Sunday, May 15, 2011

Four Year College Degree Expected Wage Premium: No Signs Of Tuition Bubble

Taking a Gary Becker approach that an investment in education is an investment in human capital, what should the expected return on that capital investment be over the working life of a wage earner who makes an educational investment in four years of college? In other words, what will the wage premium be for a four year college degree over a high school graduate that did not make the same investment in education and in human capital?

The average private college costs a student about $30,000 per year plus the opportunity cost of lost wages of about $20,000 per year for a total cost of roughly $50,000 per year. (See Wall St Journal article, "What's a Degree Really Worth?" for reasonableness of the numbers used in this post).

Assuming a longterm expected rate of return of 8 percent (approximately the longterm rate of return in the stock market, but one's own estimates can be substituted for analysis), the future value at the end of 4 years of 4 yearly $50,000 payments is about $243,000.

Assume the student graduates and works from about age 22-23 to 65 for about 42 years in total.

The student invested $243,000 in his/her own human capital by the end of the four years of college and is expecting an 8 percent yearly return on that capital. An 8 percent return on $243,000 is slightly above $19,000 if the educational investment is not amortized over the 42 working years and about $20,000 if the investment is amortized over the working years. In other words, the wage premium over a high school graduate of a college graduate should at a minimum be about $19,000-20,000 for an 8 percent return on the college education human capital investment.

In the Journal article mentioned above, the Census Bureau found the college education wage premium to be about $19,500.

If ones uses a lower return on capital interest rate, the expected wage premium will be less than the $19,000-20,000. (At a 5 percent return on capital, the expected return is $13,000, significantly below the $19,500 historical return number for the college education yearly wage premium.)

Despite the high and rising cost of private college education in the US, a fair and adequate return on the cost of the investment in human capital through a college education is still likely. College costs have not reached the level where a fair return on that investment is unattainable or unlikely, especially in the recent economic downturn where high school graduates have a much higher unemployment rate, and loss of wage income, than college graduates.

If one can expect to make a fair and adequate return on an investment, it is not in a bubble and it is not overpriced.

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