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The High Cost of College: An Economic Explanation

Friday, August 31, 2012

Despite good intentions, government has reduced price competition; as a result, prices have risen much faster than they otherwise would.

Many news articles are starting to note that middle and upper-middle class parents are having trouble paying for their children’s college educations. Most of these articles see this as a new development. But the story is actually more than 50 years old.

Throughout the 1950s, and with the best of motives, Americans gradually adopted a policy of allowing—even encouraging—colleges to use what economists call first degree price discrimination. Here’s how this price discrimination works:

1.    Every good or service offered for sale has a different value for each of the various people who will choose to buy it. That is, some people will be willing and able to pay much more for any good or service than other people will be able or willing to pay for the same good or service.

2.    Normal market pricing consists of the producer of a good or service choosing the price that allows the producer to make a reasonable profit after production costs. When the prices posted by all producers are added together, they comprise the supply curve. When the prices that all the potential consumers are willing to pay are added together, they comprise the demand curve. Competition among producers forces market prices into a narrow range. Those who are only willing to pay a lower price than that range buy none of that good or service. Those consumers who are willing and able to pay a price higher than the range—sometimes a much higher price—get a break and buy the good or service at a lower price than they are willing to pay.

3.    First degree price discrimination occurs when normal markets are interfered with and producers are allowed to learn exactly what each consumer is willing and able to pay for the good or service. Using this data, all the producers set individual prices for each consumer, eliminating competition and forcing the consumers that are willing and able to pay a higher price to pay it. In this pricing scheme, those who are willing and able to pay only a lower price get a break.

So what's wrong with this? Many Americans would agree that it is "unfair" for those with more means to get a break and that it is "fairer" for those with less means to get a break.

But as it turns out, this seemingly humane aim has a fundamental flaw—the same flaw that afflicts all non-market based systems: When producers no longer need to compete, production costs always rise faster than they otherwise would.

As a result, over time the cost of providing the good or service as a whole rises faster than it otherwise would. Also, the lower price provided to the person of few means gradually pays for less and less of the goods and services provided, requiring that those with more means pay a rapidly rising price. Eventually the price increases must be passed on to those of lower means, defeating the equal outcomes aim itself. 

As the prices rise and the demand for the particular good or service falls as a result, producers can employ fewer people to provide the good or service. The economy shrinks and jobs are scarcer than they otherwise would have been. The wealth of the entire nation is reduced.

This flaw of price discrimination is always present when governments aim to achieve equal outcomes. Without control over the price paid by different citizens, the desired equal outcome could not be achieved.

When producers no longer need to compete, production costs always rise faster than they otherwise would.

The reason some people are willing to accept price discrimination when equal outcomes are desired is that they mistakenly assume that a well-meaning and diligent government is capable of managing the efficient production of all goods and services even in the absence of normal market signals, such as competitive prices. But that assumption has never proven to be true. The U.S. college cost dilemma is an example of the fallacy of this assumption.

Paved with Good Intentions

In 1958, the National Defense Education Act was enacted. This act extended the federal government's college assistance program beyond the GI Bills (in 1944 and 1952), the Fulbright Scholarship (1946), and the National Science Foundation Act (1950 and 1952) by using the "needs analysis" formula developed by John Monro, the College Scholarship Service bureaucracy, and the Parents’ Confidential Statement.

Under this evolving system, the federal government asked parents to provide the most intimate details of their financial situation so it could decide how much aid to provide for their child. So far so good. But then the fundamental error was made. As part of the procedure developed to implement the National Defense Education Act, the government passed the information on to the colleges.

At that point, it was easy and natural for colleges to move to price discrimination. The means are simple: Set the price of tuition and room and board at a level higher than their actual costs and then provide monetary aid to students whose parents cannot afford to pay the inflated prices. How much higher should the prices be set? However much higher is required so that discounts can be provided to as many students as the college feels will achieve an optimal mix between high and low income students.

Note that few parents of means would have provided their financial information to the colleges directly. That would have been considered an intolerable invasion of privacy. But once the government was introduced in the middle of the information flow and once the government promised to provide at least some aid to some parents, providing the information became acceptable. Desire for the aid prompted parents to provide the information.

With access to the financial information granted, the mechanism for sustained price discrimination was fully in place. The 1960s generation of college students was the first to experience the new pricing.

Initially, the benefits of this new policy appeared to outweigh its harm. But as time has passed and the number of students receiving aid has increased relative to the number of students with the means to pay the inflated price that results from the reduced competition, an increasing number of Americans will become aware of the harmful effects of this kind of government-created market distortion.

Price discrimination is not confined to college educations. Indeed, it is linked closely with our federal government and has become more and more common in recent decades.

All "means testing" is a form of price discrimination. If a household's income is greater than some limit, it cannot receive the government benefit subject to the "means testing." Medicaid, the Supplemental Nutritional Assistance Program (SNAP), and earned income tax credits are examples of the use of such "means testing" in distributing benefits.

We need to stop giving colleges the information that is essential to sustain the price discrimination.

Increasingly, tax deductions and taxable income exemptions are subject to similar price discrimination. Examples of this include medical, job, and miscellaneous expenses. The greater our total taxable income, the more our Social Security income is subject to taxation—another form of "means testing."

The effect of price discrimination is to gradually decrease the need to keep production costs as low as possible. It has taken half a century for the full impact of this flawed method of setting college prices to become apparent. To correct it, we need to stop giving colleges the information that is essential to sustain the price discrimination.

Families that hope to qualify for federal grants or loans would still be required to provide the financial information to the government, but that information would not be automatically forwarded to the colleges, as it is today. Instead, only those families that hope to receive additional aid directly from the college would provide their financial information to the institution.  

The result of this reduced information flow would put colleges in the same position as other providers of goods and services and, over time, the effects of increased price competition will cause greater attention to cost reduction, making funding a child’s college education while simultaneously saving for retirement a more manageable task for families.

Kenneth Gould is a retired banker who lives in Lake Bluff, Illinois.

FURTHER READING: Gould also writes “The Roosevelts Would Be Appalled.” Jackson Toby offers “Student Loans for Dummies.” Michael M. Rosen says “Lights, Camera, Crazy!” Alex J. Pollock discusses “Fixing Student Loans: Let’s Give Colleges Some ‘Skin in the Game.’” Andrew Kelly contributes “How to Get More College Graduates.” Vance H. Fried outlines “Opportunities for Efficiency and Innovation: A Primer on How to Cut College Costs.


Image by Darren Wamboldt / Bergman Group

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