CHAPTER 6

6-1. Debbie is about to choose a career path. She has narrowed her options to two
alternatives. She can either become a marine biologist or a concert pianist. Debbie lives two
periods. In the first, she gets an education. In the second, she works in the labor market. If
Debbie becomes a marine biologist, she will spend $15,000 on education in the first period
and earn $472,000 in the second period. If she becomes a concert pianist, she will spend
$40,000 on education in the first period and then earn $500,000 in the second
period.Suppose Debbie can lend and borrow money at a 5 percent rate of interest between
the two periods. Which career will she pursue? What if she can lend and borrow money at a
15 percent rate of interest? Describe in general terms how Debbie’s decision depends on the
interest rate.

Debbie will compare the present value of income for each career choice and choose the career
with the greater present value. If the interest rate is 5 percent,

PVBiologist = –$15,000 + $472,000/(1.05) = $434,523.81

and
PVPianist = –$40,000 + $500,000/(1.05) = $436,190.48.

Therefore, she will become a concert pianist. If the rate of interest is 15 percent, however, the
present value calculations become

PVBiologist = –$15,000 + $472,000/(1.15) = $395,434.78

and
PVPianist = –$40,000 + $500,000/(1.15) = $394,782.61.

In this case, Debbie becomes a biologist.

As the interest rate increases, the worker discounts future earnings more, lowering the returns
from investing in education. In this case, the higher interest rate makes the payoff from the
$50,000 investment into becoming a concert pianist less valuable.

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6-2. Peter lives for three periods. He is currently considering three alternative education-
work options. He can start working immediately, earning $100,000 in period 1, $110,000 in
period 2 (as his work experience leads to higher productivity), and $90,000 in period 3 (as
his skills become obsolete and physical abilities deteriorate). Alternatively, he can spend
$50,000 to attend college in period 1 and then earn $180,000 in periods 2 and 3. Finally, he
can receive a doctorate degree in period 2 after completing his college education in period 1.
This last option will cost him nothing when he is attending graduate school in the second
period as his expenses on tuition and books will be covered by a research assistantship.
After receiving his doctorate, he will become a professor in a business school and earn
$400,000 in period 3. Peter’s discount rate is 20 percent per period. What education path
maximizes Peter’s net present value of his lifetime earnings?

The present discounted values of Peter’s earnings associated with each of the alternatives are

110,000 90,000
PVHS  100,000    $254,167 ,
1.2 1.2 2

180,000 180,000
PVCOL  50,000    $225,000 ,
1.2 1.2 2
and
0 400,000
PVPhD  50,000    $227,778 .
1.2 1.2 2

Thus, the best option for Peter is to start working immediately upon completely high school.

6-3. Jane has three years of college, Pam has two, and Mary has one. Jane earns $21 per
hour, Pam earns $19, and Mary earns $16. The difference in educational attainment is due
completely to different discount rates. How much can the available information reveal
about each woman’s discount rate?

The returns to increasing one’s education from one to two years of college and then from two to
three years of college are

$19  $16 $21  $19

r1to2   18.75% and r2to3   10.53% .
$16 $19

Having observed their educational choices, we know that Mary’s discount rate is greater than
18.75 percent (otherwise she would have invested in a second year of education and earned
18.75% on the investment), Pam’s discount rate is between 10.53 percent and 18.75 percent, and
Jane’s discount rate is less than 10.53 percent.

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6-4. Suppose the skills acquired in school depreciate over time, perhaps because
technological change makes the things learned in school obsolete. What happens to a
worker’s optimal amount of schooling if the rate of depreciation increases?

If the rate of depreciation is very high, the payoff to educational investments declines. As a result,
a worker’s optimal amount of schooling will also fall as the benefits of education erode more
rapidly.

6-5.

(a) Describe the basic self-selection issue involved whenever discussing the returns to
education.

People choose their level of education knowing their own abilities, preferences, and financial
situation. Most important here is knowing one’s abilities. Highly capable people would likely
earn a large salary even if they didn’t attend college, but they choose to attend because they earn
even more (net of the cost of college) by doing so. Likewise, less capable people know they are
less capable and that they will not get very high paying jobs even with a college degree.
Consequently, highly capably people tend to go to college while less capable people are less
likely to go to college, and the average wage of college graduates is higher than the average wage
of non-college graduates largely because of self-selected education levels due to innate skills or
abilities.

To put numbers with the problem, suppose highly capable person would earn $50,000 without a
college education and $65,000 with a college education. Similarly, a less capably person would
earn $20,000 without a college education and $35,000 with a college education. All high ability
people go to college, while none of the low ability people do. Clearly in this example, if one
knows the numbers, one would say that the return to college is $15,000 (for either group). If one
just saw the raw data of who went to college (and who did not) and each person’s income, one
would falsely conclude that the return to college is $45,000.

(b) Does the fact that some high school or college dropouts go on to earn vast amounts of
money (e.g., Bill Gates dropped out of Harvard without ever graduating) contradict the
self-selection story?

No. One, there are always exceptions. And two, if the cost of education gets large enough (or the
returns to education get small enough), even high ability people will forego college.

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6-6. Suppose Carl’s wage-schooling locus is given by

Years of Schooling Earnings

9 $18,500
10 $20,350
11 $22,000
12 $23,100
13 $23,900
14 $24,000

Derive the marginal rate of return schedule. When will Carl quit school if his discount rate
is 4 percent? What if the discount rate is 9 percent?

The marginal rate of return is given by the percentage increase in earnings if the worker goes to
school one additional year.

Schooling Earnings MRR

9 $18,500
10 $20,350 10.0
11 $22,000 8.1
12 $23,100 5.0
13 $23,900 3.5
14 $24,000 0.4

Carl will quit school when the marginal rate of return to schooling falls below his discount rate. If
his discount rate is 4 percent, therefore, he will quit after 12 years of schooling; if his discount
rate is 9 percent, he will quit after 10 years of schooling.

6-7. Suppose people with 15 years of schooling average earnings of $60,000 while people
with 16 years of education average $66,000.

(a) What is the annual rate of return associated with the 16th year of education?

The annual rate of return is ($66,000 - $60,000) / $60,000 = 10%.

(b) It is typically thought that this type of calculation of the returns to schooling is biased,
because it doesn’t take into account innate ability or innate motivation. If this criticism is
true, is the actual return to the 16th year of schooling more than or less than your answer in
part (a)?

It is typically argued that people who are innately skilled or motivated pursue more education
than those who are less innately skilled or motivated, because the cost (psychic and in terms of
the time spent in college) are less for the innately skilled or motivated. If true, then the returns to
education are over-estimated by this type of simple calculation (i.e., a 10% rate of return is too
high). Of course, the typical story might be wrong. The innately skilled or motivated might have
to give up a lot in terms of foregone earnings in order to attend college, which they might not
need in the first place (e.g., Bill Gates, NBA players). If so, then the returns to education could be
under-estimated.

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6-8. Suppose there are two types of people: high-ability and low-ability. A particular
diploma costs a high-ability person $8,000 and costs a low-ability person $20,000. Firms
wish to use education as a screening device where they intend to pay $25,000 to workers
without a diploma and $K to those with a diploma. In what range must K be to make this an
effective screening device?

In order for a low-ability worker to not pursue education, it must be that

$25,000  K – $20,000,

otherwise pursuing the diploma would be better than not pursuing the diploma for low-ability
people. Thus, it must be that K  $45,000 to make sure low-ability people don’t pursue the
diploma.

Similarly, in order for a high-ability worker to pursue education, it must be that

K – $8,000  $25,000,

otherwise not pursuing the diploma would be better than pursuing the diploma for high-ability
people. Thus, it must be that K  $33,000 to make sure high-ability people pursue the diploma.

Thus, in order to use education as a signaling device in this example, it must be that educated
workers are paid between $33,000 and $45,000.

6-9. Some economists maintain that the returns to additional years of education are actually
quite small but that there is a substantial “sheepskin” effect whereby one receives a higher
salary with the successful completion of degrees or the earning of diplomas (i.e.,
sheepskins).

(a) Explain how the sheepskin effect is analogous to a signaling model.

The sheepskin effect is analogous (in fact it is identical) to the signaling model in that purchasing
the signal doesn’t actually change the person’s skills or productivity. Rather, purchasing the
signal in effect documents or reveals that the person is a high-ability person. This is exactly the
same as the sheepskin effect. That is, paying the money and sitting through classes and doing the
work doesn’t change the person. Rather, no one without high skills would choose to do this, so
acquiring a sheepskin is a tool by which to “signal” one’s productivity even though achieving the
sheepskin had not direct effect on the individual.

(b) Typically in the United States, a high school diploma is earned after 12 years of
schooling while a college degree is earned after 16 years of school. Graduate degrees are
earned with between 2 and 6 years of post-college schooling. Redraw Figure 6-2 under the
assumption that there are no returns to years of schooling but there are significant returns
to receiving diplomas.

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 The Wage-Schooling Locus with Sheepskin Effects

Dollars

$68,000

$42,000

$30,000

$18,000

12 16 20 Years of Schooling

The bold line in the above graph gives the wage-schooling locus with sheepskin effects. In
particular, anyone without a high school diploma earns $18,000; anyone with a high school
diploma (and no college diploma) earns $30,000; someone with a college diploma (but not a
graduate school diploma) earns $42,000; and people with a graduate degree earn $68,000.

6-10. Consider a model with two periods—the first time period is the four years after high
school and the second time period is the next 40 years. A person without a college education
receives $120,000 of income during the first period and $1.2 million of income during the
second period. A college graduate pays $200,000 during the first period to obtain a college
degree and forgoes all earnings but then earns $2 million of income during the second
period. Will the individual work or go to college in the first period if her individual rate of
return between the two periods is 40%?

The present value of working immediately (not going to college) is:

PVNoCollege = 120,000 + 1,200,000/1.4 = $977,143

while the present value of getting a college degree is

PVCollege = –200,000 + 2,000,000/1.4 = $1,228,571.

Therefore, as PVNoCollege < PVCollege, the individual will choose to attend college.

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6-11. One policy objective of the federal government is to provide greater access to college
education for those who are less able to afford it. Recently many state governments have
passed budgets that have significantly reduced funding for state universities. Using supply
and demand analysis, what is the likely effect on the price of a university education to
potential students? What does your model predict in terms of the number of people who
will complete a university education?

Less state funding will not change the demand for education; however, less state funding means
that universities will need to pay for more expenses out of their own revenue, meaning that the
marginal cost of providing a university education will increase. With the supply of university
educations shifting in (up), the equilibrium will be associated with a higher price for a university
education and imply that fewer people will complete a university education.

Price of Education

S1
P1
S0
P0

E1 E0 Education

6-12. In 1970, men aged 18 to 25 were subject to the military draft to serve in the Vietnam
War. A man could qualify for a student deferment, however, if he was enrolled in college
and made satisfactory progress on obtaining a degree. By 1975, the draft was no longer in
existence. The draft did not pertain to women. According to the 2008 edition of the U.S.
Statistical Abstract, 55.2% of male high school graduates enrolled in college in 1970, but only
52.6% were enrolled in 1975. Similarly, 48.5% of female high school graduates were
enrolled in college in 1970, while 49.0% were enrolled in 1975. Use women as the control
group to estimate (using the difference-in-differences methodology) the effect abolishing the
draft had on male college enrollment.

The difference-in-differences table is

College Enrollment (percentage)

1970 1975 Diff Diff-in-diff
Men 55.2 52.6 -2.6 -3.1
Women 48.5 49.0 0.5

Thus, abolishing the draft is estimated to have lowered the college enrollment rate of men by 3.1
percentage points.

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6-13. The textbook discusses in section 6–5 some strategies for correcting for ability bias
when trying to estimate the rate of return to education.

(a) What is the main argument for why using data on identical twins can control for ability
bias? What problem arises if most pairs of identical twins pursue different levels of
education? What problem arises if most pairs of identical twins pursue the same level of
education?

The main argument for why using data on identical twins can control for ability bias rests on the
assumption that identical twins are also identical in ability. As long as this assumption is true,
then wage models can be differenced between twins, the ability portion drops out, and the true
rate of return remains. (This is shown in the textbook.) There are two issues with this method.
First, if most pairs of identical twins actually pursue different levels of education, this calls into
question the assumption that identical twins are identical in ability as differences in ability are a
likely reason for the difference in education. Alternatively, if most pairs of identical twins pursue
the same amount of education, then the rate of return to education is left to be estimated by just
the small handful of twins in the sample who have pursued different levels of education. Looking
at the equation in the text, Δs = 0 for any pair of twins with identical education, and therefore that
observation lends no predictive information for b.

(b) What is the main argument for why using certain birthdates can control for the bias?
Do you think this method will be better as identifying the rate of return to different years of
high school education or college education? Why?

The main idea for using birthdates (or birth quarter as is common in the literature) is that
education enrollment laws provide differences in kindergarten enrollment ages. Therefore, two
people can be born relatively close together in time but have up to a year different in education
when they drop out of high school at age 16. This method is likely better at estimating the rate of
return to additional years of a high school education than additional years of a college education,
because the mechanism by which birthdate is argued to serve this role pertains to dropping out of
high school. It could be useful for college as well using maturity arguments, but this is a much
less clear mechanism.

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6-14. A high school graduate has to decide between working and going to college. If he
works, he will work for the next 50 years of his life. If he goes to college, he will be in
college for 5 years, and then work for 45 years. In this model, the rate of discount that
equates the lifetime present value of not going to college and going to college is 8.24% when
the cost of each year of college is $15,000, each year of non-college work pays $35,000, and
each year of post-college work pays $60,000. For each of the parts below, discuss how the
rate of discount that equalizes the two options would change and who would make a
different schooling decision based on the change. (Extra credit: Use Excel to show that the
rate of return to schooling is 8.24% in the above case, and solve for the rates of discount
associated with each of the parts below.)

Calculating the rate of return for each case is straightforward in Excel by using the IRR function.
In particular, list Years from 0 to 49. Then list the salary for co college in the next column. In
the next list the cost of college or the salary from college for each year. Finally, create a fourth
column that is the difference in value (college minus no college). Assuming the difference values
are in cells E4 through E53, the Excel command is: =IRR(E4:E53).

(a) Each year of college still costs $15,000 and each year of post-college work still pays
$60,000, but each year of non-college work now pays $40,000.

As the dollar benefit from not attending college has increased (from $35,000 to $40,000
annually), the return to college must fall. In fact, it falls to 5.98%.

(b) Each year of college still costs $15,000 and each year of non-college work still pays
$35,000, but each year of post-college work now pays $80,000.

As the dollar benefit from college has increased (from $60,000 to $80,000 annually), the return to
college must also increase. In fact, it increases to 13.66%.

(c) Each year of non-college work and post-college work still pays $35,000 and $60,000
respectively, but now each year of college costs $35,000.

As the dollar cost to college has increased (from $15,000 for four years to $35,000 for four
years), the return to college must fall. In fact, it falls to 5.86%.

(d) Each year of college still costs $15,000. The first year of non-college work pays $35,000
but then increases by 3 percent each year thereafter. The first year of post-college work
pays $60,000 but then increases by 5 percent each year thereafter.

This problem boils down to the rates of change in salaries. As the non-college salary is
increasing at a lower rate than the college salary is increasing, the benefits from attending college
are increasing relative to the benefits from not attending college. Thus, the return to college must
increase. In fact, it increases to 12.73%.

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6-15. Suppose the decision to acquire schooling depends on three factors–preferences (joy of
learning), costs (monetary and psychic), and individual-specific returns to education.

(a) Explain how each of these factors affects one’s optimal amount of schooling?

People who receive more joy from learning are more likely to acquire more schooling. People
who face higher costs of schooling are likely to acquire less schooling. People who benefit from
a greater individual-specific return to additional years of education are likely to acquire more
schooling.

(b) Using these three factors, explain why someone who faces a very steep returns to
education function may still opt to obtain very little schooling.

Someone who faces a very steep returns to education function (so that the person benefits from a
very high individual-specific return to education) might still opt to acquire very little schooling if
the person absolutely hates the process of acquiring schooling or if the person faces
extraordinarily high costs to schooling. At the extreme, for example, someone who faces
insurmountable costs to schooling–extremely high tuition, a family situation that requires the
person to work rather than go to college, laws that facilitate segregation, etc.–simply cannot
acquire more schooling regardless of what the individual rate of return is.

(c) Consider two groups of people – Alphas and Betas. The cost of schooling is the same for
each. The average level of schooling and salary for Alpha types is 15 years and $120,000,
while the average level of schooling and salary for Beta types is 13 years and $100,000. Why
is it that 10%, which is calculated as ($120,000 - $100,000) / (15 – 13), is not a good estimate
of the annual return to an additional year of education?

This is not a good estimate of the annual return to an additional year of education because the two
groups may differ in their preferences, costs, or returns. For example, if Alpha types are more
highly motivated, their average salary if only 13 years were acquired may be $116,000 (not the
Beta’s average of $100,000). Similarly, if Beta types are less motivated, their average salary if 15
years were acquired may be $104,000 (not the Alpha’s average of $120,000). In this case, the
annual rate of return is roughly 2%, not 10%.

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