More detail on the pattern of returns to educational signals.

• Author: Habermalz, Steffen
• Position: Impact of education on productivity

1. Introduction

   Spence (1973) and Arrow (1973) formalized the idea that education can be used as a signal for innate productivity. If correlated with innate productivity, education alleviates an informational asymmetry between employers and workers concerning the productivity of a worker. Thus, employers use educational signals in the hiring process as a means of predicting expected worker productivity. This process is formally known as signaling.

   In search of evidence for the signaling hypothesis, researchers began to investigate how returns to educational signals change with labor market experience. It was conjectured that returns to educational signals should decline with work experience as employers learn about the true productivity of their employees, therefore depreciating the signal's value. However, the analysis of Layard and Psacharopoulos (1974) failed to reveal such a pattern. Riley (1979) argued that employers must be fight in predicting the true productivities of a group of workers on average. As information about worker productivity is revealed, members of a particular educational signaling group will see their wages improve and others will earn lower wages. However, if average group productivity remains constant, the predictive value of educational signals is confirmed and returns to educational signals remain unchanged. Farber and Gibbons (1996) present research that incorporates Riley's point. Their theoretical model of employer learning predicts constant returns to educational signals over time. They (like Riley) assume that the productivity of a worker does not depend on the quality of the match between job and worker, implying constant average group productivity. Using National Longitudinal Survey of Youth 1979 (NLSY79) data, they find evidence generally in favor of their theoretical results. Altonji and Pierret (2001) further develop the model of Farber and Gibbons (1996) but arrive, after relaxing informational assumptions, at the conclusion that the value of an educational signal should decrease over time. (1) They also use NLSY79 to substantiate their results. Belman and Heywood (1997) depart from earlier models by assuming that the quality of the match between workers and jobs affects worker productivity and argue that a sufficient proportion of all job-worker matches are not perfect at the time a worker is hired. This implies that (group) productivity increases over time as the quality of the job-worker match improves. In their framework, workers acquire educational signals and are hired by firms that use those signals to estimate expected productivity. Jobs require a specific level of productivity. However, a high-productivity worker matched with a low-productivity job will not be able to achieve his full productivity. He faces a job productivity constraint insofar as the job keeps him from realizing his full productive potential. Over time, as information about the true productivity of the employees becomes available, mismatched workers are reassigned to appropriate jobs, and job-worker matches become perfect. Belman and Heywood (1997) find that their model produces declining returns to educational signals over time. They provide empirical evidence using Current Population Survey (CPS) data.

   However, none of the aforementioned models addresses the important question of how and when workers' true productivities are revealed, which potentially affects the time paths of returns to educational signals. This paper addresses that shortcoming using a multiperiod version of the Belman and Heywood (1997) model, which was chosen because it incorporates the sensible assumption of improved job-matching over time. In the model, information in the first period is imperfect but symmetric (neither the worker nor the firm has knowledge of the worker's true productivity). From period two onward, the informational structure of the model changes as workers become privately aware of their true productivities. At this point, information becomes asymmetric since firms are still unsure about worker productivities. It is easy to imagine this situation in a real life setting where imperfect monitoring of workers limits the ability of the firm to generate information about workers' true productivities. The worker, better able to compare his ability to requirements of the job, gathers private information. How do workers use this private information and how do firms react as they expect this informational asymmetry?

   Stiglitz (2002, p. 463) identifies the ability to appropriate returns from information as one of the key issues in information economics: "Someone who knows his abilities are above average has an incentive to convince his potential employer of that, but a worker at the bottom of the ability distribution has an equally strong incentive to keep the information private." This paper adopts Stiglitz's view of the behavior of firms and workers in the current context. Workers who are currently overpaid (with productivities less than the job requires) have an incentive to keep this information private. Workers who are underpaid (face job productivity constraints) have an incentive to reveal their true productivity publicly and earn higher wages. Similarly, firms have an incentive to detect overpaid workers.

   The main result of the paper is that returns to (above median) educational signals initially increase, a new finding in the literature. Data from the Current Population Survey (CPS) are used to produce empirical support for this hypothesis. The paper adds an important dimension to the existing literature on the time pattern of returns to educational signals. Previous research studies found the returns to educational signals to be either decreasing or constant over time. The results here imply that focusing on a general trend between states with complete uncertainty and certainty likely leads to the omission of important details.

   The rest of the paper is organized as follows: Section 2 describes the model, provides a description of the revealing/detection process, and concludes with the presentation of the main theoretical result. Section 3 describes the data set and presents the empirical results. Section 4 provides concluding remarks.

2. The Model

   Assume N ordered worker types consisting of equal numbers of workers, [T.sub.i], i = 1 ... N with true productivities (2) [v.sub.i], i = 1, 2, 3 ... N. There are N job types [t.sub.i], i = 1 ... N, with corresponding productivity requirements [v.sub.i], i = 1 ... N. To simplify the model each firm [F.sub.i] only offers jobs of type [t.sub.i]. Each worker acquires an ordered educational signal [S.sub.i], i = 1 ... N. Agents are assumed to observe their own productivity with noise and base their decisions about the acquisition of educational signals on unbiased estimates of their own productivity. This results in signaling groups that potentially contain workers of all types and whose heterogeneity depends on the sampling distribution of the estimator used by the agents. Let [alpha] measure the proportion of workers who acquired signal [S.sub.i] and are of type [T.sub.i] (have true productivity [v.sub.i]). (3) For simplicity, I assume that workers who acquire a signal [S.sub.j] and are not of the corresponding true productivity [v.sub.j] are represented in equal proportions in each signaling group. Thus, the share of workers of any given true productivity in a signaling group [S.sub.i] that are not of true productivity [v.sub.i] is (1 - [alpha])/(N - 1).

   After hiring is completed, both employers (profit maximizers) and employees (utility maximizers) are trying to improve their position. There will be perfect matches, undermatched workers (workers who have higher productivity than the job requires), or overmatched workers (workers who have lower productivities than the job requires).

   Workers who are constrained by the job match (undermatched) have an incentive to reveal their true productivity and earn a higher wage in a different firm. (4) Firms have an incentive to detect workers who have a lower productivity than the job requires (overmatched). The ability of workers to reveal...