SOLUTIONS MANUAL CH 6

CHAPTER 6
6-1. Debbie is about to choose a career path. She has narrowed her options to two
alternatives. She can either become a marine biologist or a concert pianist. Debbie lives two
periods. In the first, she gets an education. In the second, she works in the labor market. If
Debbie becomes a marine biologist, she will spend $15,000 on education in the first period
and earn $472,000 in the second period. If she becomes a concert pianist, she will spend
$40,000 on education in the first period and then earn $500,000 in the second period.
(a) Suppose Debbie can lend and borrow money at a 5 percent rate of interest between the
two periods. Which career will she pursue? What if she can lend and borrow money at a 15
percent rate of interest? Will she choose a different option? Why?
Debbie will compare the present value of income for each career choice and choose the career
with the greater present value. If the interest rate is 5 percent,
PVBiologist = –$15,000 + $472,000/(1.05) = $434,523.81

and
PVPianist = –$40,000 + $500,000/(1.05) = $436,190.48.
Therefore, she will become a concert pianist. If the rate of interest is 15 percent, however, the
present value calculations become
PVBiologist = –$15,000 + $472,000/(1.15) = $395,434.78

and
PVPianist = –$40,000 + $500,000/(1.15) = $394,782.61.
In this case, Debbie becomes a biologist. As the interest rate increases, the worker discounts
future earnings more, lowering the returns from investing in education.
(b) Suppose musical conservatories raise their tuition so that it now costs Debbie $60,000 to
become a concert pianist. What career will Debbie pursue if the interest rate is 5 percent?
Debbie will compare the present value of being a biologist from part (a) with the present value of
becoming a pianist. The relevant present values are:
PVBiologist = –$15,000 + $472,000/(1.05) = $434,523.81

and
PVPianist = –$60,000 + $500,000/(1.05) = $416,190.48.
In this case Debbie will become a biologist, showing that as the cost of an investment increases,
the chance of pursuing that investment falls.
1
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6-2. Peter lives for three periods. He is currently considering three alternative education-
work options. He can start working immediately, earning $100,000 in period 1, $110,000 in
period 2 (as his work experience leads to higher productivity), and $90,000 in period 3 (as
his skills become obsolete and physical abilities deteriorate). Alternatively, he can spend
$50,000 to attend college in period 1 and then earn $180,000 in periods 2 and 3. Finally, he
can receive a doctorate degree in period 2 after completing his college education in period 1.
This last option will cost him nothing when he is attending graduate school in the second
period as his expenses on tuition and books will be covered by a research assistantship.
After receiving his doctorate, he will become a professor in a business school and earn
$400,000 in period 3. Peter’s discount rate is 20 percent per period. What education path
maximizes Peter’s net present value of his lifetime earnings?
The present discounted values of Peter’s earnings associated with each of the alternatives are
110,000 90,000
PVHS  100,000    $254,167 ,
1.2 1.2 2
180,000 180,000
PVCOL  50,000    $225,000 ,
1.2 1.2 2
and
0 400,000
PV PhD  50,000    $227,778 .
1.2 1.2 2
Thus, the best option for Peter is to start working immediately upon completely high school.
6-3. Jane has three years of college, Pam has two, and Mary has one. Jane earns $21 per
hour, Pam earns $19, and Mary earns $16. The difference in educational attainment is due
completely to different discount rates. How much can the available information reveal
about each woman’s discount rate?
The returns to increasing one’s education from one to two years of college and then from two to
three years of college are
$19  $16 $21  $19

r1to 2   18.75% and r2to 3   10.53% .
$16 $19
Having observed their educational choices, we know that Mary’s discount rate is greater than
18.75 percent (otherwise she would have invested in a second year of education and earned
18.75% on the investment), Pam’s is between 10.53 percent and 18.75 percent, and Jane’s is less
than 10.53 percent.
2
6-4. Suppose the skills acquired in school depreciate over time, perhaps because
technological change makes the things learned in school obsolete. What happens to a
worker’s optimal amount of schooling if the rate of depreciation increases?
If the rate of depreciation is very high, the payoff to educational investments declines. As a result,
a worker’s optimal amount of schooling will also fall as the benefits of education erode more
rapidly.
6-5.
(a) Describe the basic self-selection issue involved whenever discussing the returns to
education.
People choose their level of education knowing their own abilities, preferences, and financial
situation. Most important here is knowing one’s abilities. Highly capable people would likely
earn a large salary even if they didn’t attend college, but they choose to attend because they earn
even more (net of the cost of college) by doing so. Likewise, less capable people know they are
less capable and that they will not get very high paying jobs even with a college degree.
Consequently, highly capably people tend to go to college while less capable people are less
likely to go to college, and the average wage of college graduates is higher than the average wage
of non-college graduates largely because of self-selected education levels due to innate skills or
abilities.
To put numbers with the problem, suppose highly capable person would earn $50,000 without a
college education and $65,000 with a college education. Similarly, a less capably person would
earn $20,000 without a college education and $35,000 with a college education. All high ability
people go to college, while none of the low ability people do. Clearly in this example, if one
knows the numbers, one would say that the return to college is $15,000 (for either group). If one
just saw the raw data of who went to college (and who did not) and each person’s income, one
would falsely conclude that the return to college is $45,000.
(b) Does the fact that some high school or college dropouts go on to earn vast amounts of
money (e.g., Bill Gates dropped out of Harvard without ever graduating) contradict the
self-selection story?
No. One, there are always exceptions. And two, if the cost of education gets large enough (or the
returns to education get small enough), even high ability people will forego college.
(c) Most government-provided job training programs are optional to the worker. Describe
how the self-selection issue might be used to call into question empirical results suggesting
there are large economic benefits to be gained by requiring all workers to receive
government-provided job training.
As job training programs are optional, and willingness to work or try to get a new job or to get
retrained is probably the most important factor in a person’s success, there is certainly a self-
selection story to be told. In particular, the successful people coming out of job training
programs would likely have been successful even if left on their own because of their innate
ability or motivation. Similarly, the people who did not choose job training and failed to get a job
would likely have failed to get a job even if the government required them to pursue job training.
3
6-6. Suppose Carl’s wage-schooling locus is given by
Years of Schooling Earnings

9 $18,500
10 $20,350
11 $22,000
12 $23,100
13 $23,900
14 $24,000
Derive the marginal rate of return schedule. When will Carl quit school if his discount rate
is 4 percent? What if the discount rate is 9 percent?
The marginal rate of return is given by the percentage increase in earnings if the worker goes to
school one additional year.
Schooling Earnings MRR

9 $18,500
10 $20,350 10.0
11 $22,000 8.1
12 $23,100 5.0
13 $23,900 3.5
14 $24,000 0.4
Carl will quit school when the marginal rate of return to schooling falls below his discount rate. If
his discount rate is 4 percent, therefore, he will quit after 12 years of schooling; if his discount
rate is 9 percent, he will quit after 10 years of schooling.
6-7. Suppose people with 15 years of schooling average earnings of $60,000 while people
with 16 years of education average $66,000.
(a) What is the annual rate of return associated with the 16 th year of education?
The annual rate of return is ($66,000 - $60,000) / $60,000 = 10%.
(b) It is typically thought that this type of calculation of the returns to schooling is biased,
because it doesn’t take into account innate ability or innate motivation. If this criticism is
true, is the actual return to the 16th year of schooling more than or less than your answer in
part (a)?
It is typically argued that people who are innately skilled or motivated pursue more education
than those who are less innately skilled or motivated, because the cost (psychic and in terms of
the time spent in college) are less for the innately skilled or motivated. If true, then the returns to
education are over-estimated by this type of simple calculation (i.e., a 10% rate of return is too
high). Of course, the typical story might be wrong. The innately skilled or motivated might have
to give up a lot in terms of foregone earnings in order to attend college, which they might not
need in the first place (e.g., Bill Gates, NBA players). If so, then the returns to education could be
under-estimated.
4
6-8. Suppose there are two types of persons: high-ability and low-ability. A particular
diploma costs a high-ability person $8,000 and costs a low-ability person $20,000. Firms
wish to use education as a screening device where they intend to pay $25,000 to workers
without a diploma and $K to those with a diploma. In what range must K be to make this an
effective screening device?
In order for a low-ability worker to not pursue education, it must be that
$25,000  K – $20,000,
otherwise pursuing the diploma would be better than not pursuing the diploma. Thus, it must be
that K  $45,000 to make sure low-ability people don’t pursue the diploma.
Similarly, in order for a high-ability worker to pursue education, it must be that
K – $8,000  $25,000,
otherwise not pursuing the diploma would be better than pursuing the diploma. Thus, it must be
that K  $33,000 to make sure high-ability people pursue the diploma.
Thus, in order to use education as a signaling device in this example, it must be that educated
workers are paid between $33,000 and $45,000.
6-9. Some economists maintain that the returns to additional years of education are actually
quite small but that there is a substantial “sheepskin” effect whereby one receives a higher
salary with the successful completion of degrees or the earning of diplomas (i.e.,
sheepskins).
(a) Explain how the sheepskin effect is analogous to a signaling model.
The sheepskin effect is analogous (in fact it is identical) to the signaling model in that purchasing
the signal doesn’t actually change the person’s skills or productivity. Rather, purchasing the
signal in effect documents or reveals that the person is a high-ability person. This is exactly the
same as the sheepskin effect. That is, paying the money and sitting through classes and doing the
work doesn’t change the person. Rather, no one without high skills would choose to do this, so
acquiring a sheepskin is a tool by which to “signal” one’s productivity even though achieving the
sheepskin had not direct effect on the individual.
(b) Typically in the United States, a high school diploma is earned after 12 years of
schooling while a college degree is earned after 16 years of school. Graduate degrees are
earned with between 2 and 6 years of post-college schooling. Redraw Figure 6-2 under the
assumption that there are no returns to years of schooling but there are significant returns
to receiving diplomas.
5
The Wage-Schooling Locus with Sheepskin Effects
Dollars
$68,000
$42,000
$30,000
$18,000
12 16 20 Years of Schooling
The bold line in the above graph gives the wage-schooling locus with sheepskin effects. In
particular, anyone without a high school diploma earns $18,000; anyone with a high school
diploma (and no college diploma) earns $30,000; someone with a college diploma (but not a
graduate school diploma) earns $42,000; and people with a graduate degree earn $68,000.
6-10. Jill is planning the timing of her on-the-job training investments over the life cycle.
What happens to Jill’s OJT investments at every age if
(a) the market-determined rental rate to an efficiency unit falls?
The marginal revenue of investing in OJT declines, so Jill will invest less at each age as the return
to making the investment has fallen.
(b) Jill’s discount rate increases?
If Jill’s discount rate increases she becomes more “present oriented”, reducing the future benefits
associated with OJT. Thus her OJT investments fall as she no longer values the benefits from
making the investment as much as she had before her discount rate fell.
(c) the government passes legislation delaying the retirement age until age 70.
The marginal revenue of investing in OJT increases because the payoff period to the investment
is longer. Thus, she undertakes more OJT in this case.
(d) technological progress is such that much of the OJT acquired at any given age becomes
obsolete within the next 10 years.
The marginal revenue to investing in OJT declines and the amount of OJT acquired falls.
6
6-11. One policy objective of the federal government is to provide greater access to college
education for those who are less able to afford it.
(a) What is the difference between Pell grants and federal student loans? How does the
offering of Pell grants and student loans help the federal government achieve its goal of
providing greater access? Recently the federal government has threatened to tie Pell grant
funds and student loans to college graduation rates. Why?
Pell grants are “gifts” to low-income students that do not need to be repaid. The federal student
loan program is a program whereby students (typically any student, regardless of parental
income) can take out a loan to pay for college with two special features. (1) The rate is set by
Congress, and is typically below the going market rate, and (2) the loan is guaranteed by the
federal government, so should the student default the lender will still be paid (at the tax-payer’s
expense).
Both of these programs subsidize/reduce the cost of a college education, especially for students
from low-income households. Thus, both of these programs provide a direct incentive for 18-
year-olds to consider their college options as the price of college is less because of these
programs.
The value of Pell grants comes from having low-income students go to and complete college.
Moreover, student loan default rates are much higher among students who drop out of college
compared to those who actually graduate. Therefore, for either program to be successful in terms
of producing both outcomes and keeping costs in check, it is important for users of the program
to actually graduate from college. (There is a side issue regarding for-profit-universities where
the graduation rate is horribly low–these places are getting rich off of students and Pell grants.)
(b) Recently many state governments have passed budgets that have significantly reduced
funding for state universities. Using supply and demand analysis, what is the likely effect on
the price of a university education to potential students? What does your model predict in
terms of the number of people who will get complete a university education?
Less state funding will not change the demand for education; however, less state funding means
that universities will need to pay for more expenses out of their own revenue, meaning that the
marginal cost of providing a university education will increase. With the supply of university
educations shifting in (up), the equilibrium will be associated with a higher price for a university
education and imply that fewer people will complete a university education.
Price of Education
S1
P1
S0
P0
E1 E0 Education
7
6-12. In 1970, men aged 18 to 25 were subject to the military draft to serve in the Vietnam
War. A man could qualify for a student deferment, however, if he was enrolled in college
and made satisfactory progress on obtaining a degree. By 1975, the draft was no longer in
existence. The draft did not pertain to women. Using the data in Table 269 of the 2008
edition of the U.S. Statistical Abstract, use women as the control group to estimate (using the
difference-in-differences methodology) the effect abolishing the draft had on male college
enrollment.
The difference-in-differences table is
College Enrollment (percentage)

1970 1975 Diff Diff-in-diff
Men 55.2 52.6 -2.6 -3.1
Women 48.5 49.0 0.5
Thus, abolishing the draft is estimated to have lowered the college enrollment rate of men by 3.1
percentage points.
8
6-13.
(a) Draw the wage-schooling locus for someone for whom the returns to schooling decrease
through college but increase after college. (Assume college is completed after 16 years of
schooling and that one can receive at most 6 years of post-college schooling.)
The wage-schooling locus for someone who experiences a negative return to each year of college
but a positive return for each year of graduate study.
Dollars
This is a strange case, so the slope of
the locus during the college years (12
to 16) can be almost anything as long
as it is negative.
(b) On a new graph, plot the marginal rate of return to schooling implied by the wage-
schooling locus described in part (a).
Yearly Marginal
Return Schooling
The marginal return to each year of schooling is plotted above in the bold line to match the wage-
schooling locus of part (a).
(c) What can be said about a college graduate who faces the wage-schooling locus described
in part (a)?
9
If the returns to each year of college are negative, the immediate consequence is that no one will
go to college without then going on to graduate school. One either ends schooling after high
school or with some graduate school.
10
6-14. A high school graduate has to decide between working and going to college. If he
works, he will work for the next 50 years of his life. If he goes to college, he will be in
college for 5 years, and then work for 45 years. In this model, the rate of discount that
equates the lifetime present value of not going to college and going to college is 8.24% when
the cost of each year of college is $15,000, each year of non-college work pays $35,000, and
each year of post-college work pays $60,000. For each of the parts below, discuss how the
rate of discount that equalizes the two options would change and who would make a
different schooling decision based on the change. (Extra credit: Use Excel to show that the
rate of return to schooling is 8.24% in the above case, and solve for the rates of discount
associated with each of the parts below.)
Calculating the rate of return for each case is straightforward in Excel by using the IRR function.
(a) Each year of college still costs $15,000 and each year of post-college work still pays
$60,000, but each year of non-college work now pays $40,000.
As the dollar benefit from not attending college has increased (from $35,000 to $40,000
annually), the return to college must fall. In fact, it falls to 5.98%.
(b) Each year of college still costs $15,000 and each year of non-college work still pays
$35,000, but each year of post-college work now pays $80,000.
As the dollar benefit from college has increased (from $60,000 to $80,000 annually), the return to
college must also increase. In fact, it increases to 13.66%.
(c) Each year of non-college work and post-college work still pays $35,000 and $60,000
respectively, but now each year of college costs $35,000.
As the dollar cost to college has increased (from $15,000 for four years to $35,000 for four
years), the return to college must fall. In fact, it falls to 5.86%.
(d) Each year of college still costs $15,000. The first year of non-college work pays $35,000
but then increases by 3 percent each year thereafter. The first year of post-college work
pays $60,000 but then increases by 5 percent each year thereafter.
This problem boils down to the rates of change in salaries. As the non-college salary is
increasing at a lower rate than the college salary is increasing, the benefits from attending college
are increasing relative to the benefits from not attending college. Thus, the return to college must
increase. In fact, it increases to 12.73%.
11
6-15. Suppose the decision to acquire schooling depends on three factors–preferences (joy of
learning), costs (monetary and psychic), and individual-specific returns to education.
(a) Explain how each of these factors affects one’s optimal amount of schooling?
People who receive more joy from learning are more likely to acquire more schooling. People
who face higher costs of schooling are likely to acquire less schooling. People who benefit from
a greater individual-specific return to additional years of education are likely to acquire more
schooling.
(b) Using these three factors, explain why someone who faces a very steep returns to
education function may still opt to obtain very little schooling.
Someone who faces very steep returns to education (so that the person benefits from a very high
individual-specific return to education) might still opt to acquire very little schooling if the person
absolutely hates the process of acquiring schooling or if the person faces extraordinarily high
costs to schooling. At the extreme, for example, someone who faces insurmountable costs to
schooling – extremely high tuition, a family situation that requires the person to work rather than
go to college, laws that facilitate segregation, etc. – simply cannot acquire more schooling
regardless of what the individual rate of return is.
(c) Consider two groups of people – Alphas and Betas. The cost of schooling is the same for
each. The average level of schooling and salary for Alpha types is 15 years and $120,000,
while the average level of schooling and salary for Beta types is 13 years and $100,000. Why
is it that 10%, which is calculated as ($120,000 - $100,000) / (15 – 13), is not a good estimate
of the annual return to an additional year of education?
This is not a good estimate of the annual return to an additional year of education because the two
groups may differ in their preferences, costs, or returns. For example, if Alpha types are more
highly motivated, their average salary if only 13 years were acquired may be $116,000 (not the
Beta’s average of $100,000). Similarly, if Beta types are less motivated, their average salary if
15 years were acquired may be $104,000 (not the Alpha’s average of $120,000). In this case, the
annual rate of return is roughly 2%, not 10%.
12

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CHAPTER 6

PVBiologist = –$15,000 + $472,000/(1.05) = $434,523.81

PVBiologist = –$15,000 + $472,000/(1.15) = $395,434.78

PVBiologist = –$15,000 + $472,000/(1.05) = $434,523.81

$19  $16 $21  $19

Years of Schooling Earnings

Schooling Earnings MRR

The annual rate of return is ($66,000 - $60,000) / $60,000 = 10%.

In order for a low-ability worker to not pursue education, it must be that

Similarly, in order for a high-ability worker to pursue education, it must be that

(a) Explain how the sheepskin effect is analogous to a signaling model.

(a) the market-determined rental rate to an efficiency unit falls?

(b) Jill’s discount rate increases?

The difference-in-differences table is

College Enrollment (percentage)

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