Friday, November 30, 2007

A Tuition Bubble? Part 3 of 4

By Andrew Gillen

This is the third in a four part series that will explore the similarities between the housing bubble and rapidly increasing tuition. A study that explores these issues in greater detail will be available at the conclusion of the series.
Part 1 is available here.
Part 2 is available here.

How these parallels play out in higher education

The previous postings in this series have shown that in the markets for both higher education and housing pre-2007, interest rates were low and there were lax lending standards. To be clear, these two phenomena have different causes. In the case of the housing market, low interest rates can be attributed to the Fed, while lax lending standards were encouraged by securitization. With higher education however, both phenomena can be attributed to government policy, specifically guarantees for student loans.

These lax lending standards and artificially low interest rates fuel tuition increases because they increase the ability of students to pay, which encourages schools to raise tuition. Why are schools able to get away with this? After all, most businesses can't raise prices simply because their customers' ability to pay has increased without risking losing the customers. The answer is that there are some uncommon features of the market for higher education.

Their first uncommon feature is that the field is dominated by public and non-profit schools. This means that profit maximization assumptions may not be appropriate. Indeed, when we look at the actions of schools, it is apparent that it is not profits that schools are trying to maximize, but prestige (perceived quality). Schools are always seeking more money of course, but they want more funds not to distribute as residual income to shareholders (as profit maximizing organizations do) but so that they can build a better institution.

Viewing schools as prestige rather than profit maximziers explain a lot of otherwise inexplicable decisions by colleges and universities, including the fact that they consistently turn away potential customers (applicants). It also explains the excessive funding (from the academics point of view) of athletic programs. The fact that the great majority of them lose money is irrelevant. Administrators view them as a marketing expense, because they increase the visibility and popularity of the school (which of course increases the prestige of the institution).

As it turns out, money is very useful when a school is trying to increase its prestige. It allows you to spend $136 million on a new dorm, fund popular athletic programs, and create a country club atmosphere on campus. This gives schools an incentive to charge as much as they can.

But couldn't a school undercut the competition by charging lower tuition or maybe even cutting tuition from year to year? This is where a second feature of the market for higher education comes in. With no real measure of the output of a school (what students actually learn in college), it is very difficult to have price competition, especially in light of the fact that price itself is used as a proxy for quality. This means that if a school charges less next year than it did this year, people will tend to think not that the school eliminated wasteful spending and is passing the savings on to students, but as a sign of desperation or that the school is cutting corners. Finally, we are unlikely to see prices falling because schools tend to be bureaucratic, and bureaucracies don't tend to advocate for lower budgets.

Coming Tuesday: The Conclusion

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