Friday, September 22, 2006

Scholarships, Reduced Consumer Welfare and Information

By Richard Vedder

As is often the case, my colleague Lowell Gallaway sometimes sees things in a slightly different, and more insightful, way than I do. Such is the case with today's lunch conversation.

Economists argue that market place interactions give rise to what they call "consumer surplus," a measure of the welfare gains from trades that occur. If I want to own a DVD of a movie pretty bad, and even am willing to pay $25 for it, but I can buy it at Wal-Mart for $15, I am gaining $10 in consumer surplus --the difference between what I actually paid and what I would have been willing to pay.

Wal-Mart (or whatever retailer) would love charge me $25, since I would still buy the product and the store would reap in profits the gains in the form of consumer surplus that otherwise would have come to me. But Wal-Mart does not know about the intensity of my interest in the product, so it charges me a price that maximizes its profit for the broad category of customers buying the product, many of whom are only willing to pay $18, $16, or even $15 to get it (another reason Wal-Mart wouldn't charge me $25 is that Target or Best Buy would undercut that price and I would shop elsewhere --the beauty of competition).

What selective admissions universities do is pick a uniform high "sticker" price (tuition), and then through information gathered primarily from the FAFSA form, decide on the amount of discounting from that high tuition they going to give in the form of what they call "scholarship aid". Since student willingness to pay a high price is closely associated with their financial condition, the university can do something most producers cannot do very extensively, engage in price discrimination, charging some customer $35,000, others $25,000, still other $10,000 (using other forms of information, airlines and movie theaters engage in price discrimination, as do some other businesses).

Suppose that in the absence of any financial information on students, an elite school would charge everyone $25,000 in tuition. In fact, however, its sticker price is $35,000 and the average discount (scholarship) is $10,000, leaving an average net tuition of $25,000. Of course, some students pay $35,000, others $10,000, etc. With the high tuition/discounting policy, a student who would have been willing to pay $38,000 would get $3,000 in consumer surplus; with a no discounting policy, she would have received $13,000 in consumer surplus. Universities use a high tuition/discounting policy to capture most of the consumer welfare (in the form of consumer surplus) for themselves. To be sure, there are also students who would be only willing to pay $20,000 to go to the elite school (probably because of limited financial means), who in a fixed price/no discounting world would be excluded from attendance, but in the current system they get $15,000 in "scholarship aid" and pay $20,000. They do get in, but collect no consumer surplus. Almost, certainly, tuition discounting through price discrimination lowers the total consumer welfare (aggregate consumer surplus) from what it otherwise would be. This system is justified, to be sure, in the name of greater access for lower income kids. When scholarships are used primarily for other purposes (to lure kids with high SAT scores, for example), the moral argument for the use of price discrimination to improve student access is drastically reduced.

Universities are quick in demanding information from their customers, information that generally is illegal to request in our society, but an exception is made for higher education. However, unversities are loathed to reciprocate by providing information to their customers -- what are the 5 year and 6 year graduation rates? What do kids learn while at college? What proportion of monies go for teaching as opposed to other functions? This list of questions on which we know little goes on and on.

Suggestion: If Universities are going to be allowed to collect intimate family financial information via the FAFSA form that enables them to rob students of much consumer welfare, then they should be required to provide information currently withheld from their customers, such as what is it that they produce (as measured by indicators of "value added" of learning during college). Accreditation by an agency approved by the U.S. Department of Education, or the right to access data from the FAFSA form should be tied to the provision of this type of information.


at the margin said...
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at the margin said...

Dear Dr. Vedder,

It is always nice to see the post by the professor who taught me. Yet, I cannot quite agree with this post. Why is it "robbing" when the university is simply using the price discrimination? Yes, some price discrimination can lead to the economic loss, but the situation you describe has nothing to do with the economic loss, but it is only the straight transfer to producer's surplus.

According to your story, it sounds as if any firm that uses the price discrimination is simply "robbing" their customers as they are trying to suck out every consumer surplus into their pocket, which I am certain you would not agree with. What I am saying is that you sound like every time a senior meal is given in a restaurant it is an act of the restaurant "robbing" normal customer who are paying normal price on the menu!

Yet, I do see that it can lead to huge economic loss. That is, the effort by the students to provide/prepare financial aid form to the university may be a kind of "rent-seeking" activity which is wasteful. If there is any problem with current scholarship system, this should be the problem, not the transfer of consumer surplus onto producer surplus.

Best Wishes

Your former Student SHYoon

Butter Cup said...

at the margin, I respectfully disagree with your analysis of the Doc's blog.

It is my humble opinion that in general, the professor is using FAFSA and the very personal financial information universities request, results in price discrimination and helps establish consumer surplus, or lack thereof. The university holds all the cards and is in a position to rob students. Now compare the disclosures made on the FAFSA to any, if there are any, disclosures universities make. There is no transparency for the university, yet the student or potential student’s family has to open up all of their books to establish a need for a discount – or scholarship.

Poly Muthumbi said...

After learning about the FAFSA financial aid program and realizing just how helpful it can be for your future, you need to go for it. At least there must be a way to take you to the actual process. You do this by filling up a FAFSA (Free Application for Federal Student Aid) form that requires you to fill in all important and detailed information supposed to determine your eligibility for financial aid.

Poly Muthumbi is a Web Administrator and Has Been Researching and Reporting on Student Loan Consolidation for Years. For More Information on FAFSA form, Visit Her Site at FAFSA FORM