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The Option Value of Human Capital

Yongseok Shin and Sang Yoon (Tim) Lee

No 986, 2013 Meeting Papers from Society for Economic Dynamics

Abstract: We study college enrollment and completion decisions in the presence of risk in individuals' returns to college. Although the human capital acquired through education is irreversible (i.e., it cannot be decumulated or sold off), college education comes with two inherent options: (i) college students may drop out after obtaining additional information on their post-graduation wages and (ii) college graduates may take jobs that does not require a college degree, effectively protecting themselves from the left tail of the returns-to-college distribution. These two options may dominate standard risk aversion considerations so that enrollment may in fact increase in the face of larger risk. We calibrate our model to U.S. data on education and labor market outcomes in the 1980s and show that these option values are important for explaining the ensuing trends in college enrollment and dropout rates. In particular, we decompose the relative contributions of the first and second moments of the returns-to-college distribution to the trends in education decisions and labor market outcomes.

Date: 2013
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