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There is a strong consensus among economists that education is one of the key determinants of people’s earnings. According to the human capital theory, education is an investment that increases the market skills and productivity of individuals who undertake it. Consequently, these individuals earn higher wages in the labor market for their higher skills and productivity. While monetary returns to education take the form of higher earnings that people command in the labor market, there may also be nonmonetary returns since higher education is often associated with psychic gains, such as increased respect from others.
Like any other investment decision, investing in human capital through education entails costs that are borne in the short term with the expectation that benefits will be captured in the long term. Since the returns to education will not accrue for some time, the theory predicts that present-oriented individuals are less likely to invest in education than forward-looking individuals and that younger individuals will be more likely to invest than older individuals.
The question of whether returns to education are high enough to justify the costs of additional education is an important question, not only for individuals but also for policymakers. It is often argued that government policies can improve the economic well-being of the poor by subsidizing their education, offering loans for college students, and imposing minimum education requirements.
It is important to make the distinction between the private and social rate of returns to education. The private rate of returns to education is the increase in the earnings from an additional year of education for an individual who makes the investment decision on education, while the social rate of returns to education measures the increase in national income resulting from the same year of education (Borjas 2004). It is often the social rate of returns to education that provides a basis for government programs, such as scholarships and education loans that are aimed at increasing the levels of education of individuals.
Numerous studies suggest that the rate of returns to education in the United States was around 9 percent in the 1990s (Borjas 2004). The rate of returns to education varies from individual to individual due to differences in age, ability, quality and quantity of education, and socioeconomic status. For example, it is often assumed that more able individuals benefit more from an additional year of education. Also, better-quality education is likely to enhance the productivity of individuals by improving cognitive skills, thereby increasing the rate of returns to education. It is also assumed that the rate of returns to education is a decreasing function of the quantity of education. In other words, the additional earnings generated from an extra year of education are likely to be higher for people with low levels of education than for those with high levels of education.
The rate of returns to education may also vary between individuals from different races, ethnicity, or gender due to discrimination. However, the empirical evidence on this is mixed. On the one hand, studies by Pedro Carneiro, James Heckman, and Edward Vytlacil (2003) and Christopher Taber (2001) show that the return to education is greater for more able individuals. On the other hand, Orley Ashenfelter and Cecelia Rouse (1998) find some evidence that the rate of return may be even higher for individuals coming from more disadvantaged backgrounds, and Lisa Barrow and Cecelia Rouse (2005) find that returns are similar for African Americans, Hispanics, and whites. The large disparity in education levels between different racial and ethnic demographic groups is considered to be a major reason for the observed inequality in the distribution of income and wealth in the United States. While increased educational opportunities for minority groups will certainly help narrow these inequalities, they are likely to be most effective only if coupled with policies that are aimed at eliminating the barriers to equal access to education for these groups.
The typical method for estimating the rate of returns to education requires data on the earnings and levels of education of different individuals, along with estimations of the percentage change in earnings associated with an additional year of education. This formulation is often called the Mincer earning function, named after Jacob Mincer (1922–2006), one of the pioneers of modern labor economics.
When estimating the rate of returns to education, it is important to adjust for all other differences in individual characteristics in the data, such as ability, race, ethnicity, gender, and age. A failure to adjust for all these differences will result in bias in the estimated rate of returns to education. However, the empirical difficulty of appropriately accounting for these differences constitutes an important challenge for researchers studying the returns to education. While characteristics such as age, gender, and race are readily available in most data sets, the ability levels of individuals are seldom observed in these data. It may be true that more able individuals are likely to obtain more years of education than others because it is easier for them to do so. Therefore, these individuals are likely to have higher earnings. However, such individuals may also earn more than others simply because they are more productive regardless of their levels of education. In other words, higher-ability individuals may earn higher wages than lower-ability individuals with equal levels of education. Therefore, a study not taking into account the differences in ability across individuals will result in a biased estimate of the rate of returns to education.
The discussion above assumes that education increases individuals’ earnings by raising their productivity. An alternative argument is that education can increase earnings even if it does not make individuals more productive. According to this view, education mainly serves as a signal about the qualifications of the workers to potential employers (Arrow 1973; Spence 1973; Stiglitz 1975). Employers, especially in situations where they cannot easily observe the abilities or productivity of workers, may rely on education as a signaling device in their hiring decisions. As far as the private rate of returns to education is considered, it may not matter whether it is the productivity or the signaling model that represents a correct picture of the education and earnings relationship because education is positively linked to earnings under either scenario. However, if the signaling model is the correct link between education and earnings, society will not benefit from increased education. In this case, the social rate of return to education will be zero.
- Arrow, Kenneth J. 1973. Higher Education as a Filter. Journal of Public Economics 2: 193–216.
- Ashenfelter, Orley, and Cecilia Rouse. 1998. Income, Schooling, and Ability: Evidence from a New Sample of Twins. Quarterly Journal of Economics 113 (1): 253–284.
- Barrow, Lisa, and Cecilia E. Rouse. 2005. Do Returns to Schooling Differ by Race and Ethnicity? Federal Reserve Bank of Chicago Working Paper, WP 2005–02.
- Borjas, George. 2004. Labor Economics. 3rd ed. New York: McGraw-Hill.
- Carneiro, Pedro, James J. Heckman, and Edward Vytlacil. 2003. Understanding What Instrumental Variables Estimate: Estimating Marginal and Average Returns to Education. University of Chicago Working Paper.
- Spence, Michael A. 1973. Job Market Signaling. Quarterly Journal of Economics 87: 355–374.
- Stiglitz, Joseph. 1975. The Theory of Screening, Education, and Distribution of Income. American Economic Review 65: 283–300.
- Taber, Christopher. 2001. The Rising College Premium in the Eighties: Return to College or Return to Unobserved Ability? Review of Economic Studies 68 (3): 665–691.
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