In the field of labor economics, a long-standing question is why workers with higher education tend to earn more. Two main ideas explain this: one says it’s because educated workers have better skills, while the other says it’s just a way to show they are smart and hardworking. Both views have some truth, and there is an ongoing debate about their importance.

A new study from LSE challenges the concern that too much education might be a problem if signaling is critical. Signaling means using education to show employers your abilities, not necessarily the skills you acquired. The study suggests that when signaling matters, students might not put much effort into their education, and employers may struggle to judge their abilities.

Effective signalling

The study considers three things: first, education can make people more productive; second, employers can’t perfectly know graduates’ abilities, so they focus on a few criteria like degree class; and third, employers learn more about workers’ abilities over time.

Taking all these into account, the study suggests that students might focus on visible achievements like getting a degree instead of working hard to gain practical skills. This could lead to a less skilled workforce if employers can’t easily see their true abilities.

How can policy address such inefficiencies in education? One possible approach is to reduce informational barriers, leveraging recent advancements in artificial intelligence. If we could achieve “perfect information” in the model, where employers could see not only the acquired skills but also other relevant traits like pre-schooling abilities and personality, students might invest excessively to signal those additional traits. Therefore, efforts to improve information frictions would need to encompass more than just skill acquisition.

Aside from directly addressing informational frictions, there are alternative ways to incentivize students to study diligently, such as exams and mandatory assignments. While exams have been valued in education for centuries, economic theory has not always viewed them positively.

Human capital theory doesn’t account for exams since students would acquire the optimal level of skills regardless. On the other hand, conventional signaling models view exams as socially wasteful but serving a clear purpose. However, my model suggests that exams play a vital role in motivating students to acquire skills that hold productivity value in the labor market. Educators should consider this aspect when determining examinable material.