Imperfect Information, Self-Selection and the Market for Higher Education

This paper introduces and explores signalling in the market for education based on heterogeneity in the returns to education rather than heterogeneity in costs. Workers of heterogeneous abilities face the same costs, yet a larger proportion of able individuals self-select to attend college since they are more likely to get higher returns. With imperfect information, the skill premium is an outcome which depends on the equilibrium quality of college attendees and non attendees. Incorporating a production function of college education, I discuss the properties of the college market equilibrium. A skill-biased technical change directly decreases self-selection into college, but the general equilibrium effect may overturn the direct decline, since increased enrollment and rising tuition costs increase self-selection. Higher initial human capital has an external effect on subsequent investment in school: All agents increase their education, and the higher equilibrium tuition costs increase self-selection and the college premium. This model can help explain the steady trends in increasing tuition costs, college enrollment, and the college wage gap through its relationship to the quality of college graduates. It suggests that the signaling role of education might be an important yet largely neglected ingredient in these recent changes.