Dig Baton Rouge

The Signaling and the Noise

By Scott Burns

George Bernard Shaw famously said: “if all the economists were laid end to end you’d still never reach a conclusion.” So when the economics profession arrives at a settled opinion on the returns to education, it’s not quite clear if we should react with joy or alarm.

Of all the topics that economists have studied, I would say one we are most certain about are the returns to education,” said University of Chicago economist and Freakonomics coauthor Steven Levitt. “And if anything, the returns to education have gotten larger over time.”

According to a 2011 report by the Bureau of Labor Statistics (BLS), the wage premium for attaining a college degree has doubled over the past half century. Today’s college graduates earn on average roughly 80 percent more than high school graduates.

The standard explanation labor economists offer for this rise is that rapid technological advance and globalization have raised the demand for the general reasoning and technical skills college provides. Increased industry demand for high skill (i.e. college-educated) workers on average raises real wages relative to their low-skill counterparts.

There’s no denying that college pays off for the average student. But painting the picture in such broad strokes misrepresents the subtlety of the issue. This in turn can lead to very bad decisions by both students and policymakers.

First, it causes many individuals to vastly overestimate the value of college to themselves. By focusing exclusively on average returns to college, economists neglect the profession’s most valuable and nuanced insight of the 19th century: economic decisions are made on the margin.

College is still a fairly safe bet for an average or above average student – especially if they pursue something like engineering or computer science. But to a borderline, or marginal, student who is on the fence about attending college – either because they perceive they’re at a higher risk of not graduating or because they’re considering an unmarketable degree – the decision isn’t so clear-cut.

In fact, for the nearly half of college enrollees who don’t cross the finish line at graduation, the 80 percent wage premium noted above plummets below 10 percent. Adjusting for dropouts therefore cuts the average returns to attending college in half. Add to that the foregone income students could’ve earned working over those years, and suddenly you end up with a much more complicated decision than the one commonly presented by parents and policymakers.

To a perceptive economist, these borderline students are the relevant margin to consider when we talk about expanding college enrollment—not the average and above average students. That’s because these riskier students are precisely who expanded subsidies and other policies aimed at increasing enrollment are most likely to sway.

The key point to remember is this: what’s actually relevant isn’t so much the average returns to education, but rather the expected returns for the borderline, or marginal, students

As an analogy, think back the recent housing bubble. During the boom, policymakers tried to increase home ownership because of the alleged benefits it bestowed on the average household. To achieve these goals, they had to induce riskier marginal borrowers to take on enormous debt with artificially cheap credit and the promise of exorbitant asset returns. Capital equipment and resources were wildly misallocated constructing lavish homes at exorbitant prices. When the bubble inevitably burst, foreclosure rates skyrocketed. The very subprime borrowers policymakers thought they were helping wound up without a home and heavily indebt.

The parallels between the housing bubble and the student loan bubble should be obvious. Both illustrate the dangers of trying to attain “too much of a good thing.” Expanding college enrollment through cheap credit and massive subsidies might sound enticing, but it too is bound to leave subprime students without a job and heavily indebt. Human capital can just as easily be misallocated as physical capital.

The parallels to the housing bubble in terms of the run up in prices and debt are also striking. According to the BLS, the “sticker price” (the price universities quote absent scholarship and financial aid) of college has risen at more than three times the rate of inflation over the past quarter century. Though those trends slowed during the Great Recession, net tuition (what students actually pay out of pocket) has continued to rise. In 2012, the average student graduated with $29,400 in student loan debt. College might be more accessible than ever, but it certainly isn’t more affordable.

The second problem with the way economists portray the college wage premium is that it causes policymakers to vastly overestimate the value added of college itself to society. This is essentially the argument a handful of economic heretics put forward with the “signaling theory of education.”

Proponents of the signaling theory don’t deny that there are on average positive returns to education. Where they break away from conventional thought is with how much of the enhanced worker productivity they actually attribute to the education system itself.

“We need to distinguish between two different claims: college graduates being more valuable and college itself being more valuable,” says George Mason University economist Bryan Caplan.  “A more reasonable explanation [for the rising college wage premium] is not that the skills that college teaches are more valuable than ever, but rather that the kind of people who go to college are more valuable.”

If many students aren’t really enhancing their job skills by attending college, why are the returns to graduating college so high?

According to signaling theory, employers don’t put a premium on college graduates because college itself instills them with real, practical job skills. They do so because the mere act of enduring college provides valuable information about important employee traits such as work ethic, responsibility and basic competency.

College graduates on average tend to possess many of these traits before they ever step foot on campus. As such, there are strong reasons to believe these types of people would earn more money regardless.  The oft-quoted 80 percent wage premium doesn’t simply isolate the value added of college itself; it captures all these advantages. The problem employers face is finding some way to filter the high quality workers from the rest. This is where a college degree comes into play as a quality inspection certification.

Signaling theory is still controversial amongst economists. But its central claims ring true to almost everybody who’s endured the college experience. Most graduates lament the endless hours they ‘wasted’ in school absorbing trivial information with little practical import. Signaling theorists confirm these suspicions and offer an explanation: the things you learn in college likely aren’t all that import, but the fact you’ve survived says something about your employment prospects.

None of this denies the intrinsic value of education or even the major role the education system currently plays in helping employers filter through potential employees. Signaling theorists don’t contend college is entirely about signaling; some real skills are clearly developed in college. But if signaling is even part of the story, the billions of dollars the government spends each year promoting higher education largely represents an enormous waste of resources.

The more students receive a college degree, the less information that degree conveys to employers. The value of everyone else’s degrees is effectively diluted. Students therefore have to invest in more costly education to make sure their signal doesn’t get lost in all the noise. Students (and more accurately taxpayers) are forced to pay more for degrees that are increasingly worth less and less, and at times worthless. The biggest beneficiaries of such a scheme are college administrators, Ed Hardy and Natural Light.

Economists label this sort of sticky situation a “collective action problem.” It makes sense for each individual to bulk up on academic credentials. But society would be far better off if we called off the wasteful arms race scaled back subsidies to education. A good place to start would be to move away from an educational system that more fittingly belongs in a Pink Floyd music video and towards a more emergent and multifaceted education and job training system that more accurately reflects the diversity of the workforce it serves.

Scott Burns is a 24-year-old economics PhD student at George Mason University. He received his economics BA from LSU in 2011.


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