Trade-off between risk and return plays a central role in empirical work on investment in financial capital.
By way of comparison, this trade-off has received little attention in the empirical literature on investment in education. To date, most research is centered on identifying the effects of additional schooling on the average earnings of individuals in a given year or at a particular age. By way of comparison, there is little causal evidence on how education affects life-cycle earnings profiles, earnings volatility, and unemployment risk. Yet theory suggests these factors could be important both in explaining an individual's decision to invest in education, and in understanding earnings dynamics and inequality over the life-cycle. Therefore, the relevant rate of return to education should take risk and uncertainty into account, rather than based on expected average earnings alone.
The goal of this project is to provide a detailed picture of the causal relationship between schooling and earnings over the life-cycle, following the same individuals across their working lifespan. There are a number of key questions addressed. What are the causal impacts of additional schooling on the level and dispersion of earnings over the life-cycle? How does an exogenous increase in education affect earnings dynamics and life-cycle inequality? To what extent do unemployment risk and earnings volatility affect the incentives to invest in education? What is the insurance value of education in a standard life-cycle model with incomplete markets?
This project estimates the internal rate of return of education under incomplete market and credit constraints, both of which are market failures. One question central to the discussion of education policy is why so many individuals do not choose higher level of schooling, given that the estimated internal rate of return to schooling (IRR) is substantially higher than the internal rate of return to financial assets. Most of the existing IRR estimates are based on risk neutral agents maximizing expected discounted earnings, or equivalently, risk-averse individuals maximizing expected utility when consumption markets are complete. The IRR calculated in this project takes into account of labor market risk facing individuals of different levels of schooling over the life cycle and risk preferences of individuals, given the market failure in providing insurance against earnings and unemployment risk. It also takes into account the credit market failure in terms of constrained education borrowing because future earnings cannot be used as collateral. Therefore, this project relates to the goal of the Keynes Fund by helping us understand the impact of market failure in education choice.
