Income Variance and College Educations

By Fester:

I�m getting late into the discussion concerning the college degree wage premium and the mysterious lack of increased college participation rates. Kevin Drum at Washington Monthly offers a very intriguing hypothesis that I want to build on for a bit.

Right. And maybe that's the problem. When I say that the premium for getting a college degree used to be 30% and now it's 90%, what do I mean? One possibility is something like this:

1973: high school grad makes $42K, college grad makes $55K.

2006: high school grad makes $42K, college grad makes $80K.

This probably would motivate more kids to get college degrees. But that's not what actually happened. Here's what actually happened for male workers (all figures adjusted for inflation):

1973: high school grad makes $42K, college grad makes $55K.

2006: high school grad makes $31K, college grad makes $61K.

The skill premium hasn't gone up because a college degree is way more lucrative than in the past. In fact, it's only slightly more lucrative over the long term and completely stagnant among recent grads. Rather, the skill premium has gone up because the value of a high school degree has cratered.

So here's my thought: even though the two scenarios above are (roughly) economically equivalent, they might not be psychically equivalent. If the value of a college degree had gone way up, that really might prompt more kids on the margin to study harder and go to college. Not only would that higher value be fairly obvious since it would get a lot of attention, but the prospect of doing better is highly motivating. But does the declining value of a high school degee motivate them in the same way? I doubt it, even though mathematically the effect is the same. For starters, many teenagers may not really understand the hard reality of the trend in non-college wages, and in any case a slow but steady decline simply doesn't motivate people the same way as dangling a reward in front of them does. Instead of making them try harder, it tends to make them feel helpless and angry.

College degrees do not guarantee a good income. Instead it increases the probability of a decent income but there is high levels of dispersions of results even when controlling for major, grades and schools. For instance, I keep in contact with roughly half a dozen fellow graduates of my undergraduate major. So everyone is roughly the same age (+/- a year), came from the same school and everyone performed reasonably well to very well (min GPA was roughly 3.5, max was 3.98). Excluding one individual who is in law school, everyone else is employed. The income range is very broad as one classmate is earning roughly half of about average wages and another classmate is making about twice as much as anyone else in the group. That is some massive variance even from a group of reasonably similiar individuals. Backing this away from ancetode and towards data, Brad DeLong noted in response to Greg Mankiw in 2006 that most income gains were being concentrated at the top of the income distribution where not having a bachelor�s degree is profoundly unusual:

The big rise in inequality in the U.S. since 1980 has been overwhelmingly concentrated among the top 1% of income earners....It's hard to attribute this pattern to a rise in the premium salary earned by the well-educated by virtue of the skills their formal education taught them. Such a rise in the education premium would produce a much smoother rise in relative incomes among the whole top tenth of the income distribution.

Greg�s response is interesting as it hints at the higher levels of variance in returns to education:

I am not convinced that the conclusion follows from the facts presented. I would guess that the top 1 percent of income earners (those earning more than $276,945) are disproportionately very well educated--doctors, lawyers, MBAs, etc. So the rise in the income of the top 1 percent could well represent in large part a higher education premium. What might well be true is that the returns to education have become increasingly non-linear: The most educated are now getting a bigger return from a marginal year of education than those with moderate amounts of education. In other words, two years getting an MBA from Harvard Business School may increase a person's income more in percentage terms than does two years getting an Associate Degree from Mass Bay Community College. My understanding from my labor economist friends is that some evidence favors this hypothesis of increasing nonlinearity. To some extent, the returns to human capital are random (as is true of physical capital). Getting an MBA gives you a shot at being CEO, but it is not a guarantee. This may be part of the Lemieux finding that higher levels of education are associated with higher residual variance.

Variance is expensive. The standard assumption in economics is diminishing marginal utility which means people are risk averse as losing the last dollar of income is (slightly) more painful than gaining an additional dollar of income is �enjoyable�. Average wages with low variance have higher net present value than the same average wage with much larger swings between highs and lows.

This process of where reasonably similiar individuals are experiencing a 4x dispersion of wages after six years out of college is an expensive situation as everyone is paying back the same tuition (minus any grants and parental funds of course) so we all pretty much have started our adult lives with mortgages. Prospective students who are aware of the variance and don�t believe that they have a chance of going to med school, or Harvard Business School are much more aware of the costs of failure to thrive and that may be outweighing the potential rewards of a college education as an economic decision.