The Signal and the Human Capital

The most prominent theory for why college graduates earn more on average than individuals who didn’t finish college is “Human Capital Theory.” The idea is that a college education is a skill-building process, and the labor market rewards more productive workers (more education –> more human capital –> higher wages).

Another well-known theory for why college graduates earn more is that a college degree effectively sends a signal to the labor market of one’s higher productivity. The idea is that a college education isn’t so much a skill-building process as it is a skill-indicator. It filters out the less skilled workers. Employers learn who’s more productive and therefore deserve higher pay, and more productive people have a way to communicate their higher value to potential employers. In this model, it’s still a helpful social structure (and individually rational for workers and employers). However, in the case of higher education, the social problem with a pure signaling explanation is its resource-intensiveness.

A ton of evidence indicates that education is a skill-building process and not merely a signal. While a 100% signal interpretation isn’t plausible, there’s evidence suggesting that a credential has value beyond human capital development. If you can imagine a figure comparing years of education on the x axis and wages on the y axis, studies have found “jumps” in the years where a credential is awarded (known as the “sheepskin effect” in higher ed). If firms figure out how to identify talent without relying on traditional postsecondary credentials as a signal, expect them to think creatively about cost savings. All else equal, it would be cheaper to hire people with two years of postsecondary education than four.

Skill development and certification are central postsecondary functions, and technology could affect both. Greater modularity and an emphasis on competency versus seat time could help students spend more time developing human capital and less time “satisfying requirements.” Better assessment technology could help employers identify the skills that offer the most value. The symbiotic relationship here could be transformative, especially considering the weaknesses of current postsecondary practices (Google found GPAs weren’t a useful metric). Higher education could be a social institution more committed to labor market skill-building and skill-assessment. Books like Academically Adrift and Google’s giving up on GPAs both suggest that higher education has room to improve in both areas. There are legitimate concerns about a laser-like focus on employability, but a thoughtful move in that direction seems to be what students, parents, and employers want. Economic theory suggests that firms will train–or pay to train–their workers in firm-specific skills but not general-employment skills. So long as this theory is consistent with reality, general education will continue to belong to the academy.

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An Economic Problem with the Status Quo

“College may cost a lot, but graduates earn more than enough to make up for it.”

-Status Quo, 2014

This is true. It says so right here. Economically speaking, on average, postsecondary education is still an individually rational investment despite the considerable cost. The value of a college degree compared to a high school degree has been rising for the last 30+ years, and college graduates say that college is worth it. So what’s the economic problem with the cost of college? As long as the value increases at a faster rate than the cost, people will continue to enroll despite the price tag, right? Not necessarily.

A problem with this reasoning is that it implicitly assumes that new species won’t enter the postsecondary ecology and disrupt homeostasis. An expensive horse and carriage can be worth the cost when the alternative is walking, but demand would nevertheless collapse once cars and bicycles enter the market. If there’s a bubble in higher education, I don’t think it’s the same kind of bubble we observed in mortgage-backed securities. People aren’t necessarily overspending on something of dubious value. If the bubble bursts, I don’t think it will be because firms suddenly decide that a postsecondary credential is worthless and refuse to pay the premium to support it. The threat to the status quo is that high-quality higher education could be offered for cheaper. I’ll spare you the microeconomic details of risk aversion, but a cheap education that would lead to a $45,000 salary could be preferable to an expensive education that yielded a $60,000 salary, even if there’s easy access to loans and the more expensive education tends to be worth the investment.