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Applying Economic Analysis to Decision-Making in Schools

Reallocation of Existing Resources, Incentives, Venture Capital (Equity), Market Approaches

In the 1999 through 2000 school year, spending for all levels of education amounted to $646.8 billion. According to the National Center for Education Statistics, of this total, $389 billion was spent for K–12 education and the remaining $257.8 billion was expended by postsecondary institutions. Despite the substantial financial commitment to education, the impact of economics on the way educational institutions allocate and use their resources has been remarkably limited. Economics is concerned with obtaining the best possible outcome from a limited budget, and thus seems an ideal approach for dealing with how to allocate resources within schools. Although economists are beginning to analyze educational problems in increasing numbers, they have yet to make major inroads in improving educational productivity. This article describes ways in which economic analysis could be used to improve decision-making in educational institutions, and to inform the allocation and use of educational resources.

Even though virtually all educators believe that additional resources will lead to higher student performance, it remains unclear how best to spend dollars to achieve that goal. As a result, demands for more money, absent a well-reasoned description of how the money will be used, does not build confidence that money–by itself–will make a difference.

Researchers have used production functions–a statistical approach linking outcomes with specific inputs–to understand how money matters. To date, this research has been inconclusive with some arguing that money matters and others suggesting a systematic link between higher levels of resources and more money does not appear to exist. This stems in part from disagreement over the proper outcome of schooling.

Traditional allocation tools like cost–benefit analysis are infrequently applied in educational settings due largely to the difficulty of placing a monetary value on the outcomes or benefits of education. Henry M. Levin and Patrick McEwan suggest that linking costs to some measure of performance, or effectiveness, is a better approach for education. Under this model, the cost per unit gain of achievement is estimated so that programs that are more efficient, or cost effective, can be identified and chosen.

Eric Hanushek argues that the proper incentives for better performance and efficient use of educational resources are not in place, and that holding schools accountable for student performance is essential to use more effectively existing and new money. Improvement of student performance, with or without new funds, requires improved decisionmaking in the following four areas.

  • Reallocation of existing resources
  • Incentives for improved performance
  • Development of the concept of venture capital for schools and school systems
  • A more market-based budgeting environment

Reallocation of Existing Resources

Regardless of what impact additional funds might have, it is important that existing resources be used as efficiently as possible. In many districts it may be possible to reduce class size through different assignments of teachers throughout the district. To the extent that smaller class size improves student performance, these changes would offer an improvement in student performance at little or no cost.

Before seeking additional funds, schools may investigate other ways to restructure what is done with current funds. Allan Odden and Carolyn Busch argue that schools can find additional resources through a combination of creative use of categorical funds, elimination of classroom aides, and reallocation of resources, such as the elimination of one or two teaching positions. Although some of these options may result in larger classes, or fewer teachers, the more intensive use of staff and greater professional development activities available have resulted in improved student performance in many of the schools that have adopted this approach.


The use of incentives to encourage schools or school districts to allocate resources in ways that lead to improved student performance is not a new idea. Unfortunately, the incentives that seem to have the most success have been sanctions. Schools faced with threats of intervention often act quickly to improve performance rather than risk the stigma of a sanction. Conversely, many positive incentives have been less successful. For example, high-performing schools are often granted waivers from state regulation in exchange for success. In this case, the regulatory system loosened constraints that may have made the organization successful. Perhaps the more appropriate incentive would be to provide such waivers to under-performing schools with the hope that increased flexibility would lead to improvements.

Hanushek argues that the incentives currently in place in schools do not encourage teachers to work towards improving student performance and therefore need to be changed. He suggests that there is not sufficient awareness of positive performance incentives, and that more experimentation and research is needed.

Venture Capital (Equity)

One problem of education in the early twenty-first century is that once funds are appropriated to a school or program, they become the possession of that entity. In a study of the costs of implementing California's "Caught in the Middle" reforms for middle schools, published in 1992, David Marsh and Jennifer Sevilla found that the annual costs of restructuring schools to meet the requirements of this program were between 3 and 6 percent higher than current average expenditures per pupil in California schools. However, they also concluded that the first year start-up costs amounted to approximately 25 percent of annual costs. The problem schools face is finding those start-up funds. Often such funds are not available for all schools in a district, and schools receiving such funds treat them as a continuous source of revenue. Yet if such funds were rotated among schools, it would be possible to institute new programs in all schools over a few years.

Related to the concept of venture capital is the concept of revolving funds. This notion offers a way for school districts to deal with large purchases, like computers, that occur on a regular but nonannual basis. Budget procedures in school districts do not reward schools for saving resources in one year to make large purchases the next year. A school that receives a sum of discretionary money in one year is likely to lose any of the funds it has not expended by the end of the fiscal year. As a result, schools are often unable to make a large coordinated purchase.

A solution to this would be a revolving fund in the district to pay for such purchases. Schools would receive large appropriations of funds for such purchases once every few years. Finding a way to use the money in a revolving fashion would facilitate continued improvements in educational programs. The major problem is determining who gets the venture capital funds first and who has to wait. In many large districts, the superintendent publishes lists of the best- and worst-performing schools, and such lists could be used to prioritize the allocation of these funds. Another issue is the equity of the distribution. Although some schools will get more funds one year than others, over the established time period, all schools will receive an equal amount–one simply has to accept the idea that equity is measured over some time frame, and not on an annual basis.

Market Approaches

Many reformers call for market-based changes in the organization of schools. There are many ways to introduce the market into the educational arena, but most of these fall under the heading of school choice. Public school choice can be considered as either an intradistrict or interdistrict choice, and these can be broken down further into the various types of programs in each category. Two other types of choice involve the blurring of the line between public and private education: private school vouchers and privatization of former public schools.

Intradistrict choice programs, by definition confined to one school district, grew largely out of an attempt to desegregate schools, rather than to provide competition or parent choice. The first of these programs is called controlled choice, where districts created models for assigning students to schools outside of the traditional neighborhood school model as a way of reducing segregation. A second type of intradistrict choice program is the magnet school. Magnet schools were designed to attract white students to schools with high minority populations, often located in heavily minority communities.

The newest model of intradistrict choice is the charter school. With the development of the charter school, the purpose of the choice models shifted away from desegregation to a focus on providing parents with the choice to send their children to schools that may be less regulated than their traditional neighborhood school. These schools operate under a charter between those who organize the school (typically teachers and parents) and a sponsor (typically the local school board or state board of education).

Interdistrict choice programs allow the transfer of students between school districts. Although interdistrict choice programs also grew out of attempts to desegregate, they always had the goal of increasing parental choice as well. Many states allow interdistrict choice through open enrollment policies, which vary from state to state; some states mandate that all districts have open enrollment while others allow districts to choose whether they wish to be open or closed.

Perhaps the most talked-about form of choice program is the voucher program. Voucher programs can be organized in different ways, but the basic idea is to give some children access to private schools by issuing vouchers to their families, which the families then give to the school in lieu of a tuition payment. Often these programs have the intention of allowing low-income students to go to schools they could not otherwise afford to attend, although vouchers are not necessarily limited to those in poverty.

A final market-based approach is the privatization of schools that were formerly public. This is also a relatively new approach, and one that arose largely out of a demand for strategies that could save failing schools. The argument is that if public education functions like a monopoly (a firm that has control over its price and product) because it is not subject to competition, it has little incentive to function efficiently. By introducing some competition through privatization, schools would be forced to provide higher-quality education at a lower price.

Recent efforts to collect resource data at the school site and even student level may lead to enhanced knowledge of how resources impact student outcomes. To the extent that such knowledge is applied to decisions about how schools are operated, the long-term impact may be improved educational productivity through enhanced and informed decision-making.


HANUSHEK, ERIC A. 1994. Making Schools Work: Improving Performance and Controlling Costs. Washington, DC: The Brookings Institution.

HANUSHEK, ERIC A. 1997. "Assessing the Effects of School Resources on Student Performance: An Update." Educational Evaluation and Policy Analysis 19 (2):141–164.

LEVIN, HENRY M., and MCEWAN, PATRICK. 2000. Cost Effectiveness Analysis: Methods and Applications. Thousand Oaks, CA: Sage.

MARSH, DAVID, and SEVILLA, JENNIFER. 1991. Goals and Costs of Middle School Reform. USC Center for Research on Education Finance Policy Brief. Los Angeles: University of Southern California, Center for Research on Education Finance.

ODDEN, ALLAN, and BUSCH, CAROLYN. 1998. Financing Schools for High Performance. San Francisco: Jossey-Bass.


NATIONAL CENTER FOR EDUCATION STATISTICS. 2001. "Digest of Education Statistics: Table 31." <http://nces.ed.gov/pubs2001/digest/dt031.html>.


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