Why do most workers with college degrees earn so much more than those without degrees? How does a nation's education system relate to its economic performance? Knowing how education and training interact with the economy can help you better understand why some workers, businesses, and economies flourish, while others falter.

As the labor supply increases, more downward pressure is placed on the wage rate. If the demand for labor by employers does not keep up with the supply of labor, wages usually fall. An excess supply of workers is particularly harmful to employees working in industries with low barriers to entry for new employees, i.e., they don't have a degree or any specialized training.

Conversely, industries with higher education and training requirements tend to pay workers higher wages. The increased pay is due to a smaller labor supply capable of operating in those industries, and the required education and training carries significant costs.

Key Takeaways

  • The knowledge and skills of workers available in the labor supply is a key determinant for both business and economic growth.
  • Industries with higher education and training requirements tend to pay workers higher wages.
  • Differences in training levels is a significant factor that separates developed and developing countries.
  • An economy's productivity rises as the number of educated workers increases since skilled workers can perform tasks more efficiently.

How Education Benefits a Nation

Globalization and international trade require countries and their economies to compete with each other. Economically successful countries will hold competitive and comparative advantages over other economies, though a single country rarely specializes in a particular industry. A typical developed economy will include various industries with different competitive advantages and disadvantages in the global marketplace. The education and training of a country's workforce is a major factor in determining how well the country's economy will perform.

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How Education And Training Affect The Economy

Training 

A successful economy has a workforce capable of operating industries at a level where it holds a competitive advantage over the economies of other countries. Nations may try incentivizing training through tax breaks, providing facilities to train workers, or a variety of other means designed to create a more skilled workforce. While it's unlikely an economy will hold a competitive advantage in all industries, it can focus on a number of industries in which skilled professionals are more readily trained.

Differences in training levels is a significant factor that separates developed and developing countries. Although other factors are certainly in play, such as geography and available resources, having better-trained workers creates spillovers throughout the economy and positive externalities. An externality can be a positive effect on an economy due to a well-trained workforce. In other words, all companies benefit from the external factor of having a skilled labor pool from which to hire employees. In some cases, the highly-skilled labor force might be concentrated in a specific geographic region. As a result, similar businesses may cluster in the same geographic region because of those skilled workers (e.g., Silicon Valley, CA).

For Employers

Ideally, employers want workers who are productive and require less management. Employers must consider many factors when deciding whether or not to pay for employee training.

  • Will the training program increase the productivity of the workers?
  • Will the increase in productivity warrant the cost of paying for all or part of the training?
  • If the employer pays for training, will the employee leave the company for a competitor after the training program is complete?
  • Will the newly trained worker be able to command a higher wage?
  • Will the worker gain an increase in bargaining power or leverage for a higher wage?
  • If increases in pay are warranted as a result of the training, will the increases in productivity and profits be enough to cover any pay raises as well as the overall cost of the training program?

While employers should be wary about newly trained workers leaving, many employers require workers to remain with the firm for a certain amount of time in exchange for the paid training.

Businesses may also face employees who are unwilling to accept training. This can happen in industries dominated by unions since increased job security could make it more difficult to hire trained professionals or fire less-trained employees. However, unions may also negotiate with employers to ensure its members are better trained and thus more productive, which reduces the likelihood of jobs being shifted overseas.

For Workers

Workers increase their earning potential by developing and refining their capabilities. The more they know about a particular job's function, the more they understand a particular industry, the more valuable they become to an employer. Employees want to learn advanced techniques or new skills to vie for a higher wage. Usually, workers can expect their wages to increase at a smaller percentage than the productivity gains by employers. The worker must consider a number of factors when deciding whether to enter a training program:

  • How much extra productivity would he or she expect to gain?
  • Is there a cost to the worker for the training program?
  • Will the worker see a wage increase that would warrant the cost of the program?
  • What are the labor market conditions for better-trained professionals in that field?
  • Is the labor market significantly saturated with trained labor already for that specialty?

Some employers pay for all or a portion of the training expenses, but this is not always the case. Also, the worker may lose income if the program is unpaid and prevents the employee from working as many hours as was done previously.

For the Economy

Many countries have placed greater emphasis on developing an education system that can produce workers able to function in new industries, such as science and technology. This is partly because older industries in developed economies were becoming less competitive, and thus were less likely to continue dominating the industrial landscape. Also, a movement to improve the basic education of the population emerged, with a growing belief that all people had the right to an education.

When economists speak of "education," the focus is not strictly on workers obtaining college degrees. Education is often broken into specific levels:

  • Primary—elementary school in the U.S.
  • Secondary—middle school, high school, and preparatory school
  • Post-secondary—university, community college, vocational schools

A country's economy becomes more productive as the proportion of educated workers increases since educated workers can more efficiently carry out tasks that require literacy and critical thinking. However, obtaining a higher level of education also carries a cost. A country doesn't have to provide an extensive network of colleges or universities to benefit from education; it can provide basic literacy programs and still see economic improvements.

Countries with a greater portion of their population attending and graduating from schools see faster economic growth than countries with less-educated workers. As a result, many countries provide funding for primary and secondary education to improve economic performance. In this sense, education is an investment in human capital, similar to an investment in better equipment.

According to UNESCO and the United Nations Human Development Programme, the ratio of the number of children of official secondary school age enrolled in school to the number of children of official secondary school age in the population (referred to as the enrollment ratio), is higher in developed nations than it is in developing ones.

The enrollment ratio differs as a metric from calculating education spending as a percentage of GDP, which doesn't always correlate strongly with the level of education in a country's population. GDP is the Gross Domestic Product, which represents the output of goods and services for a nation. Therefore, a country spending a high proportion of its GDP on education doesn't necessarily ensure that the country's population is more educated.

For businesses, an employee's intellectual ability can be treated as an asset. This asset can be used to create products and services that can be sold. The more well-trained workers employed by a firm, the more that firm can theoretically produce. An economy in which employers treat education as an asset is often referred to as a knowledge-based economy.

Like any decision, investing in education involves an opportunity cost for the worker. Hours spent in the classroom means less time working and earning income. Employers, however, pay more wages when the tasks required to complete a job require a higher level of education. As a result, although an employee's income might be lower in the short-term to become educated, wages will likely be higher in the future, once the training is complete.

Cobweb Model

The Cobweb Model helps to explain the effects of workers learning new skills. The model shows how wages fluctuate as workers learn a new skill, but also how the supply of workers is impacted over time.

The model shows that as workers learn a new skill, higher wages occur in the short-run. However, as more workers get trained over time and enter the workforce, to chase the higher wages, the supply of workers increases. The result is lower wages due to the excess supply of workers. As wages fall, fewer workers are interested in the job leading to a reduction in the supply of workers. The cycle begins again with training more workers and increasing their wages in the short run.

Since training and education take time to complete, shifts in the demand for particular types of employees have different effects in the long and short term. Economists demonstrate this shift using a cobweb model of labor supply and labor demand. In this model, the supply of labor is analyzed over the long term, but the shifts in demand and wages are viewed in the short term as they move toward a long-term equilibrium.

Cobweb model one
Image by Julie Bang © Investopedia 2019

Figure 1: Short-term shifts in demand and wage rate

In the short-run, the increase in demand for better-trained workers results in an increase in wages above the equilibrium level (graph A). We can see the shift in increased demand (D2) and where it intersects W2 representing the increased wages. However, L, which represents the short-term labor curve, also intersects W2 and D2.

Instead of the increase in wages being along the long-run labor supply curve (S), it's along the more inelastic short-run labor supply curve (L). The short-run curve is more inelastic because there is a limited number of workers who have or are able to immediately train for the new skill set. As more and more workers are trained (graph B), the supply of labor shifts right (L2) and moves along the long-run labor supply curve (S).

Cobweb model two
Image by Julie Bang © Investopedia 2019

Figure 2: New workers' effect on wage rates.

With the increase in the availability of new workers, there is downward pressure on the wage rate, which falls from W2 to W3 (graph C).

Cobweb model three
Image by Julie Bang © Investopedia 2019

Figure 3: New wage equilibrium is established

Because of the falling wage rate, fewer workers are interested in training for the skills demanded by employers. As a result, wages rise (up to W4), although the increase in wages is coming in smaller and smaller increments. This cycle of wage increases and labor increases continues until it has reached equilibrium: the original upward shift in demand meets the long-run supply of labor (graph F).

The Bottom Line

The knowledge and skills of workers available in the labor supply is a key factor in determining both business and economic growth. Economies with a significant supply of skilled labor, brought on through formal education, as well as vocational training, are often able to capitalize on this through the development of more value-added industries, such as high-tech manufacturing.