June 22, 2015
Here. The two most concrete proposals are to mandate enhanced financial counseling for prospective students, to be sure they understand federal loan programs and their options; and to mandate greater disclosure of law school finances, including tuition discounting. I was also pleased to see on p. 22 that evidence triumphed over anecdote and ideology when, citing the work of Simkovic and McIntyre, the Report notes that, "Despite the cost, the best available evidence suggests a significant lifetime income premium for those with a law degree compared to those with a bachelor’s degree."
June 18, 2015
A number of recent analyses purporting to show the negative effects of student loans compare group A, which has student loans and a bachelor’s degree to group B, which has the same level of education but no student loans (see here for an example). Not surprisingly, the studies find that the folks who have a college degree but no student loans are doing better on a variety of measures. Unfortunately, many of the studies improperly conclude that student loans are causing the bad outcomes.
The problem is that the likely alternative to student loans and a college degree for people who need to borrow to afford college is not a free college degree. The likely alternative is no college degree and no student loans—i.e., lower earnings, and eventually, a lower net worth.
Among those who will eventually graduate from college, those who will graduate with no student loans are very different from those who will graduate with student loans. These differences are present before they even set foot on campus.
Why do some people graduate from college with no debt?
1) Their parents are rich and pay for college—and most likely provide additional financial support after college
2) Their parents are not rich but are extremely devoted to their children’s education and find a way to pay for college—and most likely provide additional support after college
3) The students are exceptionally talented academically, athletically, or artistically and obtain large scholarships
4) The students are unusually hard working and market savvy and find a way to earn a lot of money while in college
5) The students live in a wealthy city or state that generously funds public services such as higher education, and probably also funds other public investments (Note that most public colleges are not generously funded and have lower completion rates than resource-rich private colleges).
These “student loan studies” are not studies of the effects of student loans. They are studies that find that people who are more talented, harder working, come from wealthier and more supportive families, and live in richer communities with more enlightened governments are more successful. This is neither surprising, nor is it relevant to student loan policy.
Eliminating student loans won’t magically give everyone rich, devoted parents, boost students’ intellectual, athletic, or artistic abilities, or turn the least developed and most mismanaged parts of the U.S. into centers of economic activity and paragons of efficient public administration.
Criticisms of student loans seem to be motivated by an idealized conception of public, taxpayer funded higher education. In practice, these systems are too often characterized by weak, underfunded institutions, misguided political interference (for an example of left-wing interference, see here; for right wing interference, see here, here, and here) and micro-management (here and here) by political leaders , price controls (here and here, and here), disruptive budgetary uncertainty (here, here and here), and resulting shortages (here, here, here, here, and here).
This does not mean that we should abandon the goal of a well-funded public higher education system where academic freedom is protected, but it would be imprudent to put all of our eggs in a single basket, particularly one that political leaders frequently raid to close budget gaps.
Scaling back student loans will undermine investment in higher education, to our collective detriment. Without access to credit, students from modest backgrounds will too often be trapped in the under-resourced institutions that our tax-adverse political systems is willing to support (or denied access altogether because of enrollment caps) instead of at least having the option to pursue the higher quality education that is ultimately in their best interests.
June 16, 2015
So how should our understanding of student loans apply to law students? Mortgages are routinely repaid over 30-years, even though owner-occupied housing is close to pure consumption (most of the value of housing is consumed as imputed rental income, with appreciation averaging only around 1 percent above inflation). Legal education typically provides a much higher rate of return than real estate, and is probably closer to investment than consumption.
Rather than focus on initial salaries at graduation alongside student loan balances, it would be more appropriate to emphasize student loan debt service payments, assuming students pay their loans over several decades and with payments that match the expected trajectory of earnings. This would be an apples-to-apples comparison—initial cash flows compared to initial cash flows.*
It also makes sense to report student loan payments in real terms by subtracting expected inflation (typically around 3 percent) from the nominal interest rate before calculating loan payments.** (As inflation increases wages and the prices of goods and services, a nominally flat debt payment becomes less valuable in terms of what the money can buy and how much work is necessary to earn enough to make the payment). Adjusting for inflation won’t take into account the increase in real earnings (above and beyond inflation) that typically comes with additional work experience and secular increases in economy-wide productivity, but at least takes into account increases in earnings that match inflation.
$100,000 in debt repaid in equal installments monthly over 30 years at a 3 percent real interest rate (6 percent nominal) comes to $5,059 per year ($422 per month) in real terms. In nominal terms (without adjusting for the power of inflation to make debts easier to repay), the payments are $7,200 per year ($600 per month).
With a graduated extended repayment plan over 25 years, the real initial monthly payments come to $3,420 per year ($285 per month). In nominal terms (without adjusting for the power of inflation to make debts easier to repay), the initial payment is around $6,000 per year or $500 per month.
Law graduates typically earn around $60,000 to $75,000 per year to start and have debt service payments of around $3,400 to $7,200 per year. Recent law graduates have much more cash at their disposal than most bachelor’s degree holders of a similar age even after paying down their loans.
Law students’ incomes can support their debt service payments, as demonstrated by the exceedingly low student loan default rates for recent law graduates. It is time for the ABA to rethink how law schools disclose debt balances and student loan repayment obligations so that students are not mislead into underinvesting in education.
Journalists and education experts should also be careful to discuss student loans using apples-to-apples comparison—cash flows to cash flows, and lifetime present values to lifetime present values.
* If student loan balances or initial cost of education are presented, these should be compared to the expected present value of the boost to earnings from the degree over the course of a lifetime. Thus, for example, whenever reporting that law school costs around $100,000 on average, it should also be reported that the average value before taxes and tuition is around $1,000,000 and that the median value is around $750,000.
** Part of what graduated loan repayments accomplishes is to make real payments closer to level. If nominal payments remain flat, as in standard fixed repayment loans, in real terms, payments decline over time and repayment of the loan is front-loaded.
Tom Friedman's latest New York Times column uses the labor market for executive assistants and executive secretaries to illustrate dubious claims about credentialing and over-education. Friedman argues that since most current executive assistants and executive secretaries don't have bachelor's degrees, employers should not try to upgrade the workforce by hiring new executive assistants and secretaries with bachelor's degrees. After all, executive assistants without bachelor's degrees can do the job, so who needs a bachelor's degree?
The problems with this reasoning should be obvious.
First, education is only one of many factors that are valued in the labor market. Some individuals who are smart, hardworking, personable, physically attractive, or fortunate, but have limited education, will inevitably be as successful or more successful than other individuals who are highly educated but less gifted in other respects. This does not in any way challenge the extremely strong evidence that a bachelor's degree can improve labor market outcomes. It simply means that we are dealing with a heterogeneous population.
If two homogenous groups who were initially equally strong on non-education factors were given different amounts of education, the more educated group would typically be more successful in the labor market. Labor economists who have studied identical twins routinely find that twins with more education are more successful than their less educated counterparts. When labor economists control for unobserved heterogeneity within education levels using fixed effects models rather than OLS regression, "over-education" effects on earnings diminish or disappear. In other words, highly educated folks who are about as successful as those with less education--and end up in the same occupations as the less educated--tend to be weak on factors other than level of education. But even within occupations that combine the worst of the more-educated with the best of the less-educated, those who are more educated still tend to earn more. Since profit-maximizing employers are not in the habit of handing out money for nothing, this suggests that the more educated are better at their jobs.
In sum, education many not always be enough to make you more successful than your neighbor or coworker, but it can make you more successful than a less educated version of yourself.
Second, the fact that something was "good enough" at some point in the past does not mean it is good enough today. Rising standards typically involve both increases in quality and commensurate increases in cost. In inflation adjusted terms, the average new car today costs about 10 times as much as a Ford Model-T in the late 1920s. But the average new car is faster, safer, more reliable, and easier to operate. Similarly, as education increases, so does the productivity of labor and the cost of labor--wages or earnings. Highly educated workers today are far more productive than their counterparts decades ago, and as a result, they earn more.
It is interesting that Friedman chose executive assistants and executive secretaries--a field where most workers have less than a bachelor's degree--as an example of supposed "over-education." According to the Bureau of Labor Statistics Occupational Employment Statistics, employment of executive assistants and executive secretaries is collapsing. Employment fell by more than half between 2007 and 2014, from over 1,500,000 workers to barely more than 700,000. In other words, the level of education that most executive assistants and secretaries had in 2007 was not enough to make it in the labor market of 2014.
Among secretaries, those with higher levels of education still earn more than their less educated counterparts after controlling for race. Employer hiring priorities cited by Friedman suggest that those who are more educated are more likely to keep their jobs or find new ones.
This is consistent with general trends in the labor market. Low and middle skill workers with limited educations are the hardest hit by automation, outsourcing and layoffs, while their more educated counterparts are navigating the recession and changes in the labor market more successfully. (During the 2007-2014 period, employment of a group of highly educated workers, lawyers--supposedly the victims of job-destroying structural change--continued to grow faster than overall employment).
For another angle on Friedman's column, readers may be interested in Frank Pasquale's critique. Pasquale discusses apparent bias in the New York Times' Higher Education coverage and argues that as newspapers struggle to adapt to a world replete with free online content and greater competition for advertising dollars, business priorities may be overriding traditional news values. Given the nearly 20 percent decline in employment for reporters and correspondents between 2007 and 2014, journalism does appear to be under serious financial pressure.
June 15, 2015
A shorthand approach sometimes used to compare the cost and benefits of higher education—comparing student loan balances at graduation to first year earnings—can be seriously misleading. The implication of this approach is that student loans have to be repaid in full shortly after graduation, and that graduates’ low initial earnings will persist for the rest of their lives.
This is an apples to oranges comparison. An investment in education pays dividends throughout one’s life. First-year earnings are one small, unrepresentative, slice of lifetime earnings. Comparing a lifetime investment to one year of expected returns on it feeds ignorance about how student loans and lifetime earnings actually work. It thus risks misleading prospective students into making financially disastrous decisions to underinvest in education.
Student loans are meant to solve a specific problem—the costs of education come as a series of large upfront payments for tuition and living expenses, while the benefits accrue later in life in the form of higher earnings. Except for the minority of students who are fortunate enough to have rich and generous parents who cover their tuition, students generally have two options—save or borrow.
Saving is inefficient because it requires students to work for many years with a lower level of education and for much lower wages, and to complete their degrees much later in life. Completing a given level of education earlier helps maximize the number of years of expected higher earnings with a higher level of education. Borrowing to invest in education is therefore more efficient than saving to invest in education. Some of the benefits of financing accrue to the student borrower in the form of higher lifetime earnings compared to saving, and some of the benefits accrue to the lender in the form of interest and fees. Another approach to financing higher education—more popular in Europe, Australia, and Canada than the United States—features higher public spending and higher tax burdens, sometimes with a tax-like percent-of-earnings fee explicitly tied to university education. The social democratic approach, like the U.S. approach, involves providing something of value up front in return for a fraction of graduates’ incomes later.
Student loans enable students to pay for their own education by converting the cash flows associated with investment in education from large upfront payments into a series of much smaller payments spread out over time. Ideally, these payments should closely match the timing of the benefits of education—that is, the timing of the boost to earnings from education.
Because the benefits of education accrue over the course of a career—perhaps 40 years or more—and earnings typically do not peak until middle age, the costs of education should ideally also be spread over a similar time frame.
The prospect of high payments needed to pay back loans very quickly ex-ante could cause prospective students to underinvest in education. As life expectancy and career length increase, so should initial investment in education.
If this goal of matching the timing of cash flows is accomplished, then at every point in time, with more education, students will have more cash at their disposal. The boost to earnings from education will more than cover student loan debt service payments, and the initial borrowing will enable students to maintain a decent lifestyle while pursuing studies instead of working full time. (For a discussion of the advantages of leveraged investments early in life, see Ayers & Naelbuff).
That is one important reason why federal student loans can be repaid over 25 to 30* years (so-called “extended” repayment). Plans are available under which monthly payments start low and increase over time to match the typical trajectory of lifetime earnings (“graduated” or “graduated extended” repayment), or in which payments dynamically adjust up and down with actual borrower earnings (if earnings fall below a certain level) to better match cash flows (“income-contingent” or “income-based” repayment).
Because these extended and income adjusted plans are better tailored to the purpose of student loans—matching positive and negative cash flows—one of these plans should be the default option for student borrowers instead of the now “standard” 10-year repayment period. 10-years to pay for an education that provides benefits over 40 years makes little sense. For law graduates, real earnings typically continue to grow for 30 years after graduation.
* Consolidated loans can be repaid over 30 years, but some consolidated loans may not be eligible for income based repayment plans.
Paying loans back slower typically will not affect the economic value of education, notwithstanding the fact that nominal interest payments will increase. Paying loans back faster or slower typically will not affect the economic value of education as long as two conditions are met:
- Interest rates remain unchanged regardless of whether a loan is repaid over 10 or 30 years (this is the case for federal student loans, but not for mortgages or most other debt instruments most of the time)
- The interest rate on student loans is appropriate, in that it matches up with default and loss risk levels for lenders, the opportunity cost of capital, and time preferences.
If condition 2 holds, then the interest rate will equal the discount rate which is used to convert cash flows occurring at different points in time into the same currency so that they can be compared. If the discount rate is 6 percent, then there is no valuation difference between paying $1,000 today or paying $1,060 one year from now, just as there is no difference between paying one U.S. Dollar or the equivalent in Euro cents. If students choose to refinance or pay their loans back faster than they are legally required to repay them, this suggests that the interest rate on student loans is too high.
June 12, 2015
The Department of Education has been overcharging low-risk professional school students for federal student loans (relative to the market rate) while keeping rates low for undergraduates who are far more likely to default. (For previous coverage, see here, here and here).
Bloomberg BNA's Bankruptcy Reporter describes the predictable consequences of this politically driven mispricing: Professional graduates are refinancing into less expensive private loans and removing themselves from the government's risk pool.
There is a simple solution that will shut down what Bloomberg describes as an "exodus of top borrowers" while preserving student lending profits for the benefit of taxpayers. The government should charge low risk graduate students less.
Update, June 13, 2015: Jordan Weissmann at Slate covers the story.
May 12, 2015
Law students are more likely than college students to retain competitive scholarships (Michael Simkovic)
Critics of competitive scholarships tied to GPA or class rank claim that these scholarships are especially troubling when used by law schools, because the mandatory grading curve means that more law students are likely to lose their scholarships than undergraduates. However, as I noted in my last post, the data actually shows that law students are more likely to retain their competitive scholarships than are undergraduates.
The remaining critiques of competitive scholarships are not strong. According to one critique, if competitive scholarships are disproportionately used by law schools who admit students with low LSAT scores and GPA and are not used by the elite law schools, this suggests something suspicious about these scholarships. Lower ranked law schools serve different student populations with spottier academic preparation who are at greater risk of failing the bar exam and may have worse study habits. Some policies and practices that are helpful to motivate this population and encourage greater study effort may not be necessary for higher ranked law schools, whose students are already highly motivated and can pass the bar exam and learn challenging material without much effort.
Another argument is that after law school critics and The New York Times attacked law school competitive scholarships, and the ABA responded by requiring disclosure of this practice, the number of law schools using competitive scholarships declined. Critics claim that the disclosure caused law schools to stop using competitive scholarships, thereby proving the scholarships were unethical all along.
But perhaps law schools were simply attempting to avoid criticism, whether merited or not. In other words, perhaps the criticism caused both the mandatory disclosure and the reduction in the use of competitive scholarships. If The New York Times quoted an impressive sounding source claiming that those who typically tie their left shoe before their right were liars and thieves, and the Justice Department disclosed an annual list of everyone who tied their left shoe first, we might find that the percent of people who tie their left shoe first would drop, notwithstanding the fact that which shoe you tie first has absolutely nothing to do with ethics. Or, as Matt Bruckner suggests, perhaps some other factor, such as changes in relative market power or law school budgets help explain the shift in financial aid policy and neither the criticism nor the disclosure had much to do with it. Without more sophisticated methods of causal inference, its premature to make strong causal claims.
May 10, 2015
Competitive Scholarships, Mandatory Courses, and the Costs and Benefits of Disclosure (Michael Simkovic)
There is a wide range of views about the benefits, costs, and appropriate use of conditional merit scholarships—scholarships that under their terms, will only be retained after the first year of law school if students maintain a minimum GPA or minimum class rank (if there is a mandatory grading curve, a minimum GPA effectively is a class rank requirement). These questions implicate both broad value judgments and also very specific empirical questions to which we many not have clear answers.
1) Is competition for grades a help or a hindrance to learning?
2) Is competition, with greater rewards for winners than for losers, inherently moral or immoral?
- Does the answer depend on whether the outcome of the competition is driven by luck, skill, or effort?
- Does the answer depend on how large the differences in rewards are between winners and losers?
3) Does disclosure alter student decision-making?
- If so, how?
- Is this a good thing or a bad thing?
- If it is a good thing do the benefits of disclosure outweigh the costs of providing disclosure?
- Are some ways of providing disclosure clearer and more meaningful than others? Could too much disclosure be overwhelming?
Disclosures are sometimes very effective at improving market efficiency. Sometimes disclosures appear to have no effect. Sometimes they have the opposite of the intended or expected effect. For example, disclosure of compensation of high level corporate executives of publicly traded companies may have contributed to an increase in executive pay (see also here.)
In the case of conditional merit scholarships, the direct administrative costs of providing disclosure appear minimal. The effects of such disclosure, if any, remain unknown. I support access to greater information about conditional scholarship retention rates, not only for law schools but also for all educational institutions.
Scholarship retention rates at many undergraduate institutions under government-backed programs appear to be lower than scholarship retention rates at most law schools. Around half of Georgia Hope Scholarship recipients lost their scholarship after the first year. Around 25 to 30 percent of Georgia Hope Scholarship recipients retained their scholarships for all four years of college. Nevertheless, conditional merit scholarships can have positive effects on undergraduate enrollment and academic performance. A fascinating randomized experiment by Angrist, Lang and Oreopolous found that financial incentives improved grades for women but not for men. A recent experiment also found evidence that merit scholarships tied to grades can increase student effort and academic performance at community colleges.
Unfortunately, there is some evidence that the use of merit scholarships tied to GPA by undergraduate institutions—where grade distributions and course workload vary widely by major—can reduce the likelihood that students complete their studies in science technology engineering and math (STEM) fields. Students who major in STEM fields have a higher chance of losing their scholarships
In other words, if students can shop for “easy As” rather than study harder to improve their performance, they can reduce their own future earning prospects. The approach law schools take—merit scholarships tied to mandatory grading curves and a required curriculum—may be better for students in the long run. Indeed, law students might benefit financially if additional courses, such as instruction in financial literacy, were mandatory.*
Greater disclosure of grading distributions may exacerbate grade shopping and grade inflation, which can undermine student effort and learning. Some models suggest that grade inflation is contagious across institutions (see also here). (It should be possible to disclose scholarship retention rates without disclosing grade distributions).
In some contexts, such as securities regulation or pharmaceuticals, disclosure requirements tend to be high. In other areas, such as employment contracts, disclosure tends to be more limited. We may not always get the balance right. These questions have lead to a rich research literature in law, economics, and psychology (see Bainbridge, Lang, Mathios, Coffee, Kaplow, Easterbrook and Fischel, Romano, and Schwartz). In all cases, whether and how disclosures alter behavior is an empirical question. How the benefits compare to the costs are empirical questions mixed with subjective value judgments.
Given the current limited state of knowledge, and good faith and understandable disagreements about subjective value differences, strident views on one side or another, and moral condemnations of those entertaining different viewpoints, are not appropriate.
Law professors have an obligation to teach students to think like lawyers, weigh evidence, and consider different arguments and different perspectives. We should not shut down discussion with swaggering declarations of the moral superiority of our own views or ad-hominem attacks against those with whom we disagree.
A recent post (in the comments) by Brian Tamanaha (or someone posting under his name and with a similar rhetorical style**) highlights the unfortunate tendency by some toward moral posturing. Tamanaha writes:
“[Those who condemn conditional scholarships are] speaking up for the integrity of legal academia. It is embarrassing that law professors would now rise up to defend employment reporting standards … criticized by outsiders (see New York Times "Bait and Switch" piece), practices which have since been repudiated and reformed by new ABA standards. I do not understand why Simkovic is re-raising these resolved issues, but it does not help us regain our collective credibility.
After reading these posts, I have begun to wonder whether a sense of professional responsibility is what separates the two sides in this discussion. It is not a coincidence that John Steele, [Bernard Burk], and others who strongly condemn these practices have taught legal ethics.”
In other words, if you question Brian Tamanaha’s reasoning and conclusions—as I have—then you have no integrity and dubious ethics, are irresponsible and unprofessional, and are an embarrassment to the legal academy.
Bernard Burk, though declaring his disdain for ad-hominem attacks, accuses those with whom he disagrees of being “partisan.” He compares competition for grades and scholarships to physically beating students. Burk compares law schools to gangsters and evil witches. He claims that the positive effects of conditional scholarships on student motivation and learning “smells of post-hoc rationalization.” (Most of the labor economics studies demonstrating positive effects of financial incentives on student performance were available before The New York Times and the law school critics targeted law school conditional scholarships; the critics overlooked the peer-reviewed literature).
Deborah Merritt, though generally providing an intelligent discussion of conditional scholarship issues, compares conditional scholarships in which adults who lose the competition for grades receive a free year of law school to the fictional “Hunger Games” in which children who lose a physical struggle are murdered. (Paul Caron repeats this unfortunate comparison when summarizing the debate; so does Bernard Burk).
Paul Campos compares those who disagree with him about data disclosure standards to “Holocaust deniers.”
Law school critics have not persisted through the force of argument or evidence, but rather through their ability to make an honest discussion of the issues so unpleasant that very few who disagree with them wish to engage. We should thank Professor Telman for his courage and for elevating the conversation from polemics to evidence-based inquiry. As more professors and journalists raise substantive questions about law school critics’ narrative, it will become increasingly difficult for the critics to foreclose factual and ethical inquiry through ad-hominem attacks and hyperbole.
* A recent survey by John Coates, Jessie Fried, and Kathryn Spier at Harvard suggests that large law firm employers believe instruction in certain technically challenging business electives, especially accounting, corporate finance, and corporations, is particularly valuable on the job. Data does not exist to evaluate whether enrollment in such courses actually boosts earnings or employment, or is even correlated with greater earnings or employment. However, one working hypothesis is that such courses might be the law school equivalent of undergraduate STEM or economics majors. A study of high school financial literacy mandates suggests positive long-term effects on enrollees’ financial well-being.
** The first and only time I met Brian Tamanaha in person was at the 2013 Law & Society meeting in Boston where he spoke on a panel. Professor Tamanaha shut down questions from the audience about whether his presentation of law school data was misleading by insisting that in our hearts surely we all knew he was right and that any question about whether he was wrong on the facts, and any attempt to rely on data rather than emotionally charged anecdotes, was a sign of flawed moral character.
May 10, 2015 in Guest Blogger: Michael Simkovic, Law in Cyberspace, Legal Profession, Ludicrous Hyperbole Watch, Of Academic Interest, Professional Advice, Science, Student Advice, Web/Tech, Weblogs | Permalink
May 07, 2015
One question in the labor economics literature is why education increases earnings. The dominant view is Human Capital Theory—education increases earnings by increasing productivity of educated workers. A minority view, signaling theory, holds that education increases earnings by revealing information about potential employees to employers and facilitating the employer-employee matching process, similar to marketing expenditures matching products with customers. In other words, education indicates to employers which employees were the best all along.
On some level, the distinction is irrelevant—from the perspective of potential students it does not really matter how education increases earnings, only that it does. Whether education makes workers more efficient individually or makes the economy in aggregate more efficient by moving workers to where they can do the most good does not change the fact that employers, employees, and the economy as a whole are better off with additional education as long as the marginal benefits of additional education exceed marginal costs.
Critics of higher education sometimes claim that there is over-investment in signaling and credentialing, a kind of arms race producing negative externalities in which the social returns to education are lower than the private returns. This view, though popular with political movements seeking to reduce public support for education, does not hold much sway in the modern peer-reviewed labor economics literature.
A recent literature review by Professors Fabian Lange at Yale and Robert Topel at the University of Chicago explains the problems with the view that employers would expend valuable resources paying a premium for employees who had over-invested in education as a signal of ability: “Employer learning about productivity occurs fairly quickly after labor market entry, implying that the signaling effects of schooling are small.”
In other words, employers can quickly and efficiently sort employees on their own by observing their productivity on the job, retaining and promoting strong performers, and terminating weaker employees. Employers do not need educational institutions to perform this task for them, nor are employers willing to pay premium wages for information they can more cheaply obtain themselves.
Suppose, for example, that the only value of a Harvard Law degree were as signal of ability to employers. Harvard admits students based almost exclusively on standardized test scores and undergraduate grades, which are also observable to employers. Almost everyone who is admitted to Harvard graduates.
A clever employer realizes it can save money by employing bachelor’s degree holders with admissions letters from Harvard, but who have not yet attended. Harvard gets wise and refuses to confirm admissions. Employers now look directly at LSATs and GPAs, and perhaps hire former admissions officers to consider softer factors. The employer and employee can effectively split the cost savings of not getting the Harvard degree and also the value of the time that would be spent in schooling instead of working.* If additional information is required, personality testing, assessments of physical and mental health, assessments of writing samples, background checks and the like can all be performed for a fraction of the cost and in a fraction of the time as a Harvard degree.
In spite of potentially massive efficiency gains and financial reward for employers and employees, this is not what actually happens in the real world (with the exception of a stacked "experiment" by Peter Thiel). Why not? Because employers believe that the schooling itself is valuable and makes employees more productive.
Lange and Topel also explain how “sheepskin effects” (disproportionately higher earnings premiums for college completers than for college dropouts with a few years of college) have been misinterpreted as support for the signaling hypothesis, when they actually reflect selection effects and dynamic decision making about educational investments:
"Diploma effects are often presented as evidence for screening theories of schooling. We disagree. Instead we view diploma effects as evidence that individuals face uncertainty about their individual returns to schooling and that this uncertainty is revealed as individuals acquire schooling. Those least capable to profit from schooling drop out before the completion of degree years. Those graduating exhibit larger returns than those who dropped out at lower levels of schooling. This reasoning was informally developed by Chiswick (1973). Since then, a number of authors (Altonji (1993), Heckman, Lochner and Todd (2003), Keane and Wolpin (1997) and Eckstein and Wolpin (1999)) examined different aspects of sequential schooling choice under uncertainty. We build a simple model in this spirit with the intention to show how individual’s schooling decisions can generate (large) diploma effects if individuals learn about their returns while in school."
There are additional problems with signaling theory, which I explained in Risk Based Student Loans:
“Signaling Theory implies that labor market outcomes should not depend on what students study, but only on how well they perform academically relative to other students with similar standardized test scores, or perhaps whether they demonstrate a strong work ethic by choosing a challenging major. Differences in earnings by field of study appear to reflect the value of field-specific skill development rather than differences in ability levels. Even within engineering, there are large starting wage differences by specialty.
Human Capital Theory also helps explain higher average per-capita productivity and wages in states and nations with higher levels of educational attainment. If education only sorted workers according to ability, it would presumably only increase the variance of wages (i.e., income inequality), while leaving the mean unaltered.
Further, Human Capital Theory helps explain the willingness of many employers to pay for professional degree programs for successful employees. Employers’ willingness to educate workers whom employers already know to be of high quality suggests that employers believe that professional education has skill-development value rather than mere sorting value.”
In The Knowledge Tax I expand on this, explaining the evidence linking investment in education to more rapid economic growth rather than merely redistributing income from the less educated to the more educated.
* Note that in many states, including New York and California which collectively comprise 28 percent of the law market, a law degree is not legally required to sit for the bar exam. Instead, “law office study”, or an apprenticeship under the supervision of an attorney, possibly following one year of law school, will suffice.