March 13, 2008

The Weird Economics of Higher Education

MTSU economics professor and blogger Martin Kennedy kicked off a small discussion at VolunteerVoters.com with his comment about higher education tuition cost increases. I've posted two long comments looking at the weird economics of higher ed tuition. I'm reposting them here, with very minor edits, in the extended portion of this entry.

COMMENT #1
The rapid cost inflation of higher education has been tied directly to the increase in federal tuition aid. You are seeing the same cost inflation in higher education for the same reason you have seen it in healthcare - the more the government disrupts market forces, the less incentive universities have to compete on costs and the less the paying consumers (students and parents) care about costs.

The CATO Institute produced a landmark study of the economic effects of higher federal tuition aide in January 2005. You can read the executive summary or download the entire study at this link.

The economics at work here are rather easy to explain. Federal aid for tuition goes up. That leads to increased demand for higher education. The law of supply and demand kicks in - prices rise.

Additionally, government aid sets a "floor" to prices - and as the government increases how much it will help a student pay for college, the universities are able to raise prices to soak up that additional money.

In the case of healthcare, services for which the government helps pay - via Medicare, Medicaid - continue to see rapid cost inflation, while services that neither government nor most insurance carriers will cover, such as Lasik vision correction, see declining prices.

The commenter (at VolunteerVoters.com) who discussed the costs of "heating the dorms … to new construction of buildings" should know that building a new residence hall at a university with rising enrollment is about one of the surest money-makers on earth. Residence buildings generate a profit.

And there's something else to consider about residence halls: the government doesn't help pay students' living costs like it does tuition. The result is that universities compete to build the best residence halls with attractive services, and to price them consistent with market forces. You will see some cost inflation in housing, but it will be in line with the overall inflation rate. Tuition consistently rises faster than the overall inflation rate.

Government subsidizes one but not the other.

COMMENT #2
Economist Gary Becker, writing at the blog he shares with economist Richard Posner, notes that while tuition costs have risen rapidly, the return on investment has been rising faster.

He wrote the following on Feb. 24:

The agitation about the fraction of endowment that colleges spend is driven in large measure by the rapid rise in tuition since the late 1970's. The increase in tuition has been much faster than the rise in consumer prices over the same time period. However, the benefits from a college education in the form of higher earnings, better health, better educated children, and many other aspects of life have grown much faster than tuition has. The result is that benefits net of all college costs have increased at an unprecedented fast rate during the past 30 years. College-educated persons increasingly have achieved elite status not only in the United States, but in other countries as well, including developing countries like China, India, and Mexico.

So it is hard to feel sorry for college students despite the rise in college tuition.
To be sure, high tuition makes it more difficult for students and their parents to finance a college education. To make that easier, especially for students with few financial resources, colleges have been engaging in greater price discrimination by increasing financial aid to students with limited resources while they are sharply raising tuition to students from more well to do families. This price discrimination policy has enabled many more students from poorer families with good high school records to go to colleges where they pay little tuition. Students also can help finance their college costs with student loans when they do not receive sufficiently large support from their colleges. The debts of students who borrow a lot by the standards of what the average student borrows is still usually not large relative to the earnings most students receive after working for several years. I believe students in need of financial support often do not borrow enough. By borrowing more, they would be able to work less, and thereby concentrate on their studies and finish school more rapidly.

Given what I wrote about in my previous comment, this sentence (from Becker) jumped out:

"Since American colleges are in a highly competitive environment, they tend to raise tuition when they can attract good students who are willing to pay more."

The "competitive environment" he speaks about is competitive in terms of attracting top students, competitive in terms of attracting donations from wealthy benefactors and foundations, competitive in sports, but not competitive in terms of keeping costs down. Just the opposite.

I am reminded of the story of a public university in the midwest that, a few years ago, faced a marketing problem: The perception among its target in-state market was that it was inexpensive but not very good academically. In fact, it was inexpensive compared to other universities, but academically it was much better than folks perceived it to be. The relative low cost was communicating to potential students an incorrect message about quality. "Cheap" was considered to be mediocre.

Their marketing solution: They drastically increased the published price of tuition for in-state students - then they, on paper, gave all in-state students automatic scholarships to fully cover the cost increase.

The perception of the school began to change - it was as expensive as its peers so it must be as good as them, too. And the school began to attract better students.

The National Center for Policy Analysis describes the effect here:

Many public universities are turning to the "private school tuition model" -- a high list price and big scholarships -- in order to attract more students. Advertised tuition prices -- a school's "sticker price" -- are on the rise because high tuition carries prestige, especially at top schools; however, financial aid, tax credits and scholarships are rising to match inflated tuition prices:

Miami University, a public school in Miami, Ohio, raised in-state tuition to match out-of-state tuition, $19,718, and then awarded automatic scholarships to in-state students to make up the difference.

After that move, the university received a record number of applications: 15,000 for 3,500 spots.