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Misdiagnosing Externalities

Here’s a letter to Café patron:

Mr. Maes:

Thanks for pointing me to Oren Cass’s June 15th essay on worker training. You ask specifically what I think of this claim of his: “But firms will not sufficiently invest of their own accord in the training of their workers for the simple reason that it is the workers who ultimately capture the value of their skills in the form of higher productivity and wages (which we should want!), so public funds are needed.

This claim is quite common, but it has always struck me as deeply flawed. Those who offer it propose to cure a non-existent problem by creating a real one.

Employer provision of worker training is not, contrary to Oren’s argument, a positive externality. Oren himself inadvertently hints at this fact by correctly observing that workers “ultimately capture the value of their skills in the form of higher productivity and wages.” His use of the term “capture” is telling: workers who capture the value of their training have incentives to pay for it if no one else will. Precisely because the value of worker training belongs to workers and not to employers, workers have incentives to purchase optimal amounts of training by agreeing to work at wages lower than otherwise, and employers thus have incentives to supply such training.

In contrast, government creates an externality when it pays for worker training. By arranging for worker Jones’s training to be paid for by taxpayer Smith, government arranges for Jones to free ride on Smith. Government thus gives to Jones incentives to spend excessive amounts of Smith’s money. Under these circumstances, there’s every reason to believe that the value of Jones’s training will be less than the value that Smith loses as a result of Jones’s free-riding.

Asserting ‘market failure’ is too easy – and, thus, easily mistaken.

Donald J. Boudreaux
Professor of Economics
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA 22030