David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 12 Risk and information
Education and signalling
II
In Chapter 10 (Case 10.3) we showed that higher education pays off in terms of future earnings.
This represents a good reason why students want to invest in degrees. An alternative theory that
explains why individuals want to invest in education is the theory of signalling. This theory says it could be
rational to invest in costly education even if education adds nothing directly to a worker's marginal product.
The theory assumes that people are born with different innate ability. Some people are good at most things,
other people are less smart and less productive. Not all smart people have blue eyes. The problem for firms is
to tell which applicants are the smart ones with high productivity. Looking at their eyes is not enough. There
is a problem of asymmetric information.
Suppose higher education contributes nothing to productivity. Signalling theory says that, in going on to higher
education, people who know that they are smart send a signal to firms that they are the high-productivity
workers of the future. Higher education screens out the smart high-productivity workers. 3 Firms can pay
university graduates more because they know that they are the high-ability workers.
To be effective, the screening process must separate the high-ability workers from the others. Why don't
lower-ability workers go to university and fool firms into offering them high wages? Lower-ability workers
could not be confident of passing the necessary exams. If studying adds to productivity, firms should offer
higher wages to people who attend university, whether or not they pass the final exams. If university screens
out the good people, firms will care not about attendance but academic performance.
Some firms hire university students before they sit their final exams. Is this evidence refuting signalling
theory? Not necessarily. Screening works in a second way. Since most people know their own ability, firms
may take it on trust that people who have stuck it out until their final year at university believe themselves to
be at the high end of the ability range.
It seems probable that education (even at the highest level) contributes something to productivity. But there
may also be an element of screening. Engineering, law and business degrees presumably contribute more to
productivity than philosophy, history or medieval French.
U_n_c_er_ta_in_ t y_a_n_d_a_ss_et_r_et_u_rn_s
There are many ways to carry wealth from the present to the future. People can hold money, government
bills or bonds, company shares, housing, gold, and so on. We now compare the rates of return on shares
and Treasury bills, two particular ways of holding wealth.
Treasury bills are issued usually for a period of three months. The Treasury sells a bill for, say, £99 and
simultaneously promises to buy back the bill for £100 in three months' time. People who buy the bill, and
later resell it to the government, earn around 1 per cent on their money in three months. By reinvesting
the proceeds to buy three more bills in the course of the year, they will earn around 4 per cent a year. Each
time an individual buys a bill, the implicit nominal interest rate over the three-month period is known for
certain since the government has guaranteed the price at which the bill will be repurchased.
The real return is the nominal return minus the inflation rate over the period the bill is held. People have
a pretty good idea about what inflation is likely to be in the next three months. The real return on Treasury
bills is not very risky.
3 Screening is the process of learning inside information by observing differences in behaviour.
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