Capital Market Failure, Adverse Selection and Equity Financing of Higher Education

Tinbergen Institute Discussion Paper No. TI 05-037/3

28 Pages Posted: 19 Apr 2005

See all articles by Bas Jacobs

Bas Jacobs

Erasmus University Rotterdam (EUR); Tinbergen Institute; CESifo (Center for Economic Studies and Ifo Institute)

Sweder van Wijnbergen

Universiteit van Amsterdam; Tinbergen Institute; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Date Written: April 2005

Abstract

We apply theories of capital market failure to analyze optimal financing of risky higher education. In the market solution, students can only finance their education through debt. There is underinvestment in human capital, because some students with socially profitable investments in human capital will not invest in education due to adverse selection problems in debt markets and because insurance markets for human capital related risk are absent. Legal limitations on the use of human capital in financial contracts cause this underinvestment; without them private markets would optimally finance these risky investments through equity rather than debt and supply income insurance. The government, however, can circumvent this problem and implement equity and insurance contracts through the tax system using a graduate tax. This paper shows that public equity financing of education coupled to provision of some income insurance is the optimal way to finance education when private markets fail due to adverse selection. We show that education subsidies to restore market inefficiencies are sub-optimal.

Keywords: Human capital, capital market imperfections, credit rationing, financing risky investment, optimal education finance, graduate taxes, education subsidies

JEL Classification: H21, H24, H52, H81, I22, I28, J24

Suggested Citation

Jacobs, Bas and van Wijnbergen, Sweder, Capital Market Failure, Adverse Selection and Equity Financing of Higher Education (April 2005). Tinbergen Institute Discussion Paper No. TI 05-037/3. Available at SSRN: https://ssrn.com/abstract=701222 or http://dx.doi.org/10.2139/ssrn.701222

Bas Jacobs (Contact Author)

Erasmus University Rotterdam (EUR) ( email )

PO Box 1738
Rotterdam, Zuid-Holland 3000 DR
Netherlands
+314081452 (Phone)

HOME PAGE: http://people.few.eur.nl/bjacobs

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

Sweder Van Wijnbergen

Universiteit van Amsterdam ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands
+31 20 525 4011 / 4203 (Phone)
+31-35-624 91 82 (Fax)

Tinbergen Institute

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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