Economics 101: Signalling Model Explains Labour Market Emphasis on Education

What is the signalling model of education, and how does it work in the GCC and beyond?

The human capital model of education, developed in the 1950s, analysed education as a way of building valuable skills. It provided economists with an intellectual foundation for treating education as a source of wealth, paving the way for the big expansion in higher education that has happened in advanced economies since the 1970s.

An alternative, complementary assessment of the role of education, known as the signalling model, was proposed by the American economist Michael Spence in the 1970s.

In its simplest form, the model says people differ in their ability to perform revenue-generating tasks for employers, just as in the human capital model. The problem faced by firms at the hiring stage is that they can only imperfectly determine people’s innate abilities; tests and interviews help, but a significant part of how good you are at your job is unknown to an employer.

Unlike the human capital model, education, most notably university education, has no effect on your ability. However, people who have high ability in the labour market also find it easier to score high GPAs, and to generally excel at college, because certain attributes, such as intelligence and perseverance, make you an effective student and an effective worker. Therefore, people invest in educational qualifications as a way of credibly “signalling” their innate abilities to prospective employers, rather than to acquire skills that can be deployed in the labour market.

According to the signalling model, a top management consultancy might prefer to hire a Harvard anthropology graduate over a business major from a lower-ranked university because the Harvard student is more likely to be intelligent and perseverant, despite the fact that 95 per cent of the skills acquired from the anthropology degree are of no relevance to management consulting. According to a pure form of the human capital model the business major might have been the preferable choice, because of their relevant skills.

Naturally, advocates of the signalling model do not think that all education is signalling; for example, doctors clearly acquire critical knowledge during their medical degrees. However, the signalling model provides an explanation for why the labour market places such a high weight on education.

Thus, according to the signalling model, individuals who have higher education earn more, but at the country level, the relationship should be much weaker, because education is merely sorting people into the right jobs, rather than contributing to people’s productive abilities.

There is some evidence that the economy-level returns to education are exceeded by the individual-level returns, and it is clear that some mixture of the signalling and human capital models underlies true labour market dynamics. Correctly assessing the contribution of each model is of great value, because the greater the importance of signalling, the less effective are government subsidies to education.

For the GCC, as we mentioned in last week’s article, the large public sector pays nationals wages that are incommensurate with their productivity, partially as a way of raising living standards.

This distorts the relationship between education and income: more educated people receive higher salaries because they have acquired more skills through their education (human capital model), because their credentials signal higher innate ability (signalling model), and also because government pay structures arbitrarily assign higher salaries to people with higher education levels, regardless of any relationship it might have to innate or acquired skills.

This makes it more difficult for policymakers to infer the right level of education subsidies, as interpreting the observed relationship between income and education is even more complicated than in a traditional economy.

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