Optimal higher education enrollment and productivity externalities in a two-sector model

•We focus on the optimal level of enrollment in higher education in the presence of technology externalities of human capital.•Both production sectors exhibit productivity externalities in average human capital of workers and size of the sector.•When the marginal individual decides to go to college, he disregards that average human capital will go down in each sector.•Over the course of development, the economy may move from over- to under- and back to overenrollment.•We derive Pigouvian taxes and subsidies to internalize the externalities.

We analyze the optimal share of the skilled workforce over the course of development with two sectors using skilled and unskilled labor respectively, and technological spillovers from higher education enrollment. Productivity in each sector depends on the average quality of workers and the size of the workforce. When skill-biased technological change prevails, this structure of externalities coupled with the endogenous ability sorting of workers may well produce a pattern of overenrollment in early and late stages of development and underenrollment in between. Our normative analysis is followed by a positive analysis exploring how policy would differ under alternative political objectives.