Where do sheepskin effects come from?

by on February 18, 2017 at 1:03 am in Economics, Education, Uncategorized | Permalink

From a loyal MR reader:

I’m very curious about the macroeconomics of the sheepskin effects. Traditional productivity forecast research tends to assume the wage premium is entirely human capital. Eg, Bosler/Daly/Fernald/Hobijn use a mincer equation with five education dummies http://www.frbsf.org/economic-research/files/wp2016-14.pdf   Jorgensen’s approach dividing workers into types also assumes this is not an issue.

If sheepskin effects are purely relative status effects, then the impact on total output and income should be zero, right? This implies increasing educational attainment will have a much smaller impact on productivity and output than typical productivity forecasts imply.

But it seems to me like showing you are “high ability”, if that’s all it does, makes you able to be slotted into higher ability jobs, and that this won’t simply give you a leg up on other workers but increase the number of higher ability jobs filled.

Anyway, I’m sort of thinking out loud but would be curious to read a blog of your thoughts on this, so consider this a bleg!

In the simplest Spence signaling model, the output goes to workers, and if one more worker sends the signal and boosts his or her wage, the non-signaling workers will receive an equal amount less.  That is an equilibrium condition, but it makes less sense as an account of dynamics.  As a practical matter, it’s not clear why the employers should revise their opinion downwards for the marginal products of these less educated workers.  You could say that competition makes them do it, but it’s tough to have good intuitions about an equilibrium that is hovering between/shifting across a varying degree of pooling and separating.

As a more general extension of Spence, a richer model will have market power and payments to capital and labor.  If one more worker finishes school, that worker is paid more and the higher wage serves as a tax on production.  Yet it is a tax the boss does not perceive directly.  The boss thinks he is getting a better worker for the higher wage, but in the counterfactual with more weight on the pooling solution, the boss would have hired that same person, with the same marginal product, at a lower wage.  The “whole act of production” will be and will feel more costly, including at the margin, but the boss won’t know how to allocate those costs to specific factors.  By construction of the example, the boss however will think that the newly educated laborer is the one factor not to be blamed.  So he’ll cut back on some of the other factors, such as labor and land.  Labor in the company will be relatively more plentiful, and the marginal product of labor in that company will fall.  So the incidence of a boost in the sheepskin effect falls on the land and capital that have to move elsewhere, plus to some extent the declining marginal products and thus wages for the remaining workers in the firm under consideration.  Note that outside firms are receiving some influx of capital and land, and so in those firms the marginal product of labor and thus its wage will go up somewhat.

Or so it seems to me.  The trick is to find some assumptions where the hovering between/moving across a varying degree of pooling vs. separation is not too confusing.

1 Yancey Ward February 18, 2017 at 2:10 am

Yeah, it reliably shows you are “high ability”. Sure.

2 Brandon Berg February 18, 2017 at 3:20 am

If one more worker finishes school, that worker is paid more and the higher wage serves as a tax on production. Yet it is a tax the boss does not perceive directly. The boss thinks he is getting a better worker for the higher wage, but in the counterfactual with more weight on the pooling solution, the boss would have hired that same person, with the same marginal product, at a lower wage.

How do we know that the boss pays the same workers more, rather than paying different workers the same?

3 Thiago Ribeiro February 18, 2017 at 4:16 am

In Brazil all the bosses are Argentinian since we cannot run our own affairs

4 rayward February 18, 2017 at 7:19 am

So the higher education industry is mostly a waste of resources? No, worse, since the higher wages for those obtaining higher education degrees comes at the cost of lower investment and/or returns. Does that explain the decline in both net investment and the rate of return? Maybe my criticism of the higher education industry has been too mild. Secular stagnation: it’s for everyone. I look forward to reading the The Complacent Class.

5 A Definite Beta Guy February 18, 2017 at 10:32 am

Don’t think the OP answered the question exactly: shouldn’t signaling serve an economically useful purpose by allowing employers to separate high-skill from low-skill workers?

If a company wants to shift from low-skill piece-work production to high-work O-Ring production, individual performance becomes much more difficult to monitor, and mistakes become more much more costly. You won’t invest in O-Ring production if you have no hope of getting quality labor. The sheepskin signaling high-skill high-diligence allows O-Ring firms to hire only from a labor pool that is high-skilled, which enables O-Ring production to occur.

Obviously a rather expensive screen, but that’d be a fair consensus answer.

6 Yancey Ward February 18, 2017 at 5:52 pm

It is not only an expensive screen, but not all that effective, and on top of that it works against you in a way that most people don’t quite get.

I worked in pharmaceutical research for two decades, and what I saw over and over and over were people who were truly valuable at what they were doing getting even more advanced degrees that more often than not took them out of the lab altogether, and up and laterally into the multiple layers of management that I would argue detracted value overall as it grew layer after layer.

And this even assumes the credentials are even a good screen at all for ability itself- at anything.

7 Eric Rasmusen February 18, 2017 at 10:58 am

I think you’re wrong there, Tyler. If we start with a pooling equilibrium in which average productivity is 100 and profits are zero because of competition, and then we move to a separating equilibrium where average productivity is the same but employers know some workers have 120 productivity and pay them that, then profits will be negative unless the low-ability workers’ wage falls to below 100. Rational employers will realize that times have changed and you can’t get a good worker without a college degree any more.

On the other hand, something the basic model neglects is matching, which raises productivity. If employers can now tell worker abilities, they can hire smart workers for jobs that require smarts and dull workers for those that don’t. Productivity in smarts jobs will rise while that in dulls jobs will stay the same, so average wages will rise. Going one step further, if smart workers aren’t as good as dull workers in the dulls jobs (perhaps because they are too bored, or are prone to quit more often), then productivity in dulls jobs will rise also.

8 Bill February 18, 2017 at 11:38 am

Yes, and there are transactions costs for hiring (and firing and training) the dull when there are information signals which reveal the sharp who do not carry those costs. Seems to me that transactions costs were not captured in the earlier model.

9 JWatts February 18, 2017 at 11:04 am

“The boss thinks he is getting a better worker for the higher wage, but in the counterfactual with more weight on the pooling solution, the boss would have hired that same person, with the same marginal product, at a lower wage.”

Isn’t this just the same as saying that if average wages were lower, then bosses would on average pay less? So a tautology.

10 Scott Sumner February 18, 2017 at 12:24 pm

I don’t understand this claim:

“As a practical matter, it’s not clear why the employers should revise their opinion downwards for the marginal products of these less educated workers.”

If we start by knowing that average worker productivity is 100, but know nothing about individual worker productivity, then we would estimate that each worker has a productivity of 100. If we then discover somehow that the 50% of workers with a college degree have an average productivity of 120, then we also (by implication) discover that the 50% of workers who do not have a college degree have an average productivity of 80. So if we know average productivity but not individual productivity, then any information we receive about above average individuals (through signaling) leads us to re-evaluate downward our view of other workers.

11 Troll me February 18, 2017 at 6:33 pm

Maybe more focus on seeing the individual before you and assessing them via some well-informed questions that are pertinent, as opposed to more focus on averages which may be more useful in informing hiring policies of the largest firms?

Obviously an HR person with no specific experience in the job, given an instruction “hire 10-12 people for job description X” will need to see qualifications, experience, references … SOMETHING that tells them that they have the pool that scores an average of 120 for the specific activities they are hiring for.

But maybe a person with lots of experience in the specific activity could more easily just hire a dozen people a day for a single day of work and then pick out the keepers one or two at a time, potentially with much lower overall cost and effort by making no assumptions about qualifications.

I once found myself on a jobsite where about a dozen workers (myself included) had been hired for a single day of work for a very manual labour kind of task. They suggested that one of us could theoreticlaly be hired permanently. They were looking for workhorses at the lowest possible wage. I went home at lunch.

The assumption that employers are generally looking for people with advanced programming, physics, sciences, etc., skills is not well informed. The multitudes of ways in which this is frequently not the case, in addition to a variety of other types of complications associated with firm size, area of activity, etc., with respect to the value of signalling, might be relevant to what he was thinking of.

But on average, yeah, it should not be the more pertinent aspect.

12 Bryan Willman February 18, 2017 at 3:00 pm

I think all of this is missing some much more basic effects.

No employer can evaluate applications from every person on Earth, and employers that offer jobs with high compensation and good working conditions could often be overwhelmed by the volume of inappropriate applicants. (Big software firms, wall street, etc.)

So software firms often require “computer science or equivalent degree” – not because a CS degree necessarily shows you to be a good software engineer (it does not, trust me.) But because lack of such a degree largely shows you to be a poor prospect. Yes, there are false rejects. But the true rejects vastly outweigh them.

And the point is to get the cost of recruiting down to a manageable level. So demanding people have such a degree, and in effect rejecting all applicants who don’t have such a degree, makes the recruitment task doable with finite resources.

We should not think of the sheepskin as proving goodness, but rather, the lack of a degree is very similar to having felony convictions, or an observable drug problem – could be a successful employee, it happens. But that’s not the way to bet.

A sheepskin isn’t about proving that you are good at something, it’s about proving that you are not from a pool of people are almost all bad at it.

13 Troll me February 18, 2017 at 6:38 pm

You can indicate no qualifications required along with sought skills, and then the first order of business is to send them a SHORT evaluation to demonstrate skills, which will have filtering mechanisms in both directions.

I’ve been trying such an approach for a project, but the self-selection filtering aspect is possibly a little too effective – very nearly 100% so far (but … that’s supremely awesome if the concern is that the pool of candidates is the entire earth and you’re looking for just a few people).

Method: specify no qualifications required, plus detailed job description, then request short written answers to a few targeted questions.

14 Bryan Willman February 18, 2017 at 3:05 pm

Consider High School Graduation – not a high standard in the modern era. What do almost all employers assume about somehow who had to resort to a GED, let alone didn’t graduate at all?

It’s clearly an example of “graduated HS does NOT prove you are good”, but rather “failure to do so implies you are a very high risk as an employee.”

In Scott Sumner’s terms – a degree need not show you have productivity 120. All that is necessary is that lack of a degree shows your are from a pool with average productivity of 75 rather than 100. In such a system, I can raise my firm output from 75 (substandard) to 100 (average) by merely rejecting all candidates without degrees. This is a practical plan both logistically and legally.

At the level of high school graduation, this is largely exactly what happens.

15 Troll me February 18, 2017 at 6:43 pm

Honestly, I think GED might be a higher signal than high school diploma only.

GED indicates that the person is not highly academically motivated, but when they had some reason to they went and jumped through whatever hoop was necessary. Difficult to generalize about the high school diploma only (non-GED) group, but in this specific respect, less so.

Consider the receptiveness of the two different groups to a question like “So, to get this job/promotion, you have to go take this 2-week course”.

Also, it’s not like you just put your hand up and say “send me a GED please” – independent direction and motivation is needed to obtain one of those.

16 Troll me February 18, 2017 at 5:54 pm

Signalling is often presented as a nearly useless activity, considering that it’s sometimes used to suggest that education itself has little value.

How is sorting to work as a function of personal interests, abilities, endowments, opporutnities, etc., without signalling?

Of course, the idea that zero actual learning happens in education and that its value is near-zero beyond signalling is utter stupidity (without having to be closed to the idea that in some times and places it might apply to some sub-areas of activities, but … given the benefits of freedom and non-slavery, I’m pretty OK with that).

However, those who prefer to attack academics, experts or any sort of advanced learning in general among the broader population, they can hardly be expected to do anything other than latch on to such theories for their own agendas. Unfortunately, this makes it difficult to engage in constructive discussion of the genuine learning and signalling components of the value of education (of different levels and types).

I observe that quite a lof ot people who are big fans of signalling theory basically never ever mention anything about positive externalities of higher knowledge and ability, generally assumed to be mostly made possible due to education (prior to having lots of experience in the jobs market). I’m thinking much less so (basically not) about academics who openly discuss such issues, but more so those who might cherrypick from certain aspects of these explorations for less well-intentioned purposes.

17 Troll me February 18, 2017 at 5:55 pm

Consider asking any non-mega-corporation about whether they would rather pay the equivalent of a few percent (how much?) premium on every employee to be able to observe some “stamp of quality”, such as a certification, as compared to having to have the HR hiring and training capacity in place to ensure a similar average quality.

Companies are very free to do so, and by and large they do not. Risk aversion in hiring processes would have to be through the roof to be highly relevant in explaining that.

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