Educational Signaling, Credit Constraints and Inequality Dynamics

We develop a dynamic theory of educational signaling and income distribution in a two sector economy with missing credit markets. Education and ability matter in a modern/formal sector, not in the traditional/informal sector. Education signals unob-served ability to modern sector employers. Both quantity and quality of human capital evolve endogenously. The model generates a Kuznets inverted-U pattern in skill pre-mia similar to those observed in historical US and UK experience: initially rising, later falling as skill accumulation progresses. In the first phase the social return to educa-tion exceeds the private return: under-investment owing to credit market imperfections dominate over-investment owing to signaling distortions. In the later stage the pattern is reversed. 1University of Salerno and Boston University, respectively. Mookherjee’s research has been supported by NSF Grant no. SES-0617874. We are grateful to Bob Margo for familiarizing us with the historical literature on skill premia in the US and in the UK. 1