Monday, January 03, 2011

The Education 'Risk' Premium

A big puzzle in education is that there appears to be a huge wage premium to college--about 80%--and yet only 40% of high school graduates go to college. Above is a graph from a paper by Athreya and Eberly to be presented at this weekend's AEA meetings on the subject 'Risk and Expectations in Higher Education' [click to enlarge].

Looking at various types of post-secondary education and completion rates, there is a perverse lack of response to this carrot, typically described as strangely “anemic” (see Altonji, Bharadwaj, and Lange (2008)).

There are several ways to interpret this, such as constraints to kids going to college who can and want to, constraints facing households considering investments in human capital, or that this reflects compensation for, and responses to, an investment opportunity that is lumpy, irreversible, and most crucially, risky. That is, it's a risk premium. [The simple idea that this is from increased globalization and migration making unskilled labor worth less is not a prominent explanation, probably because academics like to assume that in aggregate skill is a function of education, a simple choice variable].

The risk premium story works like this: the average college-drop-out rate is 50%. Taking into account dropout risk, a simple calculation of risk premium accounts for about half of the excess return to college education. Thus, Gonzalo Castex proposes that the risk-premium of college participation accounts for about 29% of the excess returns to college education. Risk averse agents are willing to forgo the higher return to college in order to avoid the dropout risk.

Ah, the omnipresent risk premium. In theory, it explains so much of the variation in wealth and income around us. But when you examine it further, it simply acts like another free parameter that 'explains' the data via the magic of overfitting. Note that schools with the lowest completion rates are generally lousy schools like Southern University at New Orleans (5% graduation rate!). These schools don't generate a big wage premium, though their risk is huge. Or, if you look across majors, and account for the fact that more people 'switch' from hard majors like engineering to easy majors like sociology rather than vice versa, this drop-out risk also fails to explain the differential major wage premia. Lastly, there's PhD programs, where people seem to spend a lot of time for virtually no measurable increase in earnings compared to getting a Master's degree (see Economist article here).

A good theory doesn't have to be be consistent with all the data, but it does have to explain at least 'most' of the conspicous data points it was not designed to explain. In this case, adding a risk premium can explain the 'puzzling' college wage premium, but does not generalize across colleges, within colleges, or across degrees (BA, MA, PhD). The 'risk premium' explanation is always a red herring.


Anonymous said...

i'm not sure how much of this extends to other fields/countries but i'm not sure phd is an heavier investments then MA: talking from my own point of view, i get paid a lot considering how much time i actually spend working, 4 year secured contract and top notch healthcare insurance. Honestly, when i started (2 months ago) i don't think i would have had such a sweet offer on the private side of the fence (plus my MA thesis would not have been considered, whereas now i'd like to think that i'm compounding my earlier work)

Mercury said...

I don't see what the puzzle is. Let's assume the 80% wage premium is real yet only 40% take this "carrot."

College (should) involve some real difficulty plus it's time consuming and expensive. That's a big hurdle for a lot of people even if the lifetime earnings math still favors getting that BA/BS. In fact, if they can't do that math...that says a lot.

That math is about averages anyway. The very top earning college grads are probably skewing the numbers and hiding a lot of people who are just getting by or are still very much under water quite a ways down the road...especially these days.

I'd also be wary of any data that reaches too far back - like to a time when there were much fewer colleges that were more selective and turned out much higher caliber graduates.

The "dumb money" here is the group that pays a decent amount to go to a crappy college, not the group that could but chooses not to go to college. Let's see some stats on ethnic identity majors who graduate with $150k in debt.

If you can get into a top college - go. If you can get someone else to pay for college - go. Outside of that, don't assume a wage premium.

The only sure thing in America right now is the government job wage premium. You can take that to the bank.

Anonymous said...


Exactly what evidence is their that a top college increases wages. In post-graduate degree it appears it does. Undergrad I have a hard time believing that based on what I have seen.

Mercury said...

Oh come on. You really believe that the average annual income of a graduate from a top 20,30 or 40 U.S. university (that would include all the Ivys, the top tech and California schools etc.) might not be leaps and bounds greater than the average all-college graduate let alone the average working American?

Maybe within the Peace Corps.

najdorf said...

The decision to attend and complete college is probably one of the decisions least susceptible to straight economic/$ analysis. College has radically different utilities for different users: compare the professional student who loves academia and gets good grades without extreme effort to the marginal student who feels stifled in the classroom and has to struggle to pass classes. Many people would be significantly less happy with a $50k/year office job than they would be with a $40k/year trades job. Also most of the people making the decision do not have their own money to put at risk on an education, and are either using parental $ (a decision full of irrationalities and emotions) or borrowing without really understanding the cost of debt.