Undergraduate, Overpriced

A Brown University undergraduate degree in 1960 cost $45,000 when adjusted for inflation. Today, tuition costs around $190,000 — enough money to pay full fare for a 1960 Brown degree and a 1960 Harvard Business School degree and still have a couple thousand dollars left in couch coins. This upward trend in college tuition isn’t limited to Brown. In the last 50 years, the price of higher education has outstripped inflation by over 150 percent. Increasingly, Americans need a college degree to compete in the job market. As a result, the higher education market’s rising prices are drowning millions of Americans in debt. But the federal government’s response to rising tuition prices has focused almost exclusively on reducing the tuition burden by keeping Stafford Loan interest rates low and increasing spending on Pell Grants — both demand-side solutions. While undoubtedly important measures for students struggling to keep their heads above water, these attempts to make college more affordable fail to address the heart of the tuition issue: The nature of the higher education market promotes inflation.

Tuition is far more complex than its price tag suggests. Since different types of colleges raise revenue in different ways, the college market can be divided across two distinct lines. First, the differences between public and private universities significantly affect tuition. While government funding underwrites a large portion of public university expenses, private universities receive most of their revenue from tuition and donations. This distinction largely explains the more than twofold difference between the average annual cost of attending a public university, $17,474, and that of attending a private university, $35,074. The second dividing line is between research and nonresearch institutions. Research universities such as Harvard and Duke can generate a significant portion of their revenues through independent operations like hospitals, university publishing houses and retail operations. Smaller nonresearch institutions cannot generate revenues beyond tuition as easily and, consequently, rely more heavily on donations. With these differences in mind, it might seem odd that nearly all colleges — regardless of their funding sources — have become progressively more expensive, but these distinctions actually illuminate the sources of tuition inflation.

Rising college tuition prices essentially boil down to two major factors: increased spending and cost shifts onto students. When universities raise professors’ salaries, build new athletic facilities or fund mousetrap research, they increase spending and often leave students to foot the bill. Occasionally macroeconomic forces, like the demand for PhDs in the finance sector, can increase university spending by driving up the price of inputs such as faculty salary. When this happens, all universities — public and private, research and nonresearch — are affected. More often than not, however, universities elect to increase spending on improvements to their facilities and programs, which drives up the cost of tuition. This latter form of increased spending is especially troubling because it can justify spending on projects that do not significantly benefit the quality of the education, such as renovating gymnasiums or refurbishing eateries. This villain has an accomplice: decreasing revenue, which can also shift university costs onto students. When state and local governments cut funding or private donations plummet — as happened in the wake of the 2008 financial crisis — universities can elect to shift those costs onto students through increased tuition. In a severe enough crisis, a university may be forced to engage in cost shifts just to keep its doors open.

But the dual forces of spending and cost shifts have not affected all universities equally. History shows that research universities maintain high spending even when market forces push in the opposite direction. From 2000 to 2010, public universities faced massive cuts thanks to slashes in state and local funding. It might seem reasonable that all affected public universities would have increased tuition and decreased spending accordingly. However, while all public universities raised tuition, only nonresearch universities cut spending. In fact, the Washington Post reported that public research universities saw an average increase of $5,793 in net revenue per student between 2000 and 2010, despite the severity of local funding cuts. Even if these universities kept tuition constant for the entire decade, they still would have raised $2,651 more in revenue per student per year — something public nonresearch universities could not have accomplished. Over this period, research universities’ revenue growth stemmed from increases in both federal subsidies and profits from independent operations and were then augmented by levying higher prices onto students. Private research universities saw similar increases in spending, largely underwritten by tuition hikes.

Rising spending at universities is partially a function of rising input costs — specifically, professor salaries. Since the 1980s, professors’ wages have outpaced inflation by around one percent per year, yet professors do not seem to have had any obvious productivity boost. Computer science professors in the ’80s taught one class per semester and wrote a few papers per year, just like those of today. However, while the same professors of the ’80s could only work on firewalls, today’s professors are being recruited by Wall Street. Soaring wages of well-educated workers in other markets have forced universities to raise professors’ salaries to compete with other markets looking to hire the highly educated.

But rising professor salaries alone can’t explain ballooning tuition; between 2000 and 2010, increases in spending on instruction only accounted for 15.8 percent of increases in total spending at public research universities. The other 84.2 percent increase in spending primarily focused on institutional endeavors, such as heightened research budgets or greater public service projects. Herein lies the biggest culprit behind tuition inflation: Universities have little to no incentive to control their spending. A college can increase spending on expensive institutional projects (Brown’s strategic plan, “Building on Distinction,” comes to mind) that bring prestige and revenue, but this spending does not always raise the quality of education they provide.

Imagine that Brown buys every student an iPad to use for class. Not to be outdone, Columbia supplies its student body with Lenovos, and MIT soon reacts by giving away Google Glass. So long as the university continues to generate revenue, this amenities arms race can theoretically continue until every student at Harvard flies to class in an Iron Man suit. While this hypothetical is undoubtedly far-fetched, projects of this type can be seen all across the country. Washington University in St. Louis has Tempur-Pedic mattresses in all its dorms. Purdue University spent $98 million on a fitness center complete with a 25-person spa and a rock climbing wall. The push at nonprofit universities to increase spending isn’t just a trend; since there is little to no limit to the amount of money a university can justify spending on its endeavors, universities are compelled to raise more and more money for an endless list of potential improvements. In other words, the nonprofit nature of these universities has undermined the higher education market. Universities that spend gain prestige; those that cut fall into disregard.

The race for prestige also speaks to the growing inefficiency in the higher education market. College is what economists call an “experience good” — a good whose quality can only be known after purchase. For this reason, any market for experience goods faces intrinsic inefficiencies. The only way consumers can properly evaluate experience goods is if they buy the good consistently and can immediately judge its quality post-consumption. Before ever trying a Hershey’s bar, buyers will use signals — ingredients, brand, price, etc. — to determine the quality of the treat. If, after the purchase, the buyers realize they don’t like chocolate, then they can adjust their purchases accordingly. However, students don’t generally have the luxury of buying multiple undergraduate degrees, so they are forced to rely on signals alone. Since higher prices and fancier amenities signal a higher quality university, albeit at times incorrectly, students are drawn towards universities with high tuitions and higher spending than their more frugal counterparts. Robert E. Martin, a professor of economics at Centre College, notes that when institutions try to “compete on the basis of cost, consumers are going to construe that to mean they’re cutting quality. So you don’t have cost competition, and you thus don’t have a competitive pressure to reduce cost.”

The government and nonprofits alike have tried to remedy tuition inflation by subsidizing education with loans and grants, but this only reinforces the problem. Evidence suggests that when the government increases student aid, universities raise tuition to capture part of the subsidy. Though this has a marginal effect on rising tuition, it explains what makes the government’s response to tuition inflation so problematic: Demand-side policies are ineffective at keeping college prices low. Imagine a university that costs $2,000 per year. If the government decides to guarantee all students $1,000 per year to go to college, the university can simply raise tuition to $3,000, since everyone was already willing to pay the pre-subsidy tuition. Though the college now reaps more revenue, it can still save face by accepting students who are only willing to pay the subsidized cost and then call it generous financial aid. This puts financial pressure on low- and middle-income families and keeps barriers high for low-income students.

But there are ways to help these families without hurting schools. Supply-side solutions offer the government alternatives to step in and overhaul tuition inflation within the higher education market. Regulating a university’s access to revenue and reducing the inefficiencies of higher education associated with an experience good would help tackle rising tuition. This would mean creating avenues for students to compare universities based on final results and allowing them to see how tuition prices are related to results in the job market. Regrettably, most proposed programs centered around these ideas border on either too constraining or too weak-willed. On the toothless side, Senator Ron Wyden (D-OR) and Senator Marco Rubio (R-FL) have co-sponsored a bill that would provide additional employment and earnings data on universities and specific majors. In a more biting vein, President Obama has proposed a plan to use student debt, average net tuition and share of low-income students to give more generous subsidies to schools that keep their tuitions and student debts low. Others suggest that the government fully subsidize public universities, forcing private universities to compete with a zero-dollar price tag. None of these options presents itself as an all-encompassing political Band-Aid. But they do open up a necessary conversation about the need to regulate the higher education market beyond the trope of subsidized loans. And if we hope to bring down tuition inflation, we need to change the distorted incentives at the heart of the issue — and find ways to discourage spending on “Iron Man suits for all” policies over meaningful improvements in education.

Art by Soraya Ferdman.