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Will the "Great Hangover last more than the day after graduation for this year's college graduates?

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The recent recession has been referred to as the "Great Hangover" after the roaring times and subsequent collapse of the housing bubble only a few years ago. For recent graduates, the impact could linger on well past when the recession is over (if some recent economic research is to be believed). Graduating into the labor market during a recession can make obtaining a job more difficult initially out of college, or it can result in graduates landing a position at a pay rate below what might be commanded in a regular hiring year. What is less evident is to what extent the economic context of the initial career placement of newly minted graduates matters in determining their long-term success and earnings potential.

Lisa Kahn, a labor economist at Yale University, suggested in a 2010 Labour Economics article that graduating from college in a bad economy has persistent negative wage effects lasting far beyond when initially hired. Her results show negative wage impacts could persist well into the second decade of one's career. Using data from the National Longitudinal Survey of Youth between 1979 and 1989, Kahn finds that students graduating in worse national and state economic conditions begin in lower level occupations, have slightly higher tenure in those occupations, and possess more years of schooling.

A number of theories can potentially explain why the economic environment at the time of graduation has long-term effects on the income and job quality an individual could attain later in his career. One possibility is that in a recession, low levels of firm-specific human capital might cause workers to accumulate less job knowledge and training or suffer from depreciation of skills, which would translate into lower wages. Models by Gibbons and Waldman (2006) and Lazear (2003) suggest that even in the absence of firm-specific human capital, initial conditions can be important for long-term labor market outcomes because of the impact on task-, firm-, or sector-specific skill development. Moreover, individual tastes and attitudes toward performance (work ethics, drive to succeed, etc.) may evolve based upon their experiences and work environment (Rayo and Becker 2005). In the Gibbons and Waldman (2006) model, for example, employees develop "task specific human capital"; those hired under favorable economic conditions are initially given higher value tasks and thus develop more valuable human capital that persists throughout their careers. Similar persistent negative effects are observed when the job market takes initial job placement as a signal of ability and fails to compensate for the "bad luck" associated with market conditions. Models where search is costly either for firms or for employees lead to frictions where initial jobs are likely to affect long-term opportunities. Models where incumbent firms have useful private information (Akerlof 1970; Waldman 1984) concerning an employee's productivity or where there are limits to long-term commitment (Tervio 2009), possibly due to high unemployment, have similar negative implications.

Analyzing labor market outcomes as a function of economic conditions in the year a student graduates is not straightforward. Students may take into account national and local unemployment rates and economic conditions when choosing time and place of college graduation, which may confound the relationship. Potential tenure or work experience might also be endogenous to (determined at the same time as) current labor market conditions. After controlling for the endogeneity issues by taking into account year of birth and local economic conditions, Kahn (2010) finds that in response to a one percentage point increase in the national rate of unemployment, the post graduation wage rate will drop by 5.9 percent (Chart 1). Although this impact does decline with time, at 15 years after graduation for each percentage point increase in the national unemployment rate at graduation, individuals should still, on average, expect 2.6 percent lower wages. This negative wage impact at 15 years post-graduation is statistically significant only at the 10.0 percent level, but the reported wage impact at 10 years post-graduation of -3.8 percent per percentage point increase in the unemployment rate at graduation is strongly significant at the 1.0 percent level.

Oreopoulos, van Wachter, and Heisz (2008) cover many of the same topics Kahn discussed. Oreopoulos et al. are of interest in that they employ a Canadian data set covering the period from 1982 to 1999 and find similar results as Kahn (2010). Oreopoulos et al. find the same initial negative effects over time of graduating in a recession and further claim that the negative effect of graduating in the midst of a typical recession may differ according to the decile of the net present value of a student's expected income over the first 10 years of his or her career (Chart 2). Notably, individuals who have lower expected earnings when graduating from college will be more negatively affected in terms of decreased earnings potential from graduating in periods with higher unemployment. Since prior earnings can translate into future earnings potential, individuals may be relegated throughout their careers to lower earnings if they graduate into occupations with lower expected earnings. These lower expected earnings arguably raise the stakes of an individual student's choice of college major according to the economic climate at graduation.

Oreopoulos et al.'s (2008) baseline model estimates the impact on income of graduating in a recession for graduates according to years of experience past college, which allows for comparison with Kahn's findings. The initial negative impact of an additional one percentage point increase in unemployment for someone just graduating college was a decrease of 2.1 percent in wages. The negative impact of a higher unemployment rate lessened, although remained significant in year five post-graduation at a 0.6 percent decline per additional percentage point of unemployment upon graduation from college. The effect of economic climate at graduation from college becomes statistically insignificant at six years or more experience beyond graduation.

The studies that have looked at the impact of starting a career in a bad economy disagree when it comes to the magnitude and duration of the estimated negative wage effects, possibly because they focus on correcting for the endogeneity of graduation time and location. Mansour (2009) points out that such analyses could suffer from bias via employers' ability to positively select candidates. During periods of high unemployment, the number of candidates in the labor market is higher than the number of available jobs. Consequently, high ability workers might apply for jobs for which they are overqualified or would not otherwise apply (Okun 1973). Sum, McLaughlin, Palma, Motroni, and Khatiwada (2008) estimate that young college graduates working in jobs that do not require a college degree will, on average, earn 30.0 to 35.0 percent less per year than their counterparts employed in jobs that require a college degree. When there is excess labor supply, firms observe the productive abilities of young candidates (as signaled by their majors, internships, etc.) and hire the most productive workers available. The result is a misallocation of high ability workers to lower quality jobs, which could explain why the mean productive ability of newly hired workers in a recession is higher than among workers hired during better economic conditions (McLaughlin and Bils 2001). Not controlling for this effect might underestimate the true impact of recessions on career outcomes and severely diminish its persistence over time (Mansour 2009). After including Armed Forces Qualification Test scores as measures of ability in his regressions using NLSY79 data, Mansour (2009) shows that a 1.0 percent increase in the unemployment rate at graduation reduces wages by 5.0 percent, and this effect does not converge to zero after 12 to 15 years in the labor market.

What is immediately certain is that the class of 2010 will be entering a labor market with the highest unemployment in at least a quarter of a century. Data from the Bureau of Labor Statistics indicate that the unemployment rates for both college graduates and non-graduates younger than 25 are nearly double their pre-recession levels. Put differently, since the start of the recession, the portion of the labor force aged 16 to 24 has contracted by 1.1 million workers, while an additional 1.2 million 16- to 24-year-olds have become disconnected from both formal schooling and work. It follows that the labor force containing graduates has expanded by 8.0 to 10.0 percent, while the number of jobs has decreased markedly due to the economic climate.

For those who do graduate, the prospects are even more in question. (1) College graduates make significant investments in their education and, therefore, exhibit strong labor force attachment rates. Their labor force participation (measured as the share of the population that is either employed or actively seeking employment) averages 92.6 percent over the last business cycle (between 2000 and 2007). However, they face particularly high unemployment: the 12-month unemployment rate jumps from 5.4 percent in 2007 to an average of 9.0 percent between April 2009 and March 2010.

Although the current scenario may appear bleak on the surface, one should not be completely averse to entering the job market at this stage. While there could be long-run negative effects of graduating in a recession, individual students can cope with less optimistic labor markets in a variety of ways and a poor economy is no guarantee of an individual graduate's poor labor market results. Factoring local and national unemployment rates into an individual's decision to graduate or being open to moving geographically to a location that is less affected by the recession could negate some negative labor market effects. Oreopoulos et al. (2008) document that the unemployment rate at job entry by diminishing the worker's starting wage significantly increases the probability of job separation. A more recent paper by Bachmann, Bauer, and David (2010) focuses entirely on how increased job mobility is able to partly reverse earnings losses experienced due to economic downturns. The analysis suggests that the labor market entrants earning less than the average starting wage are more likely to change jobs, directly or indirectly. In turn, the job transitions tend to reduce the effects of entry conditions, implying that job

mobility operates as an adjustment mechanism that reduces the effect of the initial wage differences between workers.

Arguments persist for continuing one's education and venturing into graduate school, for choosing majors with higher earnings potential, and for enhanced networking to improve expected earnings beyond graduation. Job scarcity lowers the opportunity cost of accumulating more schooling and induces individuals to postpone entry in the labor market. Kahn (2010) argues that the higher the national unemployment rate, the more likely students will remain in school and will continue their education. As shown in Chart 3, recent data from the Bureau of Labor Statistics show that education pays in higher earnings and lower unemployment rates. As education levels increase, a college graduate with a bachelor's degree faced an average unemployment rate of 5.2 percent in 2009, while an individual holding less than a high school diploma faced a job market segment characterized by almost 15.0 percent unemployment. Moreover, a bachelor's degree brought home, on average, $1,025 per week in 2009, while less than a high school diploma only paid, on average, $454 in weekly earnings. According to a recent Web article by Jacobe (2010), Chief Economist at Gallup, those without a high school diploma face a 36.2 percent underemployment rate, (2) are three times more likely to be underemployed than those having a college degree, and are four times more likely to be underemployed than those who have done some postgraduate work.

With such stark differences in outcomes for individuals with differing education levels, some students might be choosing to stay in school rather than face a decreased present value of earnings. In a recent New York Times article, Rebecca Ruiz (2010) notes that the number of people registering to take the Law School Admissions Test hit an all-time high in 2009, up 20.0 percent from 2008. She also states that the number of Americans taking the Graduate Record Examination (GRE) rose 13.0 percent compared to the previous year with 670,000 test takers, which is a sharp reversal from 2008 when examinations were down 2.0 percent in spite of the recession already being underway.

As heads clear and hangovers recede for this year's graduating classes, will the "Great Hangover" continue to cause problems for young graduates? Based on the previously discussed research, it appears that could be the case. Candidates should weigh their options carefully prior to choosing to enter the labor market, as this year's economic climate could have lasting effects on their career and earnings. The evidence offered for larger decreased earnings for graduates with lower expected earnings potential places extra emphasis on choice of major and the type of hat that graduates choose to wear, in that higher earnings potential career paths seem to have higher expected earnings even in the face of a recession. Continued education in general seems to improve labor market outcomes and increase expected earnings, but individuals should be selective in their choices of academic degrees to obtain. Although an individual can succeed or fail in any economic climate, sometimes a little luck along with some GDP growth never hurts.

References

Akerlof, George A. "The Market for Lemons: Quality Uncertainty and the Market Mechanism." Quarterly Journal of Economics 84.3 (1970): 488-500.

Bachmann, Ronald, Thomas K. Bauer, and Peggy David. 2010. "Labor Market Entry Conditions, Wages and Job Mobility." IZA Discussion Paper No. 4965. http://ftp.iza.org/dp4965. pdf.

Bivens, Josh, Kathryn A. Eduards, Alexander Herter-Fernandez, and Anna Turner. May 11,2010. "The Class of 2010: Economic Prospects for Young Adults in the Recession." Economic Policy Institute. Briefing Paper #265.

Gibbons, Robert, and Michael Waldman. "Enriching a Theory of Wage and Promotion Dynamics Inside Firms." Journal of Labor Economics 24.1 (2006): 59-107.

Jacobe, Dennis. March 26, 2010. "Focus on Education May Reduce Underemployment." http://www.gallup.com/poll/ 126995/focus-education-may-reduce-underemployment. aspx (accessed June 16, 2010).

Kahn, Lisa B. "The Long-Term Labor Market Consequences of Graduating from College in a Bad Economy." Labour Economics 17.2 (2010): 303-316.

Lazear, Edward P. May 2003. "Firm-Specific Human Capital: A Skill-Weights Approach." NBER Working Paper No. 9679. http://www.nber.com/papers/w9679.

McLaughlin, Kenneth I. and Mark Bils. "Interindustry Mobility and the Cyclical Upgrading of Labor." Journal of Labor Economics 19.1 (2001): 94-135.

Mansour, Hani. 2009. "Essays on Wage Dynamics of Young Workers." PhD diss., University of California, Santa Barbara.

Okun, Arthur. "Upward Mobility in a High Pressure Economy." Brookings Papers on Economic Activity 1 ( 1973): 207-252.

Oreopoulos, Philip, Till von Wachter, and Andrew Heisz. July 2008. "The Short- and Long-Term Career Effects of Graduating in a Recession: Hysteresis and Heterogeneity in the Market for College Graduates." IZA Discussion Paper No. 3578. http://ftp.iza.org/dp3578.pdf.

Oyer, Paul. "Initial Labor Market Conditions and Long-Term Outcomes for Economists." The Journal of Economic Perspectives 20.3 (2006): 143-160.

Rayo, Luis, and Gary Becker. "Evolutionary Efficiency and Happiness." Journal of Political Economy 115.2 (2007): 302-337.

Ruiz, Rebecca R. "Recession Spurs Interest in Graduate, Lave Schools." New York Times, January 10, 2010.

Stevens, Katrien. 2008. "Adverse Economic Conditions at Labor Market Entry: Permanent Scars or Rapid Catch-Up?" Sum, Andrew, Joseph McLaughlin, Shelia Palma, Jacqui Motroni, and Ishwar Khatiwada. 2008."Out With the Young and in With the Old: U.S. Labor Markets 2000-2008 and the Case for Immediate Jobs Creation Program for Teens and Young Adults." Boston, MA: Center for Labor Market Studies.

Tervio, Marko "Superstars and Mediocrities: Market Failure in the Discovery of Talent." The Review of Economic Studies 76.2 (2009): 829-850.

Waldman, Michael. "Job Assignments, Signaling, and Efficiency." RAND Journal of Economics 15.2 (1984): 255-267.

by

Ioana Sofia Pacurar and Jay K. Walker

Sparks Bureau of Business and Economic Research

The University of Memphis

(1) A complimentary study (Stevens 2008) investigates how the macroeconomic environment at entry into the labor market affects low- and medium-skilled workers' wages over the lifecycle. The author concludes that the labor market outcomes of less skilled workers are not very vulnerable to the economic conditions at the start of the career. She uses detailed German employment data including males born between 1965-1977 who finish general and intermediate secondary school and shows that entering the labor market in a recession (with 9.0 percent versus 4.0 percent unemployment) implies 3.0-6.0 percent lower wages in the first four years of one's career, but these negative effects diminish over the next three years.

(2) Gallup classifies Americans as underemployed if they are unemployed or working part time but wanting to work full time.

Ioana Sofia Pacurar

Ms. Pacurar received her BD in Economic Studies from the University of Babes-Bolyai, Cluj Napoca, Romania, and pursued advanced studies in European trade and law. Sofia obtained a MS in Statistics, Operations, and Management Science from the University of Tennessee, Knoxville. While a graduate student at the University of Tennessee, she taught and was involved in developing teaching materials for intermediate to advanced classes in Lean Operations and developed simulations for the Executive Education Program. She obtained a Graduate Certificate in Applied Statistical Strategies in May 2004.

Ms. Pacurar is currently a PhD Candidate in Economics at the University of Memphis. Her interests lie in the area of applied microeconomics with a focus in the economics of health and aging as well as econometric strategies of program evaluation.

Jay K. Walker

Jay Walker is a PhD Candidate in Economics at the University of Memphis. His fields of interest include Applied Microeconomics, Public Economics, and Labor Economics. He is currently employed in the role of Research Associate at the Sparks Bureau of Business and Economic Research at the University of Memphis following two years serving as the Nathan Associates Research Fellow at their local office.
Chart 1. Percentage Wage Impact from an
Additional Percentage of Unemployment
Time of Graduation

     Years Since Graduation

1    -5.9%
5    -5.0%
10   -3.8%
15   -2.6%
Source: Lisa B. Kahn, "The Long-Term Labor Market Consequences of
Graduating from College in a Bad Economy." Labour Economics 17.2
(2010): 303-316.

Note: Table made from bar graph.

Chart 2. By Decile of Expected Earnings, Percent Change in
Present Value of Earnings from Graduating in a
Recession During 10 Years After College Graduation

Decile of Predicted Earnings Distribution

1    -8.4%
2    -8.4%
3    -6.0%
4    -5.8%
5    -6.0%
6    -5.5%
7    -5.4%
8    -3.5%
9    -2.0%
10    2.0%
Source: Philip Oreopoulos, Till von Wachter, and  Andrew Heisz. July
2008. "The Short- and Long-Term Career Effects of Graduating in a
Recession: Hysteresis and Heterogeneity in the Market for College
Graduates." IZA Discussion Paper NO. 3578. http://ftp.iza.org/dp3578.
pdf.

Note: Table made from line graph.

Chart 3. Weekly Median Earnings and Unemployment Rates by Education
Level, 2009

$774         All Workers         7.9

              Less Than
$454     High School Diploma    14.6

$626     High School Graduate    9.7

            Some College,
$699         no Degree           8.6

$761      Associate Degree       6.8

$1,025   Bachelor's Degree       5.2

$1,257    Master's Degree        3.9

$1,529   Professional Degree     2.3

$1,532     Doctoral Degree       2.5

Note: Data are 2009 annual averages for persons age 25 and over.
Earnings are for full-time wage and salary workers.

Source: Bureau of Labor Statistics

Note: Table made from bar graph.
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Author:Pacurar, Ioana Sofia; Walker, Jay K.
Publication:Business Perspectives
Geographic Code:1USA
Date:Sep 22, 2010
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