Monday, July 29, 2013

Brian Tamanaha’s Straw Men (Part 4): We would have to be off by 85 percent for our basic conclusion to be incorrect


Brian Tamanaha’s latest blog post has been hailed by Stephen Diamond and others as a major concession.  But in a comment below the post, Tamanaha explains to one of his followers:

 “I believe the doubts I raised about the study in my previous three posts have not been answered satisfactorily.”

We therefore continue our response to Tamanaha’s first three posts before addressing Tamanaha’s fourth post.

BT Claim 4:  Historical economic data tells us nothing about the future

"It is exeedingly rare to find reliably predictive 'historical norms' in the social sciences because social life is too complex and circumstances are constantly changing . . . S&M have produced a narrow, partial, time-bound study that has zero predictive relevance for anyone thinking about attending law school today." A proper study "may require data over several centuries."  

Response: We would have to be off by 85 percent for our basic conclusion to be incorrect

In finance, valuation entails using historical data to establish a baseline scenario.  This baseline is generally viewed as the center of a distribution of possible future outcomes.  The baseline can be modified to construct upside and downside scenarios to get a sense of what could happen if the future is better or worse than the past.  Scenario analysis can help understand how robust the findings are--that is, how much the future would need to deviate from the past to change the basic directional conclusion of the valuation analysis.  For the extreme downside, this is sometimes called "break-even analysis."

For general background focused on the corporate context, I recommend Tim Koller, Marc Goedhart & David Wessel, McKinsey, Valuation: Measuring and Managing the Value of Companies (4th Edition), and Brealey, Myers & Allen, Principles of Corporate Finance.

We estimate the present value of a law degree at the median as $610,000 as of the start of law school.  This figure is pre-tax and pre-tuition, but includes opportunity costs and financing costs. 

In other words, some combination of the student and the federal government could pay up to $610,000 for the law degree and break even.  The government might contribute to the cost through debt forgiveness through Income Based Repayment, or through some other method.

As we note in the paper, ABA data suggest that the typical tuition cost for law school, less scholarships and grants, is roughly around $30,000 per year.  Spread over 3 years, and assuming tuition rises 6 percent per year nominal (i.e., at our discount rate), this comes to $90,000 in present value terms as of the start of law school.

For law school to cease to be a value-creating investment for the majority of law students, the present value of the lifetime earnings premium would have to fall to below $90,000—a drop of 85 percent.

At the “25th percentile” (more like the 15th because of regression to the median), toward the bottom of the distribution, the law school earnings premium is $350,000.  Assuming tuition (less scholarships and grants) remains at $30,000, the 25th percentile premium would need to fall by 74 percent for a law degree to no longer be value-creating proposition toward the bottom of the distribution.  At the mean, we’d have to be off by 91 percent.

These would be extreme deviations from the pattern seen in 1996-2011.

Guest Blogger: Michael Simkovic, Legal Profession, Science, Weblogs | Permalink