Basic schooling model

In this chapter, we focus on schooling as an investment in human capital. We present the core model in its most basic specification and derive implications for interpreting wage differentials by education as reflecting returns on the schooling investment. We briefly survey international evidence on estimated private rates of return and summarize our own contributions to that literature

The basic human capital model of schooling envisages two options: (1) go to school for s years and earn an income Ys every year after leaving school, or (2) go to work right away and earn annual income Y0 (see figure 1.1). This makes the choice for schooling an investment problem. While in school, the student has forgone earnings of Y0 for every year in school and direct outlays for tuition, books, etc. of K per year. After leaving school the individual has benefits: in every working year, earnings are Ys rather than Y0. The gap in annual earnings is the dividend flowing on his investments.

The internal rate of return is the discount rate that equates the present values of the two lifetime earnings flows. But as the above suggests, we can also take it as the dividend rate Ys − Y0 relative to the investment cost, composed of forgone earnings Y0 and direct outlays K for every year in school.