Why Does Schooling Increase Wages

1
Why Does Schooling Increase Wages?

• Two main theories
• Human capital theory individuals acquire
  valuable human capital at school.
• Signaling theory schooling signals to employers
  that workers are more productive.

2
The Signaling Model (Spence)

• Two types of workers
• High ability types MP2
• Low ability types MP1
• Employers cannot observe workers type.
• Education is less costly for high types
• High ability types ce/2
• Low ability types ce
• Let PVE denote the present discounted value of a
  workers earnings.
• In a perfectly competitive market, PVE equals the
  present discounted value of a workers marginal
  product.
• PVEH2PVEL

3
Spence Model, Continued

• Now suppose that the firms implement the
  following policy
• If egte then pay the worker according to PVEH
• If elte then pay the worker according to PVEL

High ability types benefit of e

• High types get e years.
• Low types get zero years

Low ability types benefit of e
PVE
e
PVEH
e/2
Benefit from no schooling
PVEL
Years of schooling
e
4
Spence Model, Continued

• Note that both high types and low types are being
  paid the present discounted value of their
  marginal product.

Firms are able to use educational requirements to
distinguish between high ability workers and low
ability workers.
PVE
Low types
High types
PVEH
e/2
PVEL
Years of schooling
e
5
Spence Model, Continued
What is the minimum level of schooling that will
separate the high types from the low types? If e
drops below e both types will invest.
PVE
Low types benefit
e
Low type indifferent between e and zero years of
education.
PVEH
e/2
PVEL
Years of schooling
e
e
6
Summary of Key Features of Spence Model

• Individuals have different innate levels of
  productivity.
• Firms will want to pay workers their marginal
  productivity, but cannot observe productivity.
  Crucial.
• Low ability types find it more costly to invest
  than high ability types. Crucial.
• Firm to set up menus of wage and education
  combinations such that they are able to sort out
  which workers are qualified and which workers are
  not qualified.
• Thus, education increases wages because education
  serves as a signal of ability rather than
  actually increasing ability.

7
Empirical Evidence on Human Capital vs. Signaling

• Empirical evidence confirms that both components
  are important.
• The debate is over how important.
• Some Empirical Facts
• Wages of college dropout approximately equal to
  wages of high school graduates. Supports
  signaling.
• College seems like a very costly way to get a
  signal of ability. Supports human capital
  theory.
• Why do we care?
• From an individual standpoint, it doesnt matter.
• From a social standpoint it does.
• Subsidizing college education may not be
  worthwhile if signaling strong.

8
Sample Problem

• Suppose that there are two types of people
• Over-achievers
• Slackers
• Suppose a firm pays workers such that the PDV of
  their lifetime earnings is 12 if workers have at
  least 6 years of schooling, and 8 to all other
  workers.
• Will the firms wage policy enable it to
  distinguish between workers?
• Over-achievers
• PDV if 6 years school
• PDV if no school
• Slackers
• PDV if y years school
• PDV if no school
• Relationship between schooling and wages 0 years
  -- 8, 6 years -- 12.

9
Post School Human Capital Investments

• Basic Patterns in the data
• Highly educated workers earn more than less
  educated workers.
• Earnings rise with age but at a decreasing rate.
• The age-earnings profiles of different education
  groups diverge over time.
• Earnings increase faster for educated groups.

10
Age-Earnings Profiles
11
Age-Earnings Profiles
12
On-the-Job Training

• Two types
• General training
• Firm-specific training
• Definition of terms

13
On-the-Job Training

• Profit maximizing condition with two periods of
  employment
• Present discounted cost associated with hiring a
  worker has to be equal to the present discounted
  value of the benefit associated with hiring a
  worker.

• If training takes place in the first period of
  employment then

14
Who Pays for Training?

• The worker pays if the worker is getting paid
  less than his or her VMP.
• The firm pays if the wage rate plus the cost of
  training exceeds the VMP.
• Workers and firms can simultaneously pay for
  training.

15
Who Pays for General Training?

• General training increases productivity from VMP1
  to VMP2.
• The worker is more productive in other firms as
  well.
• Thus, after training, w2VMP2.
• Since we know that

• We know that w1VMP1-H
• Workers wage decreased by full cost of training.
  
• Workers pay for all of the training.
• Prediction

16
Who Pays for Firm-Specific Training?

• Suppose workers bear the full cost of the
  training.

• Risky for the worker because no guarantee that
  the firm will hire the worker after the training
  period ends (and the training is of no use at
  other firms).
• Workers will never agree to this arrangement.

17
Who Pays for Firm Specific Training?

• Suppose firms bear the full cost of the training.

• Risky for the firm because firm must recoup
  training costs later but if worker quits, then
  firm suffers a loss.
• Firms will never agree to this arrangement.

18
Who Pays for Firm Specific Training?

• Suppose firms and workers both bear the cost of
  training.

• Workers have no incentive to quit because they
  are paid more than they would be paid elsewhere.
• Firms have no incentive to fire workers because
  they are paying workers less than their VMP in
  the second period.

19
Picture of Wage Profile
20
Implications of On-the-Job Training

• Layoffs, training, and productivity
• Firms will be more reluctant to lay off workers
  who have received training investments paid for
  by the firm.

21
Implications of On-the-Job Training

• Layoffs, training, and productivity
• Less fluctuation in employment over the course of
  the business cycle in those labor markets in
  which there is a relatively high level of
  firm-specific training.
• This results in a reduction in labor productivity
  during a recession (since employment changes by a
  smaller percentage than does output), but higher
  productivity during periods of economic
  expansion.

22
Implications of On-the-Job Training

• Minimum wages
• Increases in the minimum wage may reduce the
  amount of training that occurs.
• The minimum wage sets a floor on this wage that
  limits the ability of workers to bear the costs
  of such training by accepting a lower wage.

23
On-the-Job Training and the Age-Earnings Profile

• Efficiency unit
• Standardized such that productivity is directly
  proportional to the number of efficiency units a
  person has.
• Twice as many efficiency units means twice as
  productive.
• Let R denote the rate of return on an efficiency
  unit of human capital.
• Marginal revenue from acquiring an efficiency
  unit at age 20

• Marginal revenue from acquiring an efficiency
  unit at age 30

24
Optimal Human Capital Investment
Dollars
MC
MR20
MR30
Efficiency Units
Q20
Q30
Workers will optimally choose to acquire less
human capital as they age.
25
Age-Earnings Profile
Dollars
Age-Earnings Profile
Age
26
Social Experiments and On-the-Job Training

• How do you evaluate the effectiveness of job
  training programs when participants self-select
  into programs?
• Only those who have the most to gain will enter
  into the program.
• National Supported Work (NSW) demonstration.
• Designed to help disadvantaged workers lacking
  basic job skills.
• Gave workers
• Those who entered the program received between 9
  to 18 months of training.
• Unlike other government programs,
• MDRC (Manpower Demonstration Research
  Corporation) collected earnings and demographic
  data for both the group that received the
  training and the group that did not. Data were
  collected both before and after the training
  period

27
NSW Continued
1998 Dollars
The average cost of the program per participant
was about 12,500. This, suggests that it would
take at least 10 years for the program benefits
to outweigh the program costs.
28
Potential Problems with Social Experiments

• Those who were randomized out of the program
• Those who were randomized into the program
• Only people who were interested in participating
  volunteeredyou still have self-selection.
• 1,400 gain may not necessarily be the gain that
  low-skill workers would receive if the program
  were administered to a larger fraction of the
  population.