Traditional Economic Impact:

Universities as an Economic Base Industry

The High Return to Education and Human Capital

Higher education is the primary mission of colleges and universities. By helping students become more knowledgeable and develop marketable skills, institutions of higher education expand the stock of human capital, a factor of production that has become increasingly important in the knowledge economy. In market economies, increases in individual productivity, such as those made possible through higher education, become manifest in higher individual earnings. Higher earnings, in turn, constitute the private monetary benefit of higher education that can make college a good financial investment.

Since the early 1980s, both in the United States and in other developed countries, changes in technology (e.g., computerization) and patterns of international trade have brought about significant shifts in labor demand—increases in the demand for workers with high cognitive ability and decreases in demand for workers who perform routine, codifiable tasks. These shifts in labor demand, together with changes in labor-market institutions in some countries, have had large effects on the earnings premium realized by college graduates. In the United States, the college earnings premium rose sharply throughout the 1980s and 1990s and remains at a historically high level. Recent data for U.S. full-time workers indicate that the average annual earnings of workers with a bachelor’s degree are 75 percent higher than the average earnings of workers who only have a high school education.

If college attendance is thought of as an investment, recent data for the U.S. indicate that the benefits of a four-year college education, as measured by the present discounted value of the lifetime college earnings premium, are four times as large as the costs, defined to include both tuition and foregone earnings while attending college. Estimates of the annualized internal rate of return on a college education indicate that the return is on the order of 12-to-14 percent, after adjusting for inflation. By way of comparison, the average real return on investing in U.S. stocks over the past 100 years is around 7 percent.

These estimates of a high return on a college education assume that the individual is successful in school, e.g., completeing a bachelor’s program in four or five years. The estimates also are based on simple comparisons of earnings between individuals with different educational backgrounds, which can be misleading if earnings differentials are due to other factors that also correlate with educational attainment. What is known as the issue of “ability bias” is the possibility that the earnings premium observed for college graduates is partly a reflection of the fact that people who are successful in school are those with high innate abilities and that these abilities also help them to be successful in the job market. They go on to earn high incomes not because of what they learned in college, but because they are smart. The current consensus among scholars, however, is that the true average return to education probably is not much below the estimate suggested by simple education-earnings correlations.

The benefits of a college education that can be realized by an individual go beyond higher earnings. One of the most potentially important of the nonwage benefits involves health and longevity. There is a strong association throughout the world between educational attainment and a variety of health indicators. Highly educated individuals are more likely to report themselves as being in good health, are less likely to smoke, are less likely to be depressed or feel stressed, and have longer life expectancy. If an attempt is made to monetize these health-related benefits, the rate of return on education investment can be as much as double the one estimated using market wages alone. The health-related benefits of education appear to be greater in the United States than in Europe, and so they probably have much to do with access to health care and the general social welfare policies of a country.

Education is an activity that generates positive externalities. Not only does the individual benefit from being educated, but others in society benefit as well. Numerous studies have shown, for example, that educated individuals are less likely to commit crimes; that educated mothers are more likely to use prenatal care and engage in other behaviors that improve the health of their infant children; and that educated individuals help to strengthen systems of democratic governance by being more politically active, voting more frequently, and being better informed.

Another type of positive externality associated with education involves knowledge and productivity spillovers. Individual workers are more productive if they work in close proximity to others who are highly educated. After controlling for years of schooling and other productivity attributes, an individual’s wages are seen to be higher in regions with above-average educational attainment. In macroeconomic data, the coefficient relating aggregate output to mean years of schooling in the population is much larger than what is suggested in microeconomic studies of the relationship between individual earnings and educational attainment.

When deciding how much education to obtain, an individual will underinvest if higher wages are considered to be the only benefit, ignoring nonmonetary benefits such as better health or benefits that may accrue to other members of society. This line of thinking provides a powerful argument for public support of higher education. However, given the high mobility of workers, especially college-educated workers in the United States, the argument has more merit when applied to federal assistance programs than to state programs. When state appropriations are used to subsidize higher education, it is important to know whether and for how long graduates remain employed in the local economy. Graduates who leave the state will no longer pay state taxes to defray the costs of education subsidies. If there are spillovers from education to other workers, these will not be realized locally if the graduate moves out of state. Potential mobility of graduates is a major issue for universities, especially for those in states without large urban areas, markets for skilled labor, or natural amenities that graduates find attractive.

References

Autor, D. “Skills, Education, and the Rise of Earnings Inequality Among the ‘Other 99 Percent,’” Science 344 (May 2014): 843-851. https://economics.mit.edu/files/11554

Noted labor economist David Autor provides a highly readable primer on the reasons for, and the significance of, the historic rise in the U.S. higher education earnings premium that began in the late 1970s and continued through the early 2000s. As explained by Autor, the consensus view among economists is that the rising return to higher education is the product of several forces: (1) a deceleration in the supply of college graduates that began in the late 1970s; (2) skill-biased technological changes (especially those related to computerization) that increased the value of workers with high cognitive ability and reduced the demand for workers who performed routine, codifiable tasks; (3) increased trade with developing countries (especially China) that began in the 1990s; and (4) the declining power of unions in the United States.

Card, D. “The Causal Effect of Education on Earnings,” Handbook of Labor Economics 3A (North-Holland-Elsevier, 1999): 1801-1863. https://davidcard.berkeley.edu/papers/causal_educ_earnings.pdf

In this survey of 89 scholarly papers, David Card seeks to determine the extent to which the strong positive correlation between an individual’s earnings and his or her years of schooling is due to a causal effect that education has on earnings or whether the correlation spuriously reflects other omitted factors, such as ability bias. The term “ability bias” refers to the possibility that the earnings premium observed for highly educated workers reflects the fact that people who are successful in school are those with high innate abilities and that these abilities also help them to be successful in the job market. Card concludes from his survey that the true average return on education is below, but not much below, the estimate suggested by simple education-earnings correlations.

Hill, K. “The Value of a College Education and the Burden of Student Loan Repayment,” Center for Competitiveness and Prosperity Research, Arizona State University, October 2018. https://wpcarey.asu.edu/sites/default/files/valuecolleduc10-18.pdf

The author provides estimates circa 2015 of the real private rate of return to investing in a four-year college education in the United States. The value of a college degree is assessed by comparing the average earnings of those with a bachelor’s degree but no further education to the earnings of those with a high school diploma but no college attendance. Returns are based on the discounted value of the lifetime college earnings premium and are net of the full cost of attending college. Separate estimates are made for men and women and by individual field of study. The average rate of return on a college education is found to be around 14 percent per year for both men and women. By individual major, returns are higher for women than for men,

but women tend to major in fields with lower returns. Majors with the highest returns are in STEM fields, including engineering and computer science, and in business fields such as economics, finance, and accounting. Majors with relatively low returns include education, the arts, and criminal justice.

Moretti, E. “Social Returns to Human Capital,” NBER Reporter Online (Spring 2005): 13-15. https://www.nber.org/reporter/spring-2005/social-returns-human-capital

This issue of the NBER Reporter summarizes Enrico Moretti’s extensive empirical research on the social returns to education. In a series of papers, Moretti finds evidence of positive productivity spillovers from education that arise when an individual’s educational attainment raises not only his or her productivity but the productivity of others. In other studies, Moretti and his co-authors find evidence that education also benefits society by reducing criminal participation, by making it more likely that a mother will use prenatal care and engage in other behaviors that improve the health of her infant children, and by making it more likely that an individual will be politically active, will vote, and will be a more-informed voter.

Munich, D. and G. Psacharopoulos, “Education Externalities: What They Are and What We Know,” European Expert Network on Economics of Education (EENEE) Report No. 34, February 2018. https://eenee.eu/en/resources/library/education-externalities-what-they-are-and-what-we-know/

Prepared for the European Commission, this report identifies and reviews nearly 200 papers dealing with the nonmonetary benefits of education that accrue either to the educated individual or to other members of society. The review covers both U.S. and European studies and focuses particularly on studies that control for factors other than education that might causally affect outcomes. Major classifications of nonmonetary benefits include (1) health and longevity; (2) social benefits from reduced property and violent crime; (3) intergenerational transmission of education benefits from parents to children, e.g., through higher educational attainment and improved health of children; and (4) benefits to society from greater trust and social cohesion and a strengthening of democracy.

Psacharopoulos, G. and H. Patrinos, “Returns to Investment in Education: A Decennial Review of the Global Literature,” Policy Research Working Paper 8402, World Bank Group, April 2018. https://openknowledge.worldbank.org/handle/10986/29672

This paper summarizes the results of studies estimating the return to schooling using data from 139 countries covering the period from 1950 to 2014. Most of the studies cited estimate returns to education using the coefficient estimated when the logarithm of individual earnings is regressed on years of schooling and other variables that influence productivity. The private average global rate of return is around 9 percent and has been stable for decades. The pattern

of returns across sexes, levels of education, and levels of development are similar to patterns found in earlier surveys. Returns to schooling are higher for women than they are for men. Returns to an additional year of schooling are highest for primary education and lowest for higher education. Returns to schooling are generally higher in low-income countries than they are in high-income countries, consistent with lower mean educational attainment in poor countries.

To understand the growth and decline of regions, economists find it useful to divide a region’s economic activities into two groups. Basic activities satisfy demands from outside the region and generate export income that can be used to pay for the region’s imports. Nonbasic activities exist to supply goods and services to local residents. Basic activities are a region’s economic raison d’être, i.e., its economic base. Nonbasic activities are derived from that base and grow or shrink depending on the performance of basic industries.

Traditional basic activities include agriculture, mining, most manufacturing, and tourism. Some service industries are wholly or partially basic. In contrast, retail trade, construction and most services are largely nonbasic. From the perspective of an entire state, colleges and universities are partially basic, to the extent that they receive funding from nonlocal sources, such as out-of-state students and federal research grants.