ECON 426 Lecture Notes - Lecture 13: Rational Expectations, Signalling Theory, Social Cost
13 Jun 2018
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Department
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Idea: this increase in productivity is reflected in wages
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Individuals invest into some sort of productive ability; some skill in the labor market that is productive
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i.e., those who benefit from this additional schooling are the students
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The productivity in this world (gains from obtaining additional schooling; general skills) will be internalized by
those obtaining additional schooling
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This decision is made on the margin (absent other frictions)
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The one making the schooling decision is the one bearing the cost and receiving the gains
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When students make a schooling decision, they trade-off potential gain from schooling decisions against cost
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Private and public returns are realized
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True productivity effect of schooling: raising the productivity of individuals
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So far, we've covered the Human Capital Model and the perspective of it:
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Signaling is another perspective of the private gains from schooling
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Review
The productivity gains from schooling are internalized by students
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Individuals choose schooling efficiently: trading off the marginal costs of schooling with the gains
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One view of schooling is that it raises students' productivity and this is reflected in wages
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i.e., those individuals with more schooling may be more capable or productive prior to
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Schooling signals but doesn't raise productivity
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Schooling is costly
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Excess education: education where the social return to education is lower than the social cost to
education
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If the $ value of additional education is below the $ value of the cost of that additional education, this will
cause excess education
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You could make everyone better off by cutting-off education and redistributing these gains
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This will lead to excess education from a social POV
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An alternative interpretation is that schooling singles out the students that are of high ability
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What kind of evidence can be used to falsify this model against HCM, and vice versa?
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Focus on the "extreme" version of this (going to try to find empirical implications of the extremes of each model)
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Focus on returns to schooling
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When we see large differences in earning, how much of this is due to the HC model vs Signaling model?
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Signaling: Another Perspective on the Gains from Schooling
Firms have a difficult time identifying who here is more productive than the other person (who's the best
worker?)
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And, its assumed that schooling is a mark of productivity
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Therefore, the motivation for obtaining schooling is to communicate these productivity differences to the
firm (but, this is costly)
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What firms can observe is who has more schooling
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Asymmetric information about the abilities of individuals
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Costs of education decline with ability
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Assuming the non-schooling wage is greater than the wage with schooling for the LA individual, the LA
individual chooses not to get schooling
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Only the HA types will get schooling
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Individuals are optimizers - thus, those who are low ability know it's more costly for them to go to school than
high productivity workers
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Firms expect that, because individuals are rational, the above will occur - thus there's the expectation that those
with schooling are inherently more productive
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Rational Expectations Equilibrium
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Returns to schooling reflect only the ability to communicate that you're of HA
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Through education, you don't really acquire anything productively valuable in this economy
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Something that is socially of value is privately of value for the individual- they will choose to set private costs
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Results of education
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Boeri and van Ours: "The Economics of Imperfect Labor Markets"
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Spence (1973) "Job Market Signaling"
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We will explore Signaling Theory using a numerical example
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Signaling Theory of Education
A fraction q is the "low" type: they produce $100
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A fraction (1 - q) is the "high" type: they produce $240
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Assume that there are two groups of agents that differ in their lifetime output when working:
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Workers know their type - but firms do not
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Average product = $240 - q*140
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This means that some are underpaid, and some are overpaid
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If this is all there is to it, then wages are equal to the average product:
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Asymmetric Information about Ability
Individuals can go to school for syears
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In school, they don't learn any productive skills
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$25 if you're the low type
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$20 if you're the high type
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Each year of schooling costs you:
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Numerical Example: The Signal
Appealing when we think about long-run stable economic relationships
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Agents don't systematically make errors about things that are important to them
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Rational Expectation Equilibrium (REE): equilibrium where individual beliefs are consistent with stochastic structure of
the economy
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Know the fraction of skilled individuals conditional on schooling
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Employers do not know the skill of specific individuals themselves
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Agents (employers and individuals)
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Rational Expectations
240 - 6*20 = 120, for HA types (wage - schooling cost)
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240 - 6*25 = 90, for LA types
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Pay-off for those without schooling is 100
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Pay-off for those with schooling S = 6 is:
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Assume that firms believe that if you have 6 years of schooling, then you're a "high type"; else, low type
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Schooling choices need to be optimal
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Schooling choices need to be consistent with beliefs of firms
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What conditions need to be satisfied for this to be a rational expectations model?
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A Rational Expectations Equilibrium
For HA types, the pay-off from S needs to be > than the pay-off of not going to school
A separating equilibrium is one in which HA types choose schooling and LA types don't
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Pooling and Separating Equilibrium
Lecture 13 - Education Signaling
Wednesday, February 21, 2018
4:07 PM
ECON 426 Page 1
Document Summary
So far, we"ve covered the human capital model and the perspective of it: Individuals invest into some sort of productive ability; some skill in the labor market that is productive. Idea: this increase in productivity is reflected in wages. The productivity in this world (gains from obtaining additional schooling; general skills) will be internalized by those obtaining additional schooling i. e. , those who benefit from this additional schooling are the students. When students make a schooling decision, they trade-off potential gain from schooling decisions against cost. This decision is made on the margin (absent other frictions) The one making the schooling decision is the one bearing the cost and receiving the gains. True productivity effect of schooling: raising the productivity of individuals. Signaling is another perspective of the private gains from schooling. Signaling: another perspective on the gains from schooling. One view of schooling is that it raises students" productivity and this is reflected in wages.
