The sheepskin effect is the impact on your wages of completing college or high-school that is in addition to the marginal value of the years of educational experience. Consider someone one test from graduating college, so they have 96% of a college degree. The extent to which finishing college increases the wage premium by more than 4% is the sheepskin effect. Bryan Caplan has interpreted this effect as being strongly supportive of the signaling effect of education, but is this so? As Bryan puts it:

“If finishing your last year of college sharply boosts your income, the reason probably isn’t that colleges withhold the financially lucrative material until your senior year.”

But what does it tell you about someone when they have invested a lot of money into college, come very close to collecting the payoff, but then failed to do so 75% through their senior year? Is the only difference between this person and someone who finishes college really just the small amount of extra education and the sheepskin effect? It seems extremely likely to me that someone who fails to collect their sheekpskin effect is going to be systematically very different from someone who has, and most of the plausible differences I can imagine will tend to decrease future wages for the dropout.

This is to say that dropping out is not just lacking the positive signal of education completion, but having the negative signal of failing to collect a large NPV payout. The human capital model of education could be completely correct and it wouldn’t be inconsistent with falling short of graduation having a negative wage impact. This perhaps explains why, as Bryan tells us, the sheepskin effect takes such an incredibly long time to wear out: it’s an indicator of something real about human capital, and not just an indicator of college completion.

ADDENDUM: I sense I’m not really being clear here. To put it simply: people who drop out at 96% have more wrong with them than just having 4% less education than graduates. If u could cause random drop outs at 96% completion you would observe a much smaller sheepskin effect. I don’t believe it would be zero, but I think it is incorrect to interpret the sheepskin effect as being equivalent to the signaling effect of education alone. Call it the signaling effect of failing, as it is distinct from the normal signaling effect of education.