Michael Spence is the first to formalize the signaling role of education.
The game plays out as follows. A firm wants to hire a worker for his ability, which can be high or low. Yet ability is the worker’s private information, unknown to the firm. For the same level of education, the more able the worker, the easier he can obtain that level.
The firm only knows that the proportion of the able workers is . However, it believes that higher education attainment is more productive, because he can obtain the same level of education at lower effort/cost/discomfort.
To get high wage, the high ability worker may obtain more education to ‘signal’ his ability. The lower ability worker, however, would refrain from so doing, because the pain of get that high education outweighs the happiness the higher pay can brings to him. In response, the employer will pay high ability higher wage, and low ability lower wage. Hence, in the labor market, education serves as a signaling device to separate workers; it may not necessarily improve ability. In this sense, over education can be socially wasteful, akin to advertisement.
For education to work effectively, the proportion of high ability worker cannot be too high. Otherwise, the employer may shut out lower ability workers altogether, and pay high ability workers only.
[San Francisco, CA, 7/2009]