Why would family decisions regarding investments in education diverge from socially optimal allocations? One answer is that education is not a purely private good, in that there are benefits from schooling above and beyond those that accrue to students and their families. Education may promote social cohesion, reduce crime and welfare, foster a more active and productive democracy, and improve other factors for which the value to society exceeds the value to students. However, in the absence of government intervention, families would seek to maximize private welfare and would presumably consider only the private aspects of the return to schooling. This might lead to under investment in years of schooling or school quality, and perhaps more importantly, to under investment in the external benefits of schooling at the expense of factors more closely linked with private benefits.
A second source of market failure is inadequate information regarding school quality. Families, particularly immigrant families who face language barriers, may have a very difficult time sorting schools on the basis of quality. Of course schools produce a number of outcomes, and there is little agreement over how to separate the contributions of schools from the myriad other factors that affect achievement and other school products. Consequently, while information on test scores, absenteeism and other quality indicators can be disseminated, their association with actual differences in school effectiveness is often weak.
A third potential source of market failure is monopoly power. Consider a rural area in which there are only enough students to fill a single school. There is no reason to believe that a profit maximizing firm would provide an appropriate quality of schooling. In fact much criticism of public schools focuses on the problems created by their virtual monopoly in many areas(3).