Sunday, February 10, 2008

The Law of Demand Works at Harvard

By Richard Vedder

There are some persons who say that at private American universities, the demand for education varies POSITIVELY with price --when universities raise their fees, more, rather than fewer, apply. If true, this is one of the relatively few significant examples of what economists call a "Giffen good," or the "snob effect," where raising prices leads to higher demand as customers perceive an improvement in quality associated with higher price.

I have always thought the demand for elite colleges was relatively inelastic, but still negative --higher prices scare some customers off. The whole issue is clouded somewhat by the widespread tuition discounting followed by virtually all schools, so the sticker price is greater than the average price ("net tuition fee") paid by students.

I have a mole, so to speak, at Harvard, with an inside scoop on admissions applications. Last year, Harvard had roughly 23,000 applications and, given poorer economic times this year and a virtually unchanging sized senior high school class, one would expect applicants for fall 2008 to be similar to this school year, or perhaps up 1-2 percent. Harvard, however, announced several weeks ago its new pricing plan that very publicly drastically lowers tuition fees for huge numbers of Harvard students. Most important, applicants from families with incomes below $180,000 a year know now exactly what they will have to pay when they apply --unlike most applicants, who learn of the net price only much later. Hence sticker prices are relevant at most schools, since they indicate the amount students might have to pay if turned down for financial aid (and typically 40-50 percent of students in fact DO pay these prices at top schools).

In fact, Harvard had a huge surge in applicants --over 27,000 I understand --close to a 20 percent increase. A lot of middle class parents whose kids failed to apply to Harvard thinking "it will probably cost me $30,000 or even $40,000 a year," now are applying. If the family income is $150,000, they know the cost will be only $15,000 --less than costs at the best state schools. Hence Harvard applications are soaring, presumably mostly from kids from families with $60,000 to $180,000 income benefiting from the new plan. It appears among students in this financial situation, demand is pretty elastic -- price matters.

The interesting thing is: will this change the nature of the Harvard entering class in any way? While truly poor kids were already told they would pay nothing if they went to Harvard, now Harvard is appealing to more kids from prosperous middle class families relative to the elite.

All of this means Harvard will reject more kids then ever. Other schools are responding to the Harvard initiative --in part to win over some of the growing number of Harvard rejects who are still very good students by almost any criteria, and partly to try to up their own applicant pool that may actually be falling in the way of the Harvard (and Yale) initiative.


Steven Bass said...

If quantity demanded with an increase in tuition at Harvard, it would more likely be a Veblen good (where quantity demanded increases because price is used as a proxy for quality or exclusiveness or some other desireable characteristic).

A Giffen good references a very specific type of good. It must be an inferior good which consumes a large enough portion of income where an increase in its price increases the budget constraint enough to reduce consumption of its more expensive substitutes. Because the price raise makes consumers noticeably poorer, they substitute towards the inferior good.

For example, assume that $15 of beef has the same caloric content as $5 of rice. A family buys $15 of beef and $5 of rice at those prices. But, if the price of that rice rises to $10, the family can no longer afford the same bundle. Instead, they will have to substitute completely to rice (because at a budget constraint of$20, that is the only way they can afford the same amount of food as before).

Cowboy said...

Steven, You present a good argument, but I tend to disagree.

A Veblen good is a theoretical group of commodities for which peoples' preference for buying them increases as a direct function of their price, instead of decreasing according to the theory of supply and demand.

Additionally, by definition, higher education is not a commodity in my opinion because a commodity is anything for which there is demand, but which is supplied without qualitative differentiation across a given market.

In fact, I think you gave a great example of a Giffen good. As the price of the cheap staple rises, they can no longer afford to supplement their diet with better foods, and must consume more of the staple food.

With a Giffen good, price elasticity of demand is positive. When price goes up, the quantity demanded also goes up, and vice versa.

However, when Rich Vedder mentions "the 'snob effect', where raising prices leads to higher demand as customers perceive an improvement in quality associated with higher price." he does tend to tread into "Veblen territory".

So I don't totally disagree with you. I just think that the citation of a Giffen good is more "righterer".

dubrowg said...

While I don't disagree with the premise, I don't think you can attribute any increase in apps this year to the Harvard tuition/aid plan. Why? It wasn't announced until Dec 10, and the app deadline for Fall 2008 was Jan 1. Maybe the announcement caused a late surge in apps, but it would be hard to prove - lots of apps come in last minute (I work in an admissions office at a selective school).

There are other factors -- the high school graduating cohort was actually larger this year....the baby boom echo is still a factor in the college-age population. Also what with the increased use of the common application plus the round of aid restructurings that had already been announced by Harvard and others, it's likely that the demand was already on the uptick.

The tuition-discounting announcement may have pushed a few folks over the edge at the last minute, but there's no way to empirically prove it, short of tracking this year's apps from Dec 15 to Jan 1 against previous year's rates.

The demand test comes next year.