Thursday, 2 October 2014

Why study economics? Sheepskin effects edition

Over at Offsetting Behaviour, Eric Crampton highlighted that economists have higher lifetime earnings than other graduates. The source of this claim is from this Jordan Weissmann article. I've previously written on the reasons why students should study economics (see here and here), and for a lot of prospective students deciding on their majors it really does come down to how much they can earn having done different majors. On this metric, economics does pretty well for the median graduate. However, the key addition from the Weissmann article is that, at the top end of the income distribution for each major, economists earn more than all other majors. Here's why:
So why are econ grads so good at making it rain? Part of it is that the finance and consulting industries like recruiting them, not necessarily for their specific skills, but because they consider the major a basic intelligence test. Granted, we're probably not seeing the effect of Goldman Sachs or Private Equity salaries in these charts, since they only stop at the 95th percentile of earners—but banking is a big industry, and it pays well.
Eric adds a good point which I want to expand on:
Grade-seeking students of lesser abilities drop economics for other majors; those who are left earn their grades.
One of the key characteristics of a degree or diploma is the signal that it provides to prospective employers about the quality of the applicant for positions they have available. Employers don't know up front whether any particular applicant is good (intelligent, hard working, etc.) or not - there is asymmetric information, since each applicant knows their own quality. One way to overcome this problem is for the applicant to credibly reveal their quality to the prospective employer - that is, to provide a signal of their quality. In order for a signal to be effective, it must be costly (otherwise everyone, even those who are lower quality applicants, would provide the signal), and it must be more costly for the lower quality applicants. Qualifications (degrees, diplomas, etc.) provide an effective signal (costly, and more costly for lower quality applicants who may have to sit papers multiple times in order to pass, or work much harder in order to pass). Qualifications confer what we call a sheepskin effect - they have value to the graduate over and above the explicit learning and the skills that the student has developed during their study.

Now, economics may provide a stronger signal of quality (a more valuable sheepskin effect) than other majors. Why would that be? Economics is by no means an easy major for most students. It involves learning calculus and statistics, and developing important critical thinking and logical reasoning skills. All of these things are hard (but ultimately worthwhile, given the returns to an economics major in terms of higher earnings) so, as Eric argues, lower-ability students tend to select themselves into majors other than economics.

When it comes to graduates, employers can't easily tell the difference in quality between economics and knitting [*] graduates in terms of their quality. However, if economics is known (by employers) to be more difficult (i.e. more costly in terms of time and effort) for students, then an economics major would provide an additional signal (over and above that of the degree itself) of the higher-than-average quality of the student.

We could make a similar argument for econometrics (regarded by most students as the most difficult part of an economics major). Top grades in econometrics (or even slightly-above-average grades in econometrics) may provide an additional signal of quality, over and above the signal provided by the economics major (and the degree). Which is why I always strongly recommend to our economics students that they include econometrics in their programme of study. That allows them to take advantage of multiple layers of sheepskin effects.

So, sheepskin effects provide another reason why studying economics is a great idea. If you want to convince employers that you are a top-quality student, it's hard to beat receiving top grades in a more difficult major.


[*] OK, I made that up - we don't have knitting graduates. I don't doubt there are some potential students who would be keen on a Bachelor of Knitting though.

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