College Enrollment, Dropouts and Option Value of Education

Psychic costs are the most important component of the papers that are trying to match empirical facts related with college enrollment and dropout decisions of high school graduates. The absense of psychic cost requires very high levels of risk aversion to duplicate the same facts. However, psychic costs lack any economic meaning and treated as an obscure idiosyncratic component of utility function in influential papers such as Keane and Wolpin (1997) and Carneiro, Hansen, Heckman (2003). In this paper, we model college enrollment and dropout decisions in a real options model similar to Miao and Wang (2007) where the psychic cost stems from the initial belief of students about their skill level and the option value stems from the Bayesian learning process of one's skill level. First, our model shows that papers that assume risk neutrality overestimate the value of college, college enrollment and graduation rates because the outcome of college education is risky. Second, we show that the option value of learning is much more important when agents are risk averse rather than risk neutral. Finally, we suggest a welfare improving policy that decreases both the pyschic costs, college enrollment and graduation rates whereas a decrease in the psychic costs in the aforementioned papers would increase both the college enrollment and graduation rates.