How much of education and earnings variation is signalling? (Bryan Caplan asks)
On Twitter Bryan asks me:
Would you state your human capital/ability bias/signaling point estimates using my typology?
He refers to this blog post of his, though he does not clearly define the denominator there: is it percentage of what you spend on education or explaining what percentage of the variation in lifetime earnings? I’ll choose the latter and also I’ll focus on signaling rather than trying to separate out which parts of human capital are from birth and which are later learned. My calculations are thus:
1. I don’t wish to count “credentialed” occupations, where you need a degree and/or license, but you are reaping rents due to monopoly privilege. It’s neither human capital nor signaling (it’s not about intrinsic talent), though you could argue it is a kind of human capital in rent-seeking. In any case, let’s focus on private labor markets without such barriers.
2. Most capital and resource income is due to factors better explained by human capital theories or due to inheritance. That is more than a third of earnings right there. Note that the higher is inequality, the less the signaling model will end up explaining. That is one reason why the signaling model has become less relevant.
3. Depending on job and sector, what you’ve signaled, as opposed to what you know, explains a big chunk of wages in the first three to five years of employment. Within five years (often less), most individuals are earning based on what they can do, setting aside credentialism as discussed under #1. Here is my earlier post on speed of employer learning.
Keep in mind that everyone’s wages change quite a bit over their lifetime and that is mostly not due to retraining (i.e., changes in the educational signal) in the formal sense, as most people stop formal retraining after some point. The changes are due to employer estimates of skill, modified by bargaining power. In this sense all theories are predominantly human capital theories, whether they admit it or not.
To be generous, let’s give Bryan the full first five years of income based on signaling alone, out of a forty year career. And let’s say that on average wages rise at the rate of time discount (not true as of late, but a simplifying assumption and I think Bryan believes in a claim like this anyway.)
How much of income is explained by signaling? I’m coming up with “1/8 of 2/3,” the latter fraction referring generously to labor’s share in national income. That will fall clearly under ten percent, but recall I’ve inserted some generous assumptions here.
Bryan wants to call me “a signaling denialist,” yet I see signaling as still very important for understanding some aspects of the labor market. But it’s far from the main story for the labor market as a whole, especially as you move into the out years.
That all said, this “decomposition” approach may obscure more than it illuminates. Let’s consider two parables.
First, imagine a setting where you need the signal to be in the game at all, but after that your ingenuity and your personal connections explain all of the subsequent variation in income. Depending what margin you choose, the contribution of signaling to later income can be seen as either zero percent or one hundred percent. Signaling won’t explain any of the variation of income across people with the same signal, yet people will compete intensely to get the signal in the first place.
Second, in a basic signaling model there are two groups and one dimension of signaling. That’s too simple. A signaling model implies that a worker is paid some kind of average product throughout many years, but of course the reference class for defining this average product is changing all the time and is not, over time, based on the original reference class of contemporaneous graduating peers. For the purposes of calculating your wage based on a signal, is your relevant peer group a) all those people who got out of bed this morning, b) all those people in the Yale class of 2012, or c) all those who have been mid-level managers at IBM for twenty years? This will change as your life passes.
So there’s usually a signaling model nested within a human capital model, with the human capital model determining the broader parameters of pay, especially changes in pay. The employer’s (reasonably good but not perfect) estimate of your marginal product determines which peer group you get put into, if you choose to invest in additional signals (or not). The epiphenomena are those of a signaling model, but the peer group reshufflings over time are ruled by something else. Everything will look like signaling but again over time signaling won’t explain much about the variation or evolution in wages.
Seeing the relevance of those “indeterminacy” and “nested” perspectives is more important than whatever decomposition you might cite to answer Bryan’s query.