ECON 139 SP 15 Antonovics 7 5 12 15 1 May 12th 2015 Do Workers Maximize Lifetime Earnings If we solve the ability bias problem we can learn the return to schooling on average by how much do earnings increase when schooling increases by 1 year However this doesn t tell us whether any given individual s choices are optimal because of selection bias The idea of selection bias is that there is heterogeneity in the returns to a college degree And it s never possible to observe an individual s returns since you never observe what he she would have earned if he she had made a different education choice Selection Bias For example suppose ability is multidimensional Paul is a good plumber but would make a lousy manager Marvin is a good manager but would make a lousy plumber You need a college degree to be a manager but not a plumber Suppose that Marvin goes to college but Paul does not Did they each make the right educational choice Page 1 of 16 Observed college wage differential WM WP Understates wage gain for Marvin Overstates wage gain for Paul Both may be making the right schooling choice but it s hard to know using the observed college wage differential In the model we just examined workers who were relatively good at one type of job were relatively bad at the other type of job Contrast this with ability bias in which ability is one dimensional Empirical work that attempts to correct for selection bias tends to find that people do make the right educational decisions Social Standpoint How much education is optimal from a social standpoint Concern motivated by 3 observations 1 American workers are facing increasing competition from workers in other countries 2 New technologies have increased the demand for workers with high levels of cognitive ability 3 Although Americans spend as much per pupil as other industrialized countries on education American students consistently score below students in other countries Why Does Schooling Increase Wages Two main theories 1 Human capital theory individuals acquire valuable human capital at school Acquire useful skills at school 2 Signaling theory schooling signals to employers that workers are more productive Employers need to know you are hardworking and determined prove to the employers that you are able to suffer the 4 years in college Page 2 of 16 However if it comes to what the government subsidy had helped think of the first theory The Signaling Model Spence Two types of workers High ability workers MP 2 Low ability workers MP 1 High ability worker twice productive than low ability workers Employers cannot observe worker s type Education is less costly for high ability workers High ability workers c e 2 Low ability workers c e High ability worker twice less costly than low ability workers Let PVE denote the present discounted value of a worker s future earnings In a perfectly competitive market PVE equals the present discounted value of a worker s marginal product PVEH 2PVEL Spence Model Now suppose that the firms implement the following policy If e e then pay the worker a wage of 2 as high ability worker If e e then pay the worker a wage of 1 as low ability worker There s no point for workers in getting schooling between 0 e because you end up getting 1 anyways So either pick 0 or e Page 3 of 16 Note that both high types and low types are being paid the present discounted value of their marginal product 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 Any e separating two types of workers Summary of Key Features of Spence Model 1 Individuals have different innate levels of productivity 2 Firms will want to pay workers their marginal productivity but cannot observe productivity Crucial 3 Low ability workers find it more costly to invest than high ability workers Crucial Page 4 of 16 4 Firm to set up menus of wage and education combinations such that they are able to sort out which workers are high ability and which workers are low ability Thus education increases wages because education serves as a signal of ability rather than actually increasing ability Empirical Evidence on Human Capital vs Signaling Empirical evidence confirms that both components are important The debate is over how important Some Empirical Facts The wages of college dropouts are approximately equal to the 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 doesn t matter From a social standpoint it does Subsidizing college education may not be worthwhile if signaling strong 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 Line up with Mince Model earning increases even after people finish college Page 5 of 16 On the Job Training General training training that s useful in many firms Typing taking blood pressure making hamburgers operating a forklift Firm specific training training that s useful in only one firm Specific firm specific software understanding particular administration policies Profit maximizing condition with two periods of employment Present discounted cost of hiring a worker has to be equal to the present discounted value of the benefit of hiring a worker TC1 TC2 1 r VMP1 VMP2 1 r If training takes place in the first period of employment then W1 H W2 1 r VMP1 VMP2 1 r VMP1 VMP2 training increases productivity Is Training Worthwhile Training is worthwhile as long as the cost of the training is less than the present discounted benefit of the training VMP1 VMP2 H Who Pays for Training The worker pays if the worker is getting paid less than his or her VMP W1 VMP1 The firm pays if the wage rate plus the cost of training exceeds the VMP W1 VMP1 H Page 6 of 16 Workers and firms can simultaneously pay for training VMP1 H W1 VMP1 Who Pays for General Training General training increases productivity The worker is more productive in other firms And firms must pay workers what other firms are willing to pay them Thus after training w2 VMP2 We know that Cancel out W2 1 r VMP2 1 r Thus w1 VMP1 H Worker s wage decreased by full cost of training Workers pay for all of the training Prediction workers pay