- Signaling vs. human capital theories.
In signaling theory, Spencer’s argument is that achievement of valid credentials is a crucial signal to an employer about a potential employee’s productivity. In this theory, education is taken as an individual’s effort regardless of the cost of attaining the credentials. In that respect, Spencer makes fundamental assumptions with one being that job vacancies require the prospective employees to have a certain set of skills and personality. In addition, Spencer classifies the pools of skills into two categories of good and bad, with good indicating a pool with potential for high productivity and bad as being an one indicating low productivity. (Weiss, 1995)
However, the theory argues that it is not possible to identify all the set of skills and personalities in order to separate the good and the bad pools. Thus, employers could rely on education credentials to differentiate those who have potential for higher productivity from those without good productivity prospects. To separate the two, Spencer argues that, although education does not have a direct effect on a potential employee’s productivity, it could be a good signal of them having either good or bad pool of skills since good employees would have a lower opportunity cost for pursuing more education than bad employees. In that respect, good employees would most probably seek to undertake more studies hence the validity of their credentials as a good signal of potentially high productivity which would then translate to higher earnings. (Sessions & Brown, 1999)
On the other hand, there is an argument that education has a direct effect on an employee’s earnings through its direct effect on their skills or human capital. This scenario has been associated with the human capital theory which claims that; more time spent in education system directly increases workers’ productivity through increased skills’ hence their higher earnings. In that respect, the theory has a claim that there is a direct correlation between the skills learnt which are dependent on level of education and the return on education which is measured in terms of earnings. (Chelli, Castagnetti & Rosti, 2005)
- Empirical evidence for testing the competing theories
Several estimates of the rate of return on education have been published with use of the least squares (OLS) method as their estimation and test technique. The OLS model reflects earnings’ logarithm as the dependent varariable while independent variables comprise of a constant and other observed demographic characteristics like the level of education, experience, sex and race. That empirical model is referred as the Mincerian model and is named after Jacob Mincer. (Weiss, 1995)
In that respect, the model’s schooling coefficient is an indication of the percentage change in earnings with a year’s change in level of education. According to the human capital theory, addition of the other unobserved variables that are not directly related to skills learning should not affect earnings unless employers were irrational. On the other hand, the signaling model argues that employers do not have ability to measures the effect of those unobserved characteristics that affect productivity hence taking them in consideration under the education/schooling factor. This results to a change in earnings with a change in the unobserved factors. (Chevalier et al, 2004)
A suitable empirical study that explains the usefulness of the two theories in understanding return on education is the Card and Krueger study. The study reported that people born in places where there were small class sizes and relatively high salaries for teachers got a higher return on their education. It was also reported that an incresae in those schooling factors resulted to lower earnings for those who did not complete high school and higher earnings for those who had more than 12 years of schooling. This results from the assumption that an increase in schooling/education level was associated with small class size and high teachers’ wages. (Weiss, 1995)
In conclusion, it is important to note that the two theories have played a great role in helping employers during hiring although it is difficult to classify which is better than the other. In addition, it is evident that both acknowledge the contribution of education on earnings ability. However, their difference has been demonstrated as being how education translates to productivity and earnings. That is either through the actual skills learnt in school as the human capital theory argues; or through presence of other unobserved factors in workers who have high education level that enhance their productivity hence can only be signaled by the candidates’ education level. Finally, empirical studies have confirmed that the two theories have a similar conclusion of education being a factor in determining an employee’s earnings although the human capital model excludes the unobserved traits from the model’s education factor while the signaling theory includes the traits in the factor.
Chelli, F. Castagnetti, C. & Rosti, L. “Educational Performance as Signaling Devices:
Evidence from Italy”. Economics Bulletin 9.4 (2005): 1-7.
Chevalier, A. Walker, I. Harmon, C. & Zhu, Y. “Does Education Raise Productivity, or Just
Reflect it? Economic Journal, Royal Economic Society 114.499 (2004): 499-517.
Sessions, J. & Brown, S. “Education and Employment Status: A test of the Screening
Hypothesis for Italy”. Economics of Education Review 18 (1999): 397-404.
Weiss, A. “Human Capital vs. Signaling Explanation of Wages”. The Journal of Economic
Perspectives 9.4 (1995): 155-154.