Labor Market Frictions, Search and Schooling Investments

Schooling investments have a persistent impact on future labor market trajectories therefore expectations about the labor market environment have an impact on present schooling decisions. However, since workers must invest in schooling before finding a job, part of the payoff of the schooling investment can be appropriated by firms and hence agents may held up their schooling investment. This may be especially the case in labor markets in developing countries that are usually characterized by substantial frictions (e.g. high informality rates). We propose a search-matching-bargaining model of the labor market in which individuals permanently choose (i) whether to become self-employed or remaining unemployed prior to searching for a job as employees and (ii) to acquire productivity-enhancing schooling prior to labor market entry. Potential employees are randomly matched with firms offering either legal or illegal wage contracts. Estimation of the model using Mexican micro-data enables us to quantify the sensitivity of educational investment with respect to the labor market parameters and evaluate the impacts of alternative labor market policies on the returns to schooling.