004
In summary regarding education, long-term unemployment figures seem to follow the general
unemployment trend, namely the unemployment rate falls with increasing education, and is about
three times lower for holders of tertiary education certificates than for the low-skilled. There
seems to be underinvestment in education for the unemployed.
Similarly the low employment rates of experienced employees in most Member States of the
European Union, except in the northern parts of the Union, show that persistent market failure in
training (underinvestment in the middle range of years of employment) is likely to yield low employment rates at older ages. Of course, institutional arrangements that have allowed early retirement from the labour market, have largely contributed to low employment rates of the oldest
age group. Most governments tackle the issue of the sustainability of early retirement policies, but
the first positive signs of these changes will take time to show up in employment indicators (European Commission 2004, OECD 2004). The belated responses by many Member States to the
early retirement trends, had a negative impact on the training of middle aged and older employees, due to the short expected duration to remain in the labour market.
3.
Why does market failure occur?
We briefly sketch the major arguments in the social science literature, why market failure occurs
in the market for qualifications. Becker’s (1962) seminal work on human capital theory is built on
the conventional definition of an employee’s knowledge, experience and qualifications as a productive factor, however distinguishing in the process of augmentation of human capital two types
of human capital – general and specific human capital. General human capital is acquired in fulltime schooling, specific human capital is acquired through the employment relationship. Both
forms yield returns to human capital in form of an earning stream over the life course. General
human capital enhances productivity with all potential employers, while specific human capital is
presumed to depreciate to zero at separation, that is, which can be used with one specific employer only. Since in a perfectly competitive market (which includes full information regarding
skills for all agents), the wage of the worker will be equal to his or her increased productivity after
training. The worker will be the sole claimant of all returns.
In the case of specific human capital, the employer is effectively insured against the risk of separation by the fact, that the employee cannot receive the benefit of the training outside the company she is currently working for (that is, productivity increases but the outside option does not).
In the resulting situation, the financing decision adheres to a bargaining equilibrium, with the optimal solution being that the employer and employee are both willing to fund the training cost in-
curred. In order to retain an employee, the firm will offer a wage higher than her outside option,
but lower than the increase in productivity. Therefore, in a perfectly competitive market, individuals will invest until their marginal cost of training equals their marginal increase in productivity.
However, there are several sources of market imperfection that have an impact on costs and
returns to education and training.
Liquidity Constraints: The employee generally has two ways to finance the investment in human capital: direct (monetary) investment and indirect (through accepting a wage reduction for
the period of training, Acemoglu and Pischke,1999). Thus, given that the employee finances the
training effort through a wage reduction, this will generate a significant disutility of training, and in
this sense, an efficient training market requires perfect capital markets. In the case of human
capital this can be very difficult, if impossible to achieve. Due to the fact that human capital is
inseparable from its owner, the credit institution cannot insure itself against the case of default on
the part of the trainee. In this case government action would need to ensure a better performance
of the loan market for lifelong learning investments. Providing learning accounts through a specialised bank, could be an answer to this type of market failure due to liquidity constraints.
Credit rationing: Similarly the ability to borrow on the capital market for education
and training purposes, is heavily conditional on parental income or own capital for
lifelong learning. Although there are numerous examples of student loan schemes
to finance full-time education, loan schemes for lifelong learning purposes are still
scarce and need backing up through public guarantees. Credit rationing is defined
as the existence of more demand for credit than supply of credit. This results in
some actors not able to borrow at the current interest rate (Stiglitz and Weiss,
1981). It has been demonstrated that credit rationing may indeed exist at equilibrium in a market characterized by imperfect information. This leads to the sorting of
borrowers into risk groups. Therefore, more “risky” borrowers such as the unemployed or the lower skilled will be unable to bid up the interest rate in order to gain
access to loans. Jacobs and Wijnbergen (2003) claim that the best way to finance
educational investment is to provide individuals with mechanisms for equity financing. An example would be a state-financed secondary education, which could be
considered as the state purchasing equity on the human capital of a given individual and receiving dividends through the income tax. However, even this will not
ensure the optimal level of investment since the risk-averse individual will still under- invest in human capital calling for easier access to capital to finance human
capital investments in the European Union.
Bounded rationality: The bounded rationality of individuals is another source of underinvestment in training – an individual may be too “short-sighted”, not being able to accurately estimate
the totality of the incremental cash inflows, resulting from investment and therefore having toohigh a discount rate, which can be more pertinent in the case of the less educated (Brunello and
De Paola, 2004). This view reflects a type of market failure attributable to the bounded rationality
of individuals, who perpetuate the original education selectivity of full-time schooling as well in
further training or lifelong learning, calling for governments to promote investment in human capita, as a source of future profits for the individual and society.
Wage compression: Following the theory of perfect labour markets, labour is perfectly flexible.
This implies that all workers could change jobs instantly at no cost to themselves in order to obtain their outside option and that firms could readily hire another worker, with their only consideration being productivity. However, this is not the case in reality because of the existence of the socalled “matching” and “search” frictions (or in more general terms, transaction costs). Labour is
indeed not perfectly mobile, which leads to a situation of bilateral monopoly in which matchspecific surplus is created and later shared by bargaining, with the firm obtaining a share of the
worker’s productivity as return (Acemoglu, 1997) – this is called “wage compression.” Asymmetric
information also leads to wage compression. Due to the marked difficulties in observing the exact
quantity and quality of training on the job, which also prevent the sanctions on defaults in training
promises that the firm may make, prospective external employers will have no means of ascertaining the actual amount of training that an employee may have had. These information costs
imply the fact, that a recruiting firm will value the general training of a potential employee less
than the firm that trained (Katz and Ziderman 1990). Therefore, not all training will be valued in
the market. Wage compression will discourage individual investment in training, since the worker
is not able to command the full return to the investment. However, it promotes investment in training by the firm, including investment in general training (Acemoglu and Pischke, 1999).
Risk-averse behaviour: According to economic theory, risk- averse behaviour is the natural
state of the rational investor. This implies that the individual receives higher utility from the same
return, if the asset is risk-free than in the case the asset involves a degree of risk. Risk-averse
behaviour influences the choices for general education and determines decisions on specific
tracks of general education as well as investment in firm-specific skills. External shocks or imperfect market information additionally affect the training investment decision in form of increasing
the risk of adequate returns (e.g. due to job rationing as suggested by Wasmer and Weil, 2001 or
temporary skill mismatches (Neugart and Schömann 2002). The risk-return trade-off of the riskaverse investor will be non-linear, but will tend to overcompensate individuals for risk.
Regarding individual differences in risk aversion, it is clear that the training market will be imperfect. The fact that individuals cannot use asset diversification strategies (as in other capital markets) or obtain insurance for their future earnings will result in significant underinvestment
(Layard, Robinson and Steedman, 1995). When considering the mean-variance/risk plot (as is
common in investment literature) of an educational investment, one will observe that the individual will not face a continuous line of possible portfolio choices, but rather a scatter plot of possible
asset selections (Christiansen and Nielsen, 2002). This has an important implication for the educational choice: depending on individual risk-averse behaviour, an individual may choose not to
invest in additional education since risk aversion is too high. In the stock market, she would invest
in a portfolio, which will balance risk and return, ensuring the optimal investment level. However,
in the case of education, where risk and return cannot be balanced, but constitutes an either-or
choice, the “jump” may be too high and the efficient investment may not materialize. Interdisciplinary education is considered a quasi-portfolio choice in the sense that it attempts to reduce risk
by combining several disciplines.
Adequate certification improves information and reduces market failure: The difficulty to
test for the quality of education and training and an effectively controlled certification system, has
an effect on the decision-making process of individuals. Given that the firm or a training provider
may have an incentive to default on its training promise. An employer could capture the value of
the wage reduction that employees agree to in order to finance the training. This may lead individuals to be unwilling to finance investment in training, due to their bad experience with company-provided training (knock-on effect). Formal certification of skills acquired during on-the-job
training, as is the case in certified apprenticeship systems, can have a positive effect on the level
of training provision. Certification, as the “valeurisation” and the recognition of professional experience, stimulates investment on the part of employees through potentially higher wages on the
completion of training (Croce, 2002). This will be achieved by moderating wage compression
exerted by firms and increasing bargaining power of the worker. Certification will also mitigate the
risk exposure of the individual. In theory, certification decreases the externality associated with
mobility by forcing the worker’s outside option to better reflect the increase in productivity. However, by increasing mobility of workers, which is especially relevant for the high-skilled, certification will reduce the incentive of firms to invest in general skills (Katz and Ziderman 1990, Chang
and Wang 1996).
Minimum wages: The effect of minimum wage levels on training in a competitive market is a
widely debated topic (Hashimoto 1982). Most authors conclude that minimum wages will have an
adverse effect on training, since they will diminish the capacity of workers with productivity at or
below the minimum wage level to pay for training through accepting a wage cut. This is especially
relevant to young workers, who work near the minimum wage level, since they do receive a wage
increase in the short-term but will suffer from a significant reduction in expected lifetime earnings.
More recent studies, however, have started to challenge this conclusion. Acemoglu and Pischke
(2001) claim that a company will lay off a worker only if the minimum wage plus the return they
receive due to wage compression, is lower than the actual productivity. If this is not the case, the
firm will prefer to train the worker instead, since the minimum wage has in fact made it the residual claimant of the profits of such an investment. Empirical evidence on the effect of minimum
wages on on-the-job training is inconclusive.
Investment in human capital serves as the basic rationale, but the various forms of market failure,
which we outlined in this section call for public policies to address the most basic misallocations.
Multiple transitions between working and learning over the life course as well as the combinations
of learning and working in one setting are important ways forward, which do not always need high
amounts of financial investments, but rather “institutional creativity” to facilitate lifelong learning.
4.
Estimates of rates of return to education and training suggest a continued role for
public support
In a standard approach to estimate the individual rates of return to investment in education and
training (Scheffel and Schömann 2005) based on the European Community household panel data
for 1995 and 2001, we obtain rates of return to schooling which range from 2 to 6 percent (Denmark, Germany, Italy, Spain and United Kingdom). In Spain and Italy the highest rates of return
were estimated. Since 2001 was still a year with skill shortages in the information and communication technology sector of the economy, a rise in rates of returns between 1995 to 2001 in Denmark and Germany is not surprising, but still an indication of “over-shooting” reaction of the rates
of returns to education and training to some temporary labour shortages. Whereas this can be
interpreted as a normal functioning of the market for qualifications, the imbalance of qualifications
is likely to cause misallocations in training places, if temporary movements of wages determine
long- term choices of individuals. Wrong interpretation of market signals will then produce hog
cycles for specific branches of the education system.
In addition to the positive individual rates of return, OECD estimates are even higher for social
rates of return to upper secondary and tertiary education (table 4). The advantage of an investment in education on the social level is well above the risk-free real interest rate (government
bond rate) and thus it seems that the investment in education pays off on the social level (taking
into consideration that the social costs of education are much higher than the private costs of
education).
Table 4: Social rates of return to education, by gender, 1999-2000
Social rate of return,
upper secondary education
Male
Female
Canada
Denmark
France
Germany
Italy
Japan
Netherlands
Sweden
United Kingdom
United States
9.3
9.6
10.2
8.4
5.0
6.2
5.2
12.9
13.2
8.7
10.6
6.0
6.4
7.8
9.6
Social rate of return,
tertiary education
Male
Female
6.8
7.9
6.3
4.2
13.2
13.1
6.5
6.9
7.0
6.7
5.7
10.0
6.3
7.5
5.7
15.2
13.6
13.7
12.3
Source: OECD, Education at a glance 2003.
It is worth noticing, that the data presented excludes non-economic returns, which are indeed a
crucial part of an increase in education. Since these estimates of social rates of returns are constructed around monetary values, they under-estimate the encompassing benefits of education
and training to society at large.
5.
Public policies to overcome market failure
More risk-prone individuals are able to realize a greater return on their human capital investment.
Risk-averse investment patterns decline with level of education, due to either the fact that individuals holding more education are more aware of its benefits, or due to their ability to better utilize forward-looking information under uncertainty. Therefore, the better educated will be more
prone to invest in education and will gain more in taking action. A problem of equity clearly arises
since it has also been empirically demonstrated that wealth decreases risk-averseness; thus it will
be mostly the poorer, less skilled individuals who will under-invest. The high-skilled persons, by
virtue of their high productivity, will have better access to loans. In addition, firms will be more
willing to invest in the human capital of their already trained workers, who have already proven
their “trainability.” Public policies, therefore, have an important role to support investment of the
persons with a lack of marketable skills or the lowest levels of education and training. This is a
strong argument in favour of precise targeting of labour market policies (Schmid, O’Reilly,
Schömann 1996) on groups of society who are the least likely to participate out of their own effort.
People in employment will be able to finance their training effort more easily (less credit rationing). Given that the firm is still one of the primary providers of further training, the employed will
enjoy a better access to training and stimulating learning environments. The unemployed or the
inactive may be reluctant to engage in training since the unemployment benefits provided by most
of the countries in the European Union, diminish the wage differential between employment and
unemployment. Therefore, some people may prefer to enjoy the secure welfare benefits rather
than face the disutility in time and effort of training and employment near the minimum wage
(poverty trap). Many firms view unemployment as an indication for lower skills or ability. The
stigma of low adaptability attached to unemployment as well as older employees is likely to enhance market failure in training. In order to improve the effectiveness of public training policies
accompanying image campaigns focusing on potentials of “silver (instead of older) workers” and
“responsible (instead of lone) mothers” are advisable.
Difficult to resolve is the discussion between market failure and/or policy failure in many EU countries concerning the employment of experienced workers, those 50 to 64 years of age. For many
individuals it is true, their own preferences as well as the firm’s perspective were to retire early, if
the financial arrangement would allow it. Since governments offered generous provisions in the
past, employers and employees signed “golden handshakes” into early retirement with high public
funding involved.
Due to perceived higher productivity and trainability of young employees, enterprises focus on
hiring of younger employees. Young people may view investment in training as more profitable,
since they will have more time to receive its benefits. However, short programmes on specific
skills have proven to be valuable for both experienced and young workers due to the short time
period needed to recover the relatively low costs involved in such programmes. Labour market
policies will not be able to compensate or even correct the signals of the market for qualifications,
which might mislead pupils or students to choose subject fields of little marketable value upon
graduation. Providing adequate information on realistic opportunities for all levels of skills is indeed a public function.
Co-financing is a key to any initiative in the field of lifelong learning. Individuals, firms and society
share the benefits of training and all parties should be involved in footing the bill, especially for
employment-related training. The range of possible incentives includes individual incentive
mechanisms like grants, loans, or individual learning accounts (A, Swe, D, Can, UK), some even
include free provision of training plus income support (DK, Fin, Nor, Swe). Entitlement to study
leave in form of sabbaticals or job rotation models which include the unemployed in the rotation
schemes are suited to overcome market failure due to stigmatisation of the unemployed.
Direct subsidies to individuals or employers, which compensate for part of the opportunity cost of
training e.g. the time lost while on training, can take the form of tax rebates. The Danish taximeter
system, which comprises tax exemptions plus subsidies for employers providing training, is offering an innovative solution to much needed co-financing arrangements. We consider “train-or-pay”
policies (F, Can) as a last resort measure to tackle persistent market failure. The establishment of
binding training levies for all firms can overcome the poaching dilemma for actively training firms,
so that non- training firms contribute to a national or sector- specific training fund. This allows
cross- subsidising of training and non- training firms. Thorough evaluation of public policies is a
continuous process to address market as well as potential policy failure.
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