Signaling Theory of College Degrees Is Unpersuasive

In an article on Bob Murphy writes about the “signaling” model of education:

In this approach, the reason an employer will offer a higher salary to, say, a Harvard physics major with a 4.0 GPA than he would to someone with a 2.5 GPA and a literature degree from a community college isn’t that the job will require knowledge of Maxwell’s equations for electromagnetism.

Rather, Spence’s signaling model says that the type of person who chooses to major in physics at Harvard, and can graduate with a 4.0, is also the type of person who will do well in many jobs.

So it’s not that college (and graduate school) actually endow students with useful skills, it’s just that they provide mental hoops for students to jump through and thereby exhibit their intrinsic abilities to employers.

To the extent that the Spence model is accurate, getting formal degrees is an arms race of sorts.

If everyone could agree to spend fewer years in school, then everybody would be better off. However, no individual student can benefit from unilaterally skipping college, because our society is currently stuck in the equilibrium in which productive individuals signal their talent by getting degrees from prestigious colleges.

Let me help Murphy insofar as I can. The problem with the signaling theory appears to me to be this. Let Smith the physics guy be productive at physics with 100 points of efficiency. And let Jones the literature guy be productive at literature with merely 60 points of efficiency.

It seems to me that their skills are not fully transferable to, say, accounting. We have to discount their efficiency for that occupation somehow. Let’s suppose that we discount equally by 50%. Of course, this is too generous a favor to the theory, e.g., because accounting may be easy to master for both Smith and Jones, such that even Jones can become quite proficient with it which he could never do with physics. Anyway, Smith is 50 points as efficient at accounting, and Jones is 30 points as efficient at accounting.

(We may interpret these values as competence: 100 points out of possible 150, write it as 100/150; the others might be 60/90, 50/50, and 30/50. If we want to accommodate the fact that accounting is “easy,” then change the last two sets of numbers to, say, 40/40 and 30/40.)

Clearly, on this understanding the signaling model breaks down. For employers apparently look at nothing but education. But if they do so, then, though Smith is only 20 points more efficient that Jones, he will be paid the equivalent of 40 points more. That is, Jones is only 20 points worse than Smith, but he is 40 points cheaper than Smith and may therefore be a better candidate for the accounting position. The profit from employing this factor of production, Smith, is too low (and may even be a loss) compared to the alternative, Jones. In simple terms, Smith is “overeducated.”

So, if the employer does not look and discriminate beyond the education history, then he will miss opportunities to hire people like Jones and in so doing will lose in the competition to those entrepreneurs who do look.

P.S. Another way to approach this problem, of course, is to look at unpredictable creative entrepreneurship of people to market themselves without a college degree and succeed anyway.

An “Arms Race”: Suits

Says Robert H. Frank:

If you’re one of several similarly qualified candidates who all want the same investment banking job, it’s strongly in your interest to look good when you show up for your interview. But looking good is an inherently relative concept. It means looking better than the other candidates.

If they show up wearing $500 suits, you’ll be more likely to make a favorable first impression, and more likely to get a callback, if you show up in a $2,000 suit than if you show up in one costing only $200.

… job applicants are no more likely to get the positions they seek if they all spend $2,000 on interview suits than if they all had spent only $300. But that’s no reason to regret having bought the more expensive suit.”

Now I understand that this is the very first and obviously trivial example of a wasteful “arms race” in his book The Darwin Economy. It’s a paradigmatic case, the simplest possible model to start the discussion with. However, if I were writing this book, I’d analyze this case more thoroughly, anyway, in order to show the limitations of the model.

What employers look for is a minimum standard in appearance, hygiene, and grooming among the applicants. This standard varies tremendously in different types of work. A person who is expected to entertain a sophisticated international clientele is supposed to look really good.

A person who is paid $80K for a demanding computer programming job which does not involve dealing with customers needs only to look presentable. Being disheveled and untidy is a decent sign that he won’t handle the pressure.

If I am interviewing for a dishwashing position at a restaurant, I probably don’t need a suit at all.

And if I want to be hired by a logging company to be a lumberjack, I had better not arrive in any suit! I’d get my chainsaw, don my overalls, and demonstrate my skills.

Looking at the quality and manner of dress is rational and useful to the entrepreneur. But an entrepreneur who looks only at the dress is going to be highly disadvantaged relative to a competitor who looks deeper and probes below the surface for actual skills.

If dishwashers get around $10 / hour, then if the restaurant owner were so impressed with an applicant’s suit that he gave him $40 / hour, then he’d obviously make a big mistake he’d quickly come to regret.

Now Frank assumes that the candidates are “similarly qualified.” The only thing that would set them apart is their clothing. Another assumption is that clothing is only useful for making a “first impression.” Even given these, being well-dressed indicates to the employer that the candidate wants the job a great deal, if he’s invested so much into something so peripheral to the job requirements as an expensive suit. And this means that he’s more likely to work extra hard to justify his salary.

Further, if he makes a good first impression on the manager, he may similarly impress his customers.

Further, beauty is an end in itself. A handsome guy competing against a deformed hunchback will probably win. It may be unfair, but why should the people around the office have to endure the sight of an ugly freak? Good-looking people may inspire each other.

If we stay strictly within the confines of the model, then perhaps the race for better suits is a waste. But calling it a real-world market failure is really stretching the language.

Is Woe Us Without an Army?

Frank continues, attempting to refute the libertarians:

Without mandatory taxation, there could be no government. With no government, there would be no army, and without an army, your country would eventually be invaded by some other country that has an army. And when the dust settled, you’d be paying mandatory taxes to that country’s government.

Sounds plausible, right? Until you take into account two things.

Right now, there is both the government apparatus set up to collect taxes and the popular ideology supporting taxation. Under a more-or-less anarchic order, things are different.

First, then, the conquering country’s government would have to go door-to-door threatening, registering, and then monitoring each person and firm individually for tax collection. That is so inefficient that organized continent-wide taxation may never get off the ground.

This would be especially dangerous for the enemy, since Americans are individually so well armed. Even in the absence of an organized army, the invader would have to deal with a rifle behind every blade of grass.

Second, it assumes that if the people despise taxation, then the tiny clique of the new rulers can simply force their will upon them. But in the long run and in our case even in the short run, there are no unpopular governments. If 300 million Americans opposed taxation as such, they’d make their will known to the would-be taxers quickly and pointedly.

It is only now that the threat of being conquered and taxed exists. If the Ruritanians invade the US, then all they’ll have to do is decapitate the regime by killing Obama, dismiss the Congress, and set the taxes to whatever they pleased. (Or they could order the congressmen to vote to raise taxes to maintain the illusion of political continuity. Or simply take the existing tax revenue and spend it however they pleased. Or, finally, have Bernanke print a few trillion dollars.) The IRS and Federal Reserve would continue their work as before, and the people would probably obey the new masters out of habit.

Under city-state anarchy, say, on the other hand, imposing brand-new taxes on thousands of localities would likely be met with massive resistance.

One can only herd sheep not cats. If Americans were cats, there might be no need for an army at all.

Taking into Consideration Sunk Costs

Frank offers the following scenario:

Suppose you’re about to depart for a sporting event or concert at an arena 50 miles away when an unexpected heavy snowstorm begins. If your ticket is nonrefundable, your decision whether or not to drive to the event should not be influenced by the amount you paid for it.

Yet a fan who paid $100 for his ticket is significantly more likely to make the dangerous drive than an equally avid fan who happened to receive his ticket for free.

The first fan is probably guilty of a cognitive error.

Now Frank defines behavioral economics as an “intersection of economics and psychology.” Well, let us psychologize a bit. Why would one be tempted to drive? I suggest that if he failed to drive, then he’d have to issue a judgment of himself as a loser. He is a dupe, a sucker, a sap who was so imprudent that he failed to do something so simple as to check the weather forecast. The worst part is not that he lost $100 but that he was stupid enough to do this. The self-condemnation is what stings.

Furthermore, driving in a snowstorm entails only a heightened probability of an accident. A risk preferrer may have the temperament of an impulsive and confident Artisan and decide to go anyway. The assumption of temperamental equality has to be made in addition to the assumption of equal enjoyment of the event.

I agree, however, that considering the sunk cost is an error. To continue with our psychology, a person who decided to drive may after a few minutes be thinking to himself: “I can’t see a thing! The road is awful. If I get there alive, it’ll be a miracle. I’m so dumb, I should’ve stayed home; forget this stupid ticket.” It is true that he may regret the decision.

Unsafe at Any School?

Frank proceeds to make a strange argument:

.. the invisible hand might not automatically lead to the best possible levels of safety in the workplace. … riskier jobs tend to pay more, for two reasons. Because of the money employers save by not installing additional safety equipment, they can pay more; and because workers like safety, they will choose safer jobs unless riskier jobs do, in fact, pay more.

Most parents… want to send their children to the best possible schools. Some workers might thus decide to accept a riskier job at a higher wage because that would enable them to meet the monthly payments on a house in a better school district. But other workers are in the same boat, and school quality is an inherently relative concept. So if other workers also traded safety for higher wages, the ultimate outcome would be merely to bid up the prices of houses in better school districts. Everyone would end up with less safety, yet no one would achieve the goal that made that trade seem acceptable in the first place.

1. School quality is said to be relative, because (I speculate) schools prepare students to compete for jobs in the marketplace and so affect only the relative positions of the workers. But of course, that’s not true. If all workers became better trained or smarter by the same “amount,” then the same people might end up winners and losers, but society as a whole, i.e., the consumers, would benefit from their higher efficiency, ingenuity, creativity, etc. I thought the whole point of Frank’s book was to highlight the distinction and occasional divergence between individual and social benefits!

In other words, each child benefits from better education; the children as a group in their capacity as producers and wage earners, indeed, might not benefit from the “arms race”; but the same children in their capacity as consumers do benefit. Frank has simply not looked far enough.

Moreover, what about higher education that trains scientists and scholars? They cooperate more than they compete. Surely, we’d all benefit from better economists!

2. It should go without saying that in the long run, that is, closer to equilibrium, employers would be “indifferent” between installing safety equipment and paying more to workers. There is a standard yin-yang push and pull here: the more entrepreneurs “save” by not investing in safety, the cheaper it is for others to do the opposite: install safety equipment and reap the benefits of cheaper workers; and vice versa.

As a result, both kinds of firms would exist, thereby providing people with employment choices, precisely the wonderful thing at which the market excels. Novel lines of production would sometimes call for more worker safety; other times, for less; consequently, efficiency is promoted still further by these options.

3. From the point of view of the workers, some would specialize in higher-risk jobs, for example, construction of tall buildings, such as by staying physically very fit and agile; and others would instead agree to be paid less but not worry about safety and focus more on the job instead (as opposed to on avoiding falling). Again, the market fosters choice, only this time for business firms through specialization of workers. The consumers, most of whom are the workers themselves, are the beneficiaries.

Update. Since I’m writing this as I am reading the book, Frank makes an extended argument of exactly this sort on pp. 35-9. His aim is to dehomogenize the arguments for market failure, i.e., refute those he thinks are unpersuasive and present his own.

4. The bidding up on the houses argument is bizarre. A lot of people also want to eat better food, drive more comfortable cars, and own faster computers. If the wages of such people increase, then the prices of these goods may increase, temporarily. So what?

Under sound money, for example, if risk-preferring workers are paid more, then the manufacturers of safety equipment and their factors including workers will be paid less. Demand for consumer goods will shift around due to the reshuffling of net worth of workers with different preferences, but overall, no predictable effect will occur, including anything so definite as “bidding up the prices of houses in better school districts.”

5. Finally, there’s the idea of “best possible” “levels of safety in the workplace.” Best possible according to who? The market is not a simple game whose parameters an economist controls. It’s an enormously complex massively parallel process of innovation and imitation. What is “best” is determined by the outcome of market forces; no economist can substitute his own notions of the good for those of the market actors. For goodness’ sake, have some humility, Frank. You are not a socialist central planner; you barely survived a tennis game, and you think you are competent to pronounce what is “best possible” in a global market, the forces affecting which are without number? Get real.

Social Engineering via Taxes

Frank faults libertarians for “denouncing [taxes on harmful activities] as ‘social engineering’ — attempts to ‘control our behavior, steer our choices, and change the way we live our lives.’ Gasoline taxes aimed at discouraging dependence on foreign oil, for example, invariably elicit this accusation.” An argument phrased like that elicits from Frank a ready response. “But it’s a vacuous complaint, because virtually every law and regulation constitutes social engineering. Laws against homicide and theft? … they’re social engineering. So are noise ordinances, speed limits, even stop signs and traffic lights.”

So then, there are two kinds of taxes. One kind is meant to raise revenue for the government; that people change their behavior in response to them causes such taxes to be non-market-neutral, produce deadweight loss, and is an undesirable side effect. The other kind is the exact opposite: it is meant to alter behavior; any revenues indicate only that the offending behavior has in some part persisted, and it is this that’s an undesirable side effect. Some taxes then are meant to be paid; others, entirely avoided.

It is true that all laws can be construed very widely as social engineering. But notice the difference. A law ordering the government to punish theft (thereby deterring it) is a general rule. The government laws permeate society as a whole ordering the entire people. A law is a general incentive that, when enforced, allows the consumers within the free market thereby secured to present to the businessmen the particular incentives by their buying and abstention from buying which products to output, in what quantities, and at what prices.

But consider the following passage from my book:

For an example of vicious thinking regarding full employment, I direct your attention to H.R. 2847, “Hiring Incentives to Restore Employment (HIRE) Act” passed by the US Congress on March 18, 2010. Among other things, the bill establishes a payroll tax holiday for employers who hire “qualifying workers” — individuals who have not worked more than 40 hours during the last 60 days. It is a bill like any other in the sense that the government considers the people to be trained monkeys who dance to the regulators’ both clumsy and highly intricate behavior modification tune of financial incentives and disincentives. It legislates a tax cut, in that the employers are freed from the necessity to pay their portion of Social Security for a period of time for those people they hire who have not worked for a while. … (I, 7)

You can read the reasoning following this passage in the book. The point is, as soon as the government starts building regulatory mazes for entrepreneurs to navigate, it redirects production away from the course that is most agreeable to the consumers. It substitutes government sovereignty for consumer sovereignty. In general, such conduct is uneconomic, deviating from the market’s tendency to create the greatest good for the greatest number.

It is still open to Frank to argue that regulations negate some subtle harms to third parties, negative externalities. This is fine, although I think the amount of attention that economists pay to these “market failures” is grossly out of whack with their real-world significance. Again, Frank can say that training monkeys to dance creates some group goods. But he cannot deny that consumers privately suffer.

It is true that noise ordinances can be used to control externalities, but they do so locally. In stark contrast, in proposing his remedies, Frank imagines himself king of the world.

Speed limits, etc. exist, because the government owns the roads. What is its property, it needs to manage. The people have no direct say in how the government manages the roads. Even if highways are privatized, rules for their use would exist and might even be stricter than the present government ones. So, this is no counter-argument.

Presumably, however, the government does not own businesses. Manipulating and micromanaging them seems like slouching toward socialism of the “German pattern,” as Mises puts it, whereby property is nominally private, but actual control of it belongs to the state. In such a situation, business owners are mere agents of the state. I suppose the difference is that American regulations mostly say, “If you do this, you will be punished,” while the German planners said, “If you don’t do this, you will be punished.” This is a trenchant objection, even if I do say so myself. But as the amounts of regulations pile up, and they do, the distinctions between the two systems become increasingly less vivid.

I hope Frank is not in favor of that.

Rich Government, Poor Government

Frank notes:

Countries whose citizens have the most favorable opinions of their governments tend also to be ones with the best public goods and services, the lowest levels of perceived corruption, and the highest per-capita incomes.

In contrast, those with the weakest governments — think Haiti, Somalia, or Sudan — typically have poorly functioning markets, extremely low per-capita incomes, high levels of crime and violence, and citizens who regard their governments as ineffectual and corrupt.

Here is the sequence of events. In the beginning, the government of Waldavia is extremely limited according to the Constitution and public opinion. Free markets are unleashed which encourages rapid growth in the standard of living. Over decades and centuries of laissez-faire, a massive amount of wealth is created in Waldavia.

Then two developments take place, one OK, the other bad. First, certain luxury communal goods, provided almost always locally and often privately, such as nature preserves, very well-maintained cities roads, improvements in the quality of tap water, and suchlike, become “affordable.” Commonly owned spaces approach in their beauty those kept privately.

Staggering growth in private wealth is what causes good “public goods and services” in Waldavia.

The other, bad development, is an ideological change toward statism. People forget their economics. There is moral as well as intellectual decay, such that “legal plunder” becomes the order of the day. This decline is facilitated precisely by a high level of economic development: the more wealth there is out there, the more there is for the government to steal.

It is true that the government, having at length grown huge and powerful, now provides numerous “services.” But those services only drag the economy down. Despite this, economic progress still occurs. It is greatly slowed down, but the perception of the speed of improvement is hard to put into precise terms or compare inter-generationally. Moreover, where before incorruptibility of public officials was a boon, now the market wriggles through loopholes in the law: “But for the inefficiency of the law-givers and the laxity, carelessness, and corruption of many of the functionaries, the last vestiges of the market economy would have long since disappeared,” says Mises.

Perverse money and banking regime causes panics and financial crises one after another. Decent neighborhoods are wiped out after becoming the HUD’s “projects.” Disabled people can’t get jobs. Public education ruins the children’s minds and in fact is explicitly designed to do just that, for the sake of “equality,” and since everyone cannot be made equally sharp as tacks, it is much more feasible to make everyone equally dumb as doorknobs.

Now Haiti and Sudan are somewhat free from these ills, but only because the first step of extremely limited government lasting for centuries which allowed considerable capital accumulation never happened for them in the first place. Their people’s ideology has always been bad; while Waldavia has not always labored under interventionism and taxism.

We now have Waldavia, a husk, a mere shadow of its former glory, but still greatly exceeding Third World countries in material wealth thanks to what Mises called its “reserve fund.”

Finally, out pops Frank and announces that the Waldavian Third Way between capitalism and socialism is the best thing that can ever be. He fails to see the progress that could have but did not occur because of Waldavia’s long and ugly experiment with big government.

An “Arms Race”: Schools

On pp. 25-6 Frank mentions the schools race once again. He must be serious. “Parents who want to send their children to good schools must outbid other parents for houses in good school districts. Their ability to do so depends almost entirely on relative income. Here, too, we see the logic of musical chairs: no matter how much money people earn, only half of all children can attend schools in the top half.”

First of all, this is not necessarily true on its own terms. If all schools were private, then there may be a very large and successful chain of schools, call it Walschool, such that 3/4 of all children would attend it and so be equal in the quality they receive.

Second, why limit this reasoning to schools? Only half of all people can get the top half most expensive tablet computers. Or pianos. Or safari adventures. So what?

Third, Frank is again playing a game with silly assumptions. The consumers’ interest in the quality of the children’s education would, under laissez-faire, cause competitive pressures on schools to improve. Improvement could take a vast variety of forms: novel teaching techniques, stricter certifications for teachers, ingenious incentives for students, adoption of new technologies, better safety and security, customized curricula, individual tutoring, and a hundred others that I lack the imagination to invent.

The situation with schools illustrates precisely the opposite of Frank’s theory. Whatever the relative position of individual schools, consumer incentives cause each set of schools and the company that owns it to seek constantly to create a better and cheaper service. Society straightforwardly benefits from this competition.

Now Frank can argue that schools are government-run enterprises, tax-financed, and so do not improve. Well, some considerably weakened competition does exist, insofar as there are “good” and “bad” school districts, and voters in bad districts may demand changes. But he cannot attack libertarians for affirming individual freedom to travel or move to whatever location one prefers (limited only by his neighbors’ private property rights), including for the sake of better public schools, on the grounds that the school system is statist. Let’s abolish government schooling, and the wasteful “arms race” will go away.

Some libertarians, myself including, recommend free and unrestricted immigration. It may be a somewhat unrealistic ideal due to the welfare state and the billion Chinese half of which may want to move to the US right away causing severe political problems, but economically and morally, that’s what we should aspire to. The world cannot be knitted together — out of many (individuals), one (free market) — as long as nation-states exist.

Finally, to finish off Frank’s argument, even if there is an arms race for better schools, society does benefit when a worker acquires new skills and gets a raise or moves to a better job, because he becomes to that extent more productive. Again, if everyone does that, then no one benefits as a producer, but everyone benefits as consumers. An individual worker’s quest for higher wages blesses, via his accumulation of human capital, those around him.

Why There Are Few Labor-Managed Firms

Frank’s demolition of spurious ideas of why cooperatives and other labor-managed businesses are not prevalent and in fact comprise only a trivial portion of all firms (31-35) is beautiful and superb, precisely what I would expect from any decent economist. Ideological fanatics who fancied themselves economists expected them to prosper and blamed various features of capitalism for their failing to do so. Frank systematically dismantles a slew of such arguments. This example of economic logic is certainly worth attending to.

An “Arms Race”: Evil Government Schools

Frank’s argument within his model seems to me to be something like the following.

Failing to be as productive as he can be is bad for Smith not just for one reason that his absolute consumption will fall but also for a second reason that Jones and Robinson and Brown and Green will pass him in social status and access to many valuable goods.

If school quality and price are fixed over the long term, as it may well be for the government system we have now (in fact, prices always increase), then the total pie remains the same, and the social function of consumer competition in encouraging progress (both innovation and imitation) in the schooling technology and services is checked. People can alter only the relative shares of how much of this resource they consume, but this churning of the social hierarchy, the quarrel over who gets what, is socially wasteful.

Now if Smith relaxes, then it will be his neighbors who will buy houses in the better neighborhoods. In order to keep up with the Joneses (and Robinsons and Browns), Smith has to run the rat race, even if he’d rather pursue his life-long passion for growing flowers or honing his yoga skills. But Jones and Robinson cannot rest either, because if they do, then Smith will sense an opportunity to overtake them, which he values more than even the flowers, and take it.

Here is the model. Smith prefers (1) being on top of the hierarchy to (2) growing flowers while being in the middle to (3) the rat race in which he is also in the middle to (4) being at the bottom of the hierarchy, but though he is right now at (3), choice (2) is unavailable to him, because if he takes it, he’ll actually end up with (4).

The result is that everyone is working frenetically despite the fact that if everyone slowed down a bit, such that their relative positions are unchanged, everyone would benefit by switching to some extent from (3) to (2). The pace of life will slow down, and perhaps, people will have more time to lead “examined lives,” rather than thrashing about like crazy working 15 hours per day just in order not to fall behind their neighbors.

The argument is granted, but it is no accident then that Frank has picked schools as his foil. The fact is that normally, for the vast majority of goods, capitalism is mass production for the needs of the masses. But not only that, it is a process resulting in continuous improvement in the quantity, quality, and price of the goods and services that the masses can “afford.” For goods like schools which are scarcely goods at all but economic bads, such that most children would be better off homeschooled, the solution to restoring the long-term harmony of interests is to privatize the system altogether.

Again, if hours of work are shortened by government decree, then marginal productivity of labor rises relative to the marginal productivity of capital goods. Total production falls, so it is not at first glance clear whether workers benefit or lose. That they lose becomes obvious once it is realized that when capital equipment stays idle, and human capital, unused, it’s as if they have ceased to exist. It is not the case that moving from (3) to (2) via collective action for any individual worker is without costs: his absolute standard of living will fall not only because he himself works less, but because the economy as a whole is less productive.

In short, so far in the book, Frank has not made his case that as a rule, laissez-faire fails.