COLLEGE EDUCATION: IS IT WORTH THE COST?

The rising cost of education over the last twenty or so years has led many to question if their four or more years of investment in an undergraduate education is worthwhile. The cost of the education includes not only the four years of tuition and room and board (if the next best option is to live with your parents), but also the foregone income that you do not earn during those four years. The opportunity cost of getting an undergraduate degree is very high. Is it worth it?

Recent Trends & Statistics

According to the Wall StreetJournal (9/26/94), recent college graduates earn 75 percent more than comparable high-school graduates. Moreover, 63 percent of high school graduates went to college in 1993, compared to 53 percent in 1983.

The good news is that the premium paid by employers for a college degree doubled in the 1980s. The bad news is that the increase was mainly due to the decline in wages paid to those without a college degree. The wages of college graduates increased but by relatively small amounts. As a consequence, the wage-inequality between skilled and unskilled workers has widened substantially since the early 1980s.

College education is an investment in your future. One of the benefits is higher wages throughout your working careers. Two economists, Ashenfelter and Krueger estimated by comparing identical twins that each additional year of schooling increased wages by 13 percent to 16 percent.

Why has the wage premium for a college degree increased? Either the demand for employees with a college education increased (demand shifted to the right) or the supply of college graduates fell (supply shifted to the left). In fact, it is likely that both happened. Notice that both the demand and supply shifts lead to rising wages.

Demand-side factors: The computer revolution created a demand for technically-literate workers. Also, the US comparative advantage in services increased creating a demand for white-collar employment.

Supply-side factors: In the 1970s the supply of college graduates as a share of the total work force grew at 4.3%, in the 1980s the rate of growth was 2.3%. Why? The 1970s was the decade that baby-boomers entered the work-force in mass (3.1 million). Since then, the college-age population has gradually declined when it bottomed out in 1994 at 2.5 million. It will begin to grow rapidly again in the late 1990s. In the meantime, the supply of new entrants in the labor force as a percentage of all workers has declined.

An Empirical Estimation of the Returns to A College Degree

Before we estimate the returns to a college education, it is necessary to understand the concept of present value. An annuity is a stream of income flows over time. For example, if you own a $1,000 bond that pays 10% interest annually, you receive $100 per year. The concept of present value relies on the fact that we prefer to have money now rather than later and that over time inflation erodes the value of your money.

Scenario: You win the $1,000,000 lottery and learn that you will collect the money in a series of $50,000 payments over 20 years. Have you really won a million dollars? What must be done to answer the question is to compute the present value of your annuity.

Step 1: Determine your discount rate. The discount rate is the interest rate return that you would have to be paid in order to willingly receive money one year from now as opposed to receiving it now. Example: Suppose someone was willing to give you $100 today or $110 on this exact date next year. What would you do? If you would except the $110 next year, your discount rate is 10% or less. Let's rephrase the question another way. How much money would you have to be paid next year in order to wait one year to receive the $100? Suppose the answer is $120. Then your discount rate is 20%.

Step 2: Apply this formula to your annuity:

where PV is the present value, CF is the annual cash flow received, n is the time period, N is the total number of periods in the annuity, and r is the discount rate.

In the lottery example, suppose the discount rate is 10%. The present value would be:

PV = 50,000/(1.1)0 + 50,000/(1.1)1 + 50,000/(1.1)2 + ... + 50,000/(1.1)19 = $425,678

Notice that from today's point of view, the $50,000 received in the last year is only worth $8,175 today.

Try your own scenario:

You receive $500 annually over the next 5 years. What is the present value assuming the discount rate is 10%?

Now redo the calculation assuming the discount rate is 50%. Why does the present value fall in the second example?

Now we are prepared to undertake a cost/benefit analysis of college education.

Benefits:

The most important marginal benefits from college education are 1) the increase in your future quality of life due to better job satisfaction, and 2) the present value of the annual increase in higher life-time earnings because of the college degree. We will ignore the increase in job satisfaction and quality of life since these are more difficult to quantify.

Costs:

The most important marginal costs are

1. four years of tuition,
2. lost income from not working full time.

We must compute values for each of these items.

In order to calculate the present value, we need a value for the discount rate. There are two options. One is for each individual to provide his/her own discount rate. The second option is to compute the discount rate that equates the marginal benefits and marginal costs. Then if the individual discount rate is lower than the one computed, college education is worth the cost. If the individual discount rate is higher than the one computed, college education is not worth the cost. For example, in the equation

the only variable we don't know is 'r.' We will set the costs equal to the benefits and then solve for r.

Analysis

We will do the analysis for the "typical" Humboldt State student. Tuition and room and board at HSU is approximately $6,000 per year. We will round up and assume that the typical student spends $25,000 to attend college here. Of course, this assumes no financial aid. Also, let's assume that each student could earn $1,000 per month working full time without going to college. Since summer jobs make up for some of this, we will add another $10,000 per year, or $40,000 more dollars to the cost of eduaction.

The "typical" student graduates when he or she is 22 and we will assume that they work from age 23 until age 65, a total of 43 years in the labor force. Statistics from the early 1990s show that college graduates earn about $14,000 per year more than those without college degrees. So the benefits are equal to a stream of annual payments of $14,000 for 43 years. This assumes that we will have no inflation in the future, so we are calculating the real rate of return (as opposed to the nominal return) which is the appropriate measure. The calculation we have set up, then, is the following:

Solving for r, we derive a real interest rate return of 21.5 percent. In other words, the "typical" HSU student earns an annual return of 21.5 percent for money invested in his or her education. To put this in perspective, the stock market in 1995 gained about 30 percent, triple its historical average. 10 to 15 percent returns on investment are considered strong. Most people's discount rates are not anywhere near 21.5 percent. Therefore, college students at HSU are getting a very good deal.

What if you went to school at Harvard? We assume all the figures in the calculation above are identical except that the costs of education are now likely to be near $100,000. The rate of return for Harvard is 13.9 percent, still very decent. Of course, we are assuming that someone with a Harvard degree will still only earn $14,000 per year more than someone without a college degree. In fact, the wage premium will most likely be higher.

So in a world that demands ever-more mental skills and abilities, for most people, a college degree is the surest way to economic success.