Student loans and the allocation of graduate jobs

Higher education is not just a costly signal of native talent, but also a means of raising a person's ability to hold a graduate job (and at least a certain educational achievement is required to get one). Graduate jobs differentiated by quality are allocated to graduates differentiated by native talent and parental wealth through a tournament. Non-graduates jobs pay a fixed wage to those who do not participate in the tournament. Assuming that credit is rationed, some poor school leavers will go straight into the non-graduate labour market even if they are talented enough to get a higher education and participate in the tournament. Some other will buy the same amount of higher education and end up doing graduate jobs of the same quality as less talented but richer school leavers. We show that student loans improve job matching, and bring educational investments closer to efficiency. If the size of the loan is not very large, some poor school leavers will still be liquidity-constrained and thus buy the same amount of higher education as less talented but richer ones. In that case the former will get a productivity bonus. But raising the size of the loan to such a level that nobody is liquidity constrained could be socially optimal only if social preferences were extremely egalitarian.