Education and Borrowing Constraints: An Analysis of Alternative Allocation Systems

This paper compares the allocative properties of markets and exams in an environment in which students di¤er in wealth and ability and schools di¤er in quality. In the presence of borrowing constraints, exams are shown to dominate markets in terms of matching e¢ ciency. Whether aggregate consumption is greater under exams than under markets depends on the power of the exam technology; for a su¢ ciently powerful test, exams dominate markets in terms of aggregate consumption as well. The e¤ects of income taxation are analyzed and the optimal allocation scheme when wealth is observable is derived. The latter consists of allowing markets to set school prices but having the government allocate fellowships based both on …nancial need and exam score. I wish to thank Sherwin Rosen, Jonathan Portes, Paulo Medas, Jordi Gali, Alberto Bisin, for useful comments on a much earlier version of this paper as well as seminar participants at Princeton University, University of British Columbia, and the Board of Governors of the Federal Reserve. I am grateful to the NSF and to the C.V. Starr Center for Applied Economics for …nancial support. JEL Classi…cation Nos.: D52, E44, J41