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Stay at school or start working? - Optimal timing of leaving school under uncertainty and irreversibility

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Author Info

  • Natasha Bilkic

    (University of Paderborn)

  • Thomas Gries

    ()
    (University of Paderborn)

  • Margarethe Pilichowski

    (University of Paderborn)

Abstract

At any moment a student may decide to leave school and enter the labor market, or stay in the education system. The time of departure from school determines their level of academic achievement and formal qualification. Therefore, the major purpose of this paper is to derive a timing rule for leaving school and thus answer the question: How long should I go to school? To solve this problem we apply the real option approach. Real option theory offers a different perspective of the human capital investment decision under uncertainty and irreversibility. As future income is uncertain, we model future earnings as a continuous stochastic process. We use dynamic programming techniques to derive an income threshold at which a student should leave school irreversibly, and we determine the expected optimal duration of education. Unlike other approaches using real option theory we are able to provide a full analytical discussion of various determinants affecting the timing of the decision to start work. Among other things, we find that a rising income risk increases the duration of education. With a faster growth of expected individual income during working life the duration of schooling will decrease leading to less education. An increase in the no-education wage level will reduce human capital investments. Rising marginal rewards for a year of schooling (in terms of a rising differential in income level) will encourage more investment in human capital. Increasing education costs may also increase human capital investment as long as the marginal reward for a year of schooling is sufficiently high. However, allowing for discontinuities due to various cost and income profiles of formal qualification levels, high costs of schooling may lead to an achievable maximum net wealth of human capital even for lower qualification.

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File URL: http://groups.uni-paderborn.de/fiwi/RePEc/pdf/wpaper/WP10.pdf
File Function: Revised version, 2009
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Bibliographic Info

Paper provided by University of Paderborn, CIE Center for International Economics in its series Working Papers with number 10.

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Length: 42 pages
Date of creation: Mar 2009
Date of revision:
Handle: RePEc:pdn:wpaper:10

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Keywords: human capital theory; uncertainty; irreversibllity; optimal stopping;

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References

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  1. Eaton, Jonathan & Rosen, Harvey S, 1980. "Taxation, Human Capital, and Uncertainty," American Economic Review, American Economic Association, vol. 70(4), pages 705-15, September.
  2. Bas Jacobs, 2007. "Real Options and Human Capital Investment," CESifo Working Paper Series 1982, CESifo Group Munich.
  3. Groot, Wim & Oosterbeek, Hessel, 1992. "Optimal investment in human capital under uncertainty," Economics of Education Review, Elsevier, vol. 11(1), pages 41-49, March.
  4. Vincent Hogan & Ian Walker, 2006. "Education Choice under Uncertainty - Implications for Public Policy," Working Papers 200615, School Of Economics, University College Dublin.
  5. Levhari, David & Weiss, Yoram, 1974. "The Effect of Risk on the Investment in Human Capital," American Economic Review, American Economic Association, vol. 64(6), pages 950-63, December.
  6. Johnson, Thomas, 1970. "Returns from Investment in Human Capital," American Economic Review, American Economic Association, vol. 60(4), pages 546-60, September.
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