The Economic Calculus of Education

In the last few years, there has been a growing criticism of the high cost and low impact of contemporary higher education. On the micro-level, individuals like Peter Thiel have devoted significant resources to creating alternative pathways to traditional higher education institutions, while on the macro-level, there is stronger oversight by Congress and politicians regarding the value of education today.

On a holistic level, the idea that "everyone should go to college" doesn't make sense. This simplistic refrain fails to consider the individual needs of a diverse population, as well as the actual economic needs of the marketplace. While education most certainly should not be reserved for elites, the logical opposite is not necessarily better.

All this debate about costs though has raised the question: how should you think about investing in further education? Some emphasize elements like quality of living/career, happiness or personal interest as reasons to continue being educated, but economists take a much more utilitarian approach to the question. Instead of focusing on soft qualities, economists (using the Human Capital model) remove the distinction between a financial investment and further education. In other words, the same thought process that guides our decisions with regards to stocks or bonds, for instance, should also be applied to higher education. In summary, we should use the present value of all future gains on income and compare this to the total economic cost of further education.

This process though has some peculiarities, and is the subject of this post.

The Model

What is the cost of further education? This simple question is actually quite complex to answer, so let's start simply and go from there.

The basic human capital model for education is as follows. The cost of education is the price of tuition plus the opportunity cost minus any part-time employment and the total future gains to income. To put it more simply, we have a simple table of gains and losses depending on our decision to go to work or go to school.

 GainsLosses
Go to SchoolPart-time Wages
Future Income
Tuition
Go to WorkFull-time Wages 

Baseline Wages

To analyze this model, we have to have a baseline, which is what would happen if we didn't go to school. This is the wage we can expect normally. This is going to be highly variable depending on the person. On the low end, there is the federal minimum wage, currently set for $7.25. At my high school in Minnesota, some technically-minded students could get paid $17 an hour programming for a local high-tech company as part of an internship program. While there is no theoretical max income, that probably represents a defensible possible range of incomes for high school seniors.

These are our hourly wages, and thus total income will be dependent on hours worked. We will assume the standard 40-hour work week, 48 weeks a year here. Thus, there are 1,920 hours of work per year in this model. Based on our range of incomes, a high school senior will receive between $13,920 and $32,640 of gross, pre-tax income per year. If we discount this properly with a 3% discount for a 4-year degree, we get a range of present total income of $51,742.01 to $121,326.09.

Over the course of a 49-year work life, the present values of future income would be $354,983.06 to $832,374.08.

There are a couple of issues to think about with this model before we move on:

  1. The choice to pursue further education is quite individual. Already, we can see an enormous range in incomes, depending on just wage, let alone differences in time spent on the job. The economics for each person is going to be different, and thus the decision is unique.
  2. Quite interestingly, the people who make the most as a senior in high school are also highly correlated with the people making the most money post-college Thus, as we move though the model, realize that some of the extreme cases (high wage in high school, low wage post-college) are a lot less likely to happen than they appear.
  3. We need to properly discount the income by year. This is done by using the current interest rate to calculate the future earnings in "present dollars." Thus, we would need to put $51,742.01 in the bank at 3% to get the income we otherwise would have made over four years. This calculation compensates for making our money over a four year period.

Tuition Cost

We also do the same discounting analysis with regards to tuition and part time jobs. The total tuition is $30,643.76 for a $8,244/year tuition school (the average cost of a public 4-year university), while the total tuition is $105,937.30 for a $28,500/year school (the average private non-profit 4-year university cost). Notice immediately how dramatic the difference is, almost $75,293.54. Again, the economics of education changes for every single student depending on their choices.

Part-time Wages

Let's assume that our student works 10 hours/week for 37 weeks (in school), and an additional 40 hours/week over the summer for 11 weeks (summer internship). This is 810 hours of work per year. Using the same hourly rates as before, we get a net total range of $21,828.66 to $51,184.45.

Future income

The final piece to this model is the future income of the person. This is an enormously hard number to calculate, since so much changes in people's lives. This analysis is dependent on everything from wage mobility (job promotions, etc.) to life expectancy and health. So we have to make some simplifying assumptions. Let's assume that people have 45 years of wages. We will use the normal college-graduate average of $46,000 as our base salary, and our top performer will make $150,000 to represent the possible professions (engineering, medicine).

Taking these values and doing our discount analysis again over 45 years (skipping the four years in college!), we get a range of present net future income of $1,002,089.69 to $3,267,683.78.

Concluding the Model

Let's take our average performer. Going to the workforce will net $354,983.06 over their entire lifetime. If they went to school at an average public school, they will pay $30,643.76 in tuition. While in college, they will make an income of $21,828.66 and once they finish $1,002,089.69 for the other 45-years of their life. Thus, the net for going to college is $638,291.50 for this average performer.

Now, let's take our top performer. Using the same mathematics, we get a net benefit of college of $3,288,224.47. If we decided to go to a private school instead, we would subtract $75,293.54 from both of our final numbers (the increased cost of going to a private school instead of a private school).

So, what have we proven with this analysis? Absolutely nothing. As I mentioned before, every person is an individual, and thus the costs and benefits that someone experiences will be unique. One individual might make $150,000 coming straight out of high school, blowing up our calculations. Another person may go to the most expensive school in America and take out private loans and pay them off with a credit card, spiraling the college costs much higher than this analysis would indicate. Basically, every number in this model could be vastly different, and this could radically change our recommendation.

This doesn't even touch on other issues. PhDs tend to make less per year than many master's degree holders, but they have less unemployment and tend to have better satisfaction with their jobs. These issues haven't even come into the model, since we only consider raw income. We also aren't including fringe benefits into our equation -- better jobs may provide retirement benefits that change the equation again.

Another issue is that life expectancy has been going up, and the number of years of productive work has increased. This means more income, and increases the value of getting further education. Further advances in health treatment may mean that we are actually underestimating the value of education.

Let me iterate the conclusion of this little exercise: models are valuable, but knowledge of a personal situation is a far better indicator of how to decide on education. The variables and goals available to each person are unique, and our model is drastically affected what they are. The importance of advising cannot be underestimated.

So, the next time you hear some simple refrain like "everyone should go to college" or "everyone should do engineering", take a moment to think through this implication. A cookie-cutter approach to a complex individual choice isn't just a bad idea, it could be a disaster.

Discussion

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