Allocation and the Returns to Over-education in the UK

Over-education indicates that there are mismatches between the supply and demand for skills in the labour market, and inefficiencies in the investment in education. This paper uses the 1991 wave of the British Household Panel Survey to examine the extent and the returns to over-education in the UK. For this, we divide years of education attained by workers into years of education required for the job, years of over-education and years of under-education. The paper contributes to the literature on this topic by determining the rates of return when investments in education are endogenous. We use three different approaches to measuring the returns to over-education. The first is the conventional one, in which years of education required, years of over-education and years of unver-education are included as exogenous variables in an ordinary least squares (OLS) estimation of the wage equation. The second approach uses instrumental variables for years of education required, over-education and under-education in the wage equation. By this, we allow for the mutual relation between the utilization of education and wage setting within the framework of the allocation theory. In the third approach, we extend the notions of the allocation theory by specifying separate wage regimes for each of the three modes of the allocation of skills supplied and skills required. The results suggest that OLS overestimates the returns to over-education because of ability bias. For the same reasons, the OLS estimates of the returns to under-education might be biased downwards. OLS estimates on the years of education required are biased downwards as well. The results further show that mismatches between supply and demand for skills tend to diminish with years of experience in the labour market.