The Return to College: Selection Bias and Dropout Risk

We study two long-standing questions: (i) What part of the measured return to education is due to selection? (ii) The ex post return to schooling is higher than the return to most financial assets. How large are the contributions of various frictions to the "high" return to schooling? We focus in particular on the roles of college dropout risk, borrowing constraints, and learning about ability. We develop and calibrate a model of school choice. Key model features are: (i) ability heterogeneity, (ii) students learn about their abilities while in college, (iii) borrowing constraints, (iv) dropping out of college is a choice. We find that the probability of graduating from college increases strongly with ability. Most college dropouts are students of intermediate abilities who try college in part to learn about their abilities and in part because of the option value of receiving a large earnings gain upon graduation. Ability selection accounts for about 40% of the measured college wage premium.