The Mystery of College Tuition

Many stories lately about college tuition rising faster than inflation. See, for instance, here. Quite often, the blame is laid on “administrative bloat”. I suggest that the increase in administrative costs at colleges is a symptom, not a cause, of the problem.

The cause of the problem can be found in the subsidies provided to students to attend college: financial aid, subsidized loans. Here’s how it works.

First, realize that when a tax is imposed, the burden of the tax is shared between the buyer and the seller, regardless of which party appears to pay the tax. The tax inserts a wedge between the price paid by the buyer and the amount that the seller actually receives. It moves both prices away from the equilibrium price that the market would determine in the absence of taxes. The party that is least able to escape the tax is the one who ends up carrying most of the burden. So, for instance, if the tax is on, say, cheddar cheese aged 12 years, the producers have little flexibility to increase or decrease supply. They have a pipeline of cheeses of various ages, and can neither speed up nor slow down the aging. Buyers, on the other hand, are free to switch their purchases to other kinds of cheese. So, this tax would hit the suppliers more heavily.

Now, think of the subsidy as being a “negative tax”. Here, the benefit of the subsidy will fall most heavily on the party that is least able to “escape” the transaction; that is to say, on the party that is least price-sensitive. It is much easier for potential students to respond to a subsidy, by demanding more education, than it is for the schools to respond by supplying more education. (After all, one has to build classrooms and dorms; and hire professors. This takes a while to accomplish.) This inelasticity of supply means that most of the benefit of the subsidy will flow to the supplier.

Perhaps a picture will help:

Subsidy Wedge

Notice how the price the buyer pays (Pb) is a bit lower than the original equilibrium price; but the price the supplier receives (Ps) is considerably higher than the original price. Hence, the increase in tuition, and the increase in money flowing to colleges.

Now, the colleges can’t, in the short run, increase the number of professors. Remember, they’d have to build classrooms; and it takes a few years to “make” a professor. So, what are they to do with all this extra money? Well, administrators are thicker on the ground than professors, and so can be hired more quickly. One can probably erect a building more quickly than creating a professor, so buildings are put up. Not classrooms, though: fancy “wellness centers” and cafeterias, and such.

If I am right, the solution to tuition inflation is not to attack the spending by the colleges. It is, rather, to reduce or eliminate the subsidy.

This would mean fewer people going to college. This is potentially a good thing: more people will be acquiring a skill, making America more competitive for manufacturing jobs. Colleges will lose the flow of the subsidy money, forcing them to make more prudent choices in how they spend what money they have left. We should see a drop in wellness center construction, and a pullback in the size of the administration.

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