Why Does Education Increase Earnings? (Michael Simkovic)

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.