Market failure: necessary but not sufficient

One justification for the heavy involvement of state and federal governments in education is market failure. Market failure is a micro-economic idea in which free exchange does not produce the theoretically optimal level of production and consumption. Usually this occurs because of an externality. An externality is a cost or benefit from an exchange that accrues to someone who is not a party to the exchange. Since the cost or benefit of this externality is not considered by the parties involved in the exchange, a free market might tend to under- or over-produce a particular good.

For example. I build a factory to make widgets. (All example economics problems involve widget manufacture. Did you know?) I produce widgets up to the point that the last widget I make is worth exactly as much to the purchaser as it cost me to me. For example, if widgets are worth $10 on the market, I'll make as many widgets as I can until the last, most expensive widget costs me ten dollars, and then I'll quit.

This is all well and good. I'm happy, my customers are happy. We're both benefiting from the surplus of trade. It's great! But what if there's an externality? Let's say my widget factory puts out a stream of noxious liquid that runs across my neighbor's yard. If that cost were borne by me, I'd have an incentive to make fewer widgets, since the cost of manufacture would be higher. If it were borne by my customers, they'd buy fewer widgets, since the cost of buying widgets would be higher. But since it's borne by a third party, not involved in the transaction, no one has any incentive to take the cost into account, and widgets are over-produced.

In the case of education, the externality is not a negative, it is a positive. The argument is that my education benefits others besides me. Those benefits are not taken into account when I decide how much education to buy or when the suppliers of education decide how much education to produce, so the market for education is smaller than it ought to be. Ideally.

This simple idea is the basis for billions of dollars of spending by governments on education. My own state of Washington has a constitutional clause stating that education is the state's highest priority. But is that right? Does that follow from the logic of externalities?

Let's remember that one of the options we are given is not perfection. We must compare options as they are actually available to us. Therefore, the "failed" free market for education does not have to compete with the idealized provision of education by the state, but rather by the provision of education by the state as it actually exists. Although it is possible that a free market in education would tend to under-supply, are we sure this is worse than the other alternatives? How do we know that the current system doesn't over-supply the education market? I have yet to hear anyone even raise this issue.

Education is important. But it's not infinitely important. Let's have some thought to return on investment in our spending decisions regarding education. Let's at least be sure that the benefits of the marginal dollar outweigh the costs.