Option Value and Transitions in a Model of Postsecondary Education

Option value arises in environments where an investment needs to be made under uncertainty. The decision to invest in postsecondary education is a perfect example. Students, as they learn about the uncertain educational outcomes, can drop out or transfer up to harder and more rewarding schools or even down to easier and less rewarding institutions, carrying a fraction of the accumulated human capital; here, academic 2-year colleges serve as a stepping stone towards more demanding environments as it provides a cheaper learning technology. A positive theory of postsecondary education is built and contrasted empirically. Using an estimated version of the model, it is found that option value explains a large share of the returns to postsecondary education. The elimination of academic 2-colleges, with freshmen enrollment of nearly 40% of that of 4-year colleges, would decrease total enrollment by 6% with very limited effect on the ex-ante returns to education.