published in: Econometrica, 2002, 70 (2), 2078-2091
We estimate a structural dynamic programming model of schooling decisions with
unobserved heterogeneity in school ability and market ability on a sample taken from the
National Longitudinal Survey of Youth (NLSY). Both the instantaneous utility of attending
school and the wage regression function are estimated flexibly. The null hypothesis that the
local returns to schooling are constant is strongly rejected in favor of a convex wage
regression function composed of 8 spline segments. The local returns are very low until
grade 11 (1% per year or less), increase to 3.7% in grade 12 and exceed 10% only from
grade 14 to grade 16. The average return increases smoothly from 0.4% (grade 7) to 4.6%
(grade 16). The convexity of the log wage regression function implies that those who obtain
more schooling also experience higher average returns. We strongly reject the null
hypothesis that unobserved market ability is uncorrelated with realized schooling attainments,
which underlies many previous studies that have used OLS to estimate the return to
schooling. The correlation between realized schooling and market ability is found to be
positive and is consistent with the existence of a positive “Ability Bias”.
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