There is extensive literature in Game Theory which approaches graduate education as a signaling game. I will give a brief explanation of this is, but if you feel like you would like to explore this further, I suggest chapter 16 of Steven Tadelis book: Game Theory – An Introduction, or a less formal literature in the blog post by Phil Arena “signaling advice for Graduate Students”, or the post at Less Wrong called “What is signaling, really?”.

When people apply for jobs, the potential employers have no information about which “type” of worker the applicants will turn out to be. To keep life simple, without loss of generality, suppose there are only two kinds of people: High Performance and Low Performance. Each person knows what their true type is, but they have no direct way to “reveal” their type to potential employers, so the signals begin. People who want to get high paying jobs will try to get graduate degrees to “prove their worth” to potential employers. Notice that regardless of the person type, this person can apply to grad school and try to “mimic” a High Performance type behavior. So, if both types of people can apply to grad school and send the same type of signal, why does it work? First, there are two underlying assumptions here: 1st one, which is arguable, is that grad school has no power to change a person’s performance level (which is different than saying grad school is useless. The idea here is that grad school may help you develop some tools, or get more familiar with certain topics, but won’t change your capacity of doing things). Th 2nd one, which is pretty reasonable, is that it is harder for Low performance individuals to get grad degrees than for High performance individuals, and it is precisely this difference in “cost” that makes graduate degrees a plausible signal for potential employers to infer performance.

What people often don’t realize is the intertemporal externality component that is attached to signals when we broader the model not only for the decision (go to Grad school, Not go to Grad School), but also to which Grad school you go to. We all know, the better ranked the department is, the better the “signal” for the job market. But notice, that the better a student from a certain school performs, the better the chances of the department of that particular education institution to be ranked up, and influence the quality of thesignal for all future students. A similar argument can be made for a student not perfoming its best. However, when a graduate student is deciding how much effort to put into studying, he only takes into consideration his own return of investment, and doesn’t take into consideration the impact on the effectivesness of the signal for students to come (thus the source of externality).

This is a model with great potential to be explored, which can also affect an alumni’s decision to donate money to the institution from which he got his degree.