Comparing two approaches to the rate of return to investment in education

Abstract

The economic value of investment in education has typically been measured by its rate of return, frequently estimated by the internal rate of return or the earning function approach. Given the importance of the rate of return estimates for individuals and countries, especially developing countries, in making decision on educational investment, we need to know how these methods compare as empirical researchers have used only one method, mainly due to data constraints. This study presents and compares the rate of return estimates obtained from these two methods using household data‐sets that have been typically employed in such studies. The results of the study confirm the previously established stylized facts about the rate of return to education. In addition, the internal rate of return approach exhibits ‘diminishing returns’ to schooling, reflecting ever rising cost of higher increments of schooling, while the earning function approach yields the opposite pattern, reflecting the greater relative increase associated in earnings with additional schooling. Moreover, the rate of return is greater using the internal rate of return approach than the earning function approach. Finally, the internal rate of return approach reveals a more accurate estimate of the earning return to the actual amount invested in schooling, whereas the earning function approach is more thorough in measuring earning differences associated with additional schooling.

Keywords:

• cost of education
• economics of education
• investment in human capital
• rate of return
• Turkey

Acknowledgements

The author would like to express sincere appreciation and gratitude to W. Lee Hansen of the University of Wisconsin‐Madison for generous contributions of his time and extensive comments, in addition to two anonymous referees. Any error, however, is the author's own.