What is the (Real Option) Value of a College Degree

Abstract

The value of a college degree is often quantified as the difference in earnings between those with and without a degree. The research presented here operationalizes this idea in two important ways. First, since future income and tuition are uncertain, a contingent claims model is developed and the appropriate discount rate for valuing future earnings is, therefore, endogenized given an economy that does not permit arbitrage. Second, the model is sensitive to the valuation of the real option to obtain an advanced degree in addition to the valuation of the earnings for an individual with an undergraduate degree. In this framework, the value of a high school diploma is shown to be the sum of: (1) capitalized earnings, (2) the real option to obtain an undergraduate degree and (3) the embedded or compound real option to obtain an advanced degree. Numerical examples are presented that demonstrate the performance and key drivers of the model. One important finding is that by ignoring the real options to further one's education, the value of a college degree is likely significantly understated.