“Education and Work”
by Kevin M. Murphy
It is truly an honor for me to be here today and have the opportunity to speak to the graduates of an institution that is so near and dear to my heart. As a Ph.D. graduate of the University of Chicago and a faculty member of this institution for the past fifteen years I can honestly say that you should be proud to be a graduate of what I regard to be the finest academic institution in the world.
While I could go on and on about what a great institution this is and how today marks a milestone in our graduates’ lives, I won’t. After all, I am an economist, and as such, I am doomed to discuss much less profound subjects. Economics is “the dismal science,” and when it comes to being dismal, I am not to be outdone. What I will give you today, is the abridged version of the economist’s view of education.
As soon as someone discovers that I am an economist, I am always poised for the next inevitable question: “So, Mr. Economist, what is going to happen to the stock market?” I usually go on and on trying to explain the efficient markets hypothesis and the like, but eventually I fall back on my stock response, “I am not that kind of an economist anyway. I am a labor economist.” “What is that?” is the usual response. Explaining this is always an uphill battle. People tend to think of economics in terms of GNP, inflation, and the stock market. When you talk about investment, people think of steel plants and heavy equipment. When you talk about markets they think about Wall Street. When you talk about supply and demand they think about pork bellies and corn futures. A labor economist, you see, examines these same issues but applies them to workers rather than physical assets. To a labor economist, markets determine wages and employment, capital refers to human capital, and human capital investment refers first and foremost to investments in education. As a matter of intellectual history, the economic emphasis on “human” as opposed to “physical” capital was developed here at Chicago by the likes of H. Greg Lewis and Nobel Prize - winners Ted Schultz and Gary Becker. There is good reason for this emphasis: human capital, defined as the stock of workers and their skills, is nearly three times as important as physical capital in terms of their relative contributions to national output. Moreover, investment in education alone exceeds investment in all physical assets. From an economic perspective, education is important.
As an aside, let me mention something about the broader concept of human capital and its relationship to economic growth. Why is it that we as a society expect to be richer in the future than we are today? Why is it that we as a society are richer today than we were in the past? Some would claim that it is because we have accumulated more physical assets like factories and machines, but that is really more of a result than a cause. The true source of economic growth is the accumulation of knowledge and skills, that is, the accumulation of human capital. We expect to be richer in the future because we expect to know more than we do today. We will have more human capital. How do we get more human capital? One of the main ways of investing in human capital is education. That investment process is precisely what you graduates have been engaged in for the past several years, and it is what you or your parents have been paying for.
So what can you expect as a return on your investment in human capital? While the performance of the stock market routinely hits the front page and makes the nightly news, the returns to human capital investment receive far less attention. This is so in spite of the greater economic significance of human capital compared to physical capital that I alluded to above. Everyone here, I assume, is familiar with the boom in the stock market, with the Dow Jones Average hitting all time highs. But what, you might ask, has been going on with the labor market equivalent of the Dow Jones Industrials? The answer is a good one, particularly for those of you here today. There has been a boom in the human capital investment market and a remarkable boom at that.
The main index of the return to human capital investment, the Dow Jones Average of the labor market as it were, is the wage premium paid to workers with a college degree relative to the wage for those with just a high school diploma. In 1980, this premium was about 35 percent (close to its all time low); by the mid-1990s, the college wage premium had risen to an all time high of over 70 percent (roughly double its level just fifteen years earlier). The rise in the college premium was mirrored in other educational returns as well. The premium for a graduate degree, like those being conferred on many of you here today, has also doubled, from roughly 45 percent in 1980 to more than 90 percent by the mid-1990s. Hence, measured broadly, the economic value of higher education roughly doubled in the fifteen years from 1980 to 1995, a rather incredible change. The contrast with the preceding decade of the 1970s was even more dramatic. Over the 1970s the premium for a college degree had fallen (from about 45 percent in 1970 to roughly 35 percent in 1980). By 1980, there was widespread discussion that Americans had become overeducated. Stories of college graduates waiting tables and driving cabs were everywhere. Even a well-known book by labor economist Richard Freeman, The Overeducated American, lamented the decline in the payoff for a college degree. Clearly, the message today is different; the dramatic rise in the payoff to higher education has shifted the focus to expanding educational opportunities rather than worrying about overeducation.
The rising premium for a college education since 1980 was part of a broader labor market phenomenon that saw rapidly growing returns to a wide range of skills and greater inequality in wages generally. Wage differentials between those at the top of the skill distribution and those in the middle increased as did the differentials between those in the middle and those at the bottom. The labor market phenomenon of higher returns to skill has been pervasive - reaching from the factory floor to the corporate boardroom. Growing wage inequality has not been a story of the “underclass” or the “super-rich” as some have lead us to believe but a far reaching tale that has touched all segments of our society. While many have lamented the resulting rise in income inequality, it seems hard to feel too bad about the greater payoff to a college or graduate degree. Today, investments in education pay and pay well. To those of you here, and in particular to those of you who paid the bill, undoubtedly this is good news. Maybe even great news to those parents here today - based on the higher payoff to their education, your kids can certainly afford to pay you back.
But, what accounts for the recent bull market in education? While there are no definitive answers, some key elements have been identified. First, the increased premium for those with more schooling is real; it is not simply a reflection of the changing composition of those who stop their education after high school and those who go on to higher education. This point brings up memories for me. Back in the early 1980s, when I would give seminars on the returns to education and describe the decline in the college wage premium over the 1970s, someone would always offer a simple explanation of the sort, “I know what happened. Over the 1970s more and more people went on to college and with more individuals going on to college, the average quality of those matriculating declined and hence we saw lower wages for college graduates and a smaller premium for education.” While I did not believe this story at the time and presented evidence to contradict it, it was hard to definitively reject it. Ten years later, back on the same seminar circuit, I was peddling the updated message, “Over the past decade, the premium for a college education has been rising and is at an all-time high.” Sure enough, that same fellow would be in the audience, twenty pounds heavier and with significantly less hair. After I finished my presentation, the same fellow would retort, “I know what happened, over the 1980s more and more people went on to college. With more people going on to college, the average quality of the remaining high school graduates declined, resulting in a decrease in high school wages and an increase in the premium for a college degree.” Fortunately, by this time, there was enough evidence available to dismiss composition stories of both varieties and pronounce the rising premium for education as real and not a result of such “quality changes.” My reason for recounting this story is to illustrate the supreme power of economic analysis; economists can not only disagree about just about anything, they can even argue both sides using exactly the same argument!
Enough on what is not the answer. What does explain the tremendous rise in the economic rewards to education? The answer comes back to basic economics, the economics of supply and demand. There is no denying that the demand for college graduates soared during the 1980s. Many factors were at work, including industrial changes like the growth in professional services, financial markets, and other education-intensive sectors; technological changes like the widespread adoption of computers and other elements of modern technology; and the forces of international trade, which displaced jobs for less-skilled workers and promoted jobs for the more highly educated. However, none of this was new. Economic changes favoring the more skilled have been a part of the economic landscape for decades, if not centuries. Since such demand-side changes were not new, why then didn’t we see similar effects on wages during the 1970s? The answer comes from the other side of the market, the supply side. The decade of the 1970s had seen the greatest growth in the working population of college graduates in history. The arrival of the highly educated baby boom cohorts into the labor force during the 1970s flooded the market with college graduates and outpaced the growth in demand. With supply growing faster than demand, relative wages for college graduates declined. By the 1980s, the subsiding of the baby boom and the leveling off of college continuation rates during the 1970s were slowing the growth of the college work force, and eventually the growth in demand exceeded the slowing growth in supply. Economic forces were now pushing college wages upward as the growth in demand outstripped the growth in supply. That story has continued throughout the 1980s and into the 1990s.
Where do we stand today? As I stated above, the premium for a college degree and other forms of education (like graduate degrees) are at or near their all-time highs. Supply has started to respond. Coincident with the rise in the college premium, there has been a significant rise in investment. In classic economic fashion, more individuals of all ages are going to school to try to capture these higher returns. Certainly those here have no need to wonder where this supply growth is coming from; all you have to do is to look around this room.
Finally, where are we going from here? While no one has a crystal ball, and forecasting the labor market is not much easier than forecasting the stock market, I think that the rise in the premium for a college degree has run its course. Increased investments by individuals such as those graduating here today have brought the growth in supply back in line with the growth in demand. It looks like these forces are roughly in balance consistent with a stable return to higher education. However, even if there were to be a modest decline in the college wage premium, rates of return would still remain substantially above historical levels and equal to or above the long-run returns on other assets. From an economic perspective, education is and will continue to be a great investment.
Kevin M. Murphy is the George Pratt Shultz Professor in the Graduate School of Business.