Competition unfairly lowers tuition fees for wealthy students at the expense of others
Consumers almost always win when there is increased competition. We all learned in Econ 101 that competitive markets force companies to innovate and economize, and to generate the lowest prices possible. You would think that we could apply this principle to colleges and universities.
But the market for higher education is different from the market for milk. Competition among colleges actually drives down prices for high-income students at the expense of higher prices for low-income students.
Why does competition help in the milk market but not in higher education? You have many choices where to buy milk. Beyond the fat content and the organic varieties, it’s largely the same no matter where you buy it. Its price is determined by supply and demand. Sellers cannot charge more than the market price because no one would buy from them. If firms are highly profitable, new ones enter, increasing competition and lowering prices.
That’s what competition can do.
As I explain in my book, that’s not how the college market works. Not all colleges are the same. “Consumers” (students and parents) prefer some schools to others and are willing to pay more to attend them. This gives elite schools enormous market power. I teach my students that the presence of market power is bad for consumers.
For example, there’s a reason your cell phone bill is so high. The market power of Verizon and AT&T inflates prices, increasing corporate revenues and profits at the expense of consumers.
Competition among colleges actually drives down prices for high-income students at the expense of higher prices for low-income students.
But market power in higher education offers an advantage: it allows colleges to charge different prices to different students. Those who can pay more are charged more. This generates greater revenue. However, most higher education institutions (and certainly all of those that are publicly funded) are non-profit organizations. So, rather than lining their pockets, they are using this increased revenue to drive down prices for low-income students.
This is called financial aid. Having all those complicated forms filled out by students allows colleges to figure out how much to charge whom.
Elite private colleges, which have the most market power, may charge students from high-income households the most. This generates more revenue. The returns on investment from their large endowments further improve their bottom line. Together, these benefits allow them to charge students from low-income households less than elsewhere. At least, this is what we observe.
Public institutions, however, generally have less market power and struggle to make college affordable for low-income students.
Related: Colleges provide misleading information about their costs
The biggest problem, however, is that states are capping public institution sticker prices below market levels, which reduces school revenue from high-income students, limiting the money available for financial aid. and thus overwhelming students from low-income households. Direct state funding to public institutions could fill the void, but these funds are insufficient.
Non-elitist private establishments are in direct competition with public establishments. This limits the amount these privates can charge high-income students. Although they frequently advertise high prices, they offer “merit awards” to all or most students, which reduces the actual price high-income students pay.
Without large endowments or direct public funding, tuition-dependent private institutions also struggle to provide sufficient financial aid to low-income students.
Competition between institutions generates other cases where students from high-income families benefit at the expense of those from low-income families. Consider genuine merit awards, offered to highly qualified students. They generally only benefit high-income students. Deserving low-income students also receive merit awards, but these funds largely replace need-based aid. Once an institution adopts this approach to help attract higher paying students, all institutions must do so to be competitive.
The practice of “poaching” high-income students accepted – and therefore particularly desirable – from other institutions have a similar effect.
In either case, if all institutions engage in these practices, none of the competing institutions will have gained a price advantage and enrollment patterns are unlikely to change. However, revenue will be lost. In game theory, this is called the “prisoner’s dilemma”.
If schools stopped competing in this way, their increased revenue could be used to provide greater financial aid.
If we want college to be affordable for everyone, we need a different approach.
Related: STUDENT VOICE: Doubling the Pell Scholarship will make college a reality for more students like me
The solution is unlikely to come from the institutions themselves. Private institutions with limited endowments do not have enough money to reduce their fees for students from low-income families. Public institutions are constrained by state policies focused on keeping prices lower. More direct state funding seems unlikely.
Our best hope for closing the college affordability gap is to double the value of the Pell grant. This would entirely close the gap in public institutions between what students from low-income families can afford to pay and what they are currently being asked to pay. It would also extend the reach of the Pell Grants to the middle class. It is a more targeted solution than the “free college” proposals offered by some.
Students taking Econ 101 learn that government intervention in market outcomes only makes sense in limited situations. It’s one of them.
Phillip Levine is Katharine Coman and A. Barton Hepburn Professor of Economics at Wellesley College and author of the book “A Problem of Adjustment: How the Complexity of College Pricing Harms Students and Universities.” He is also the founder and CEO of My intuition, a non-profit organization that provides colleges and universities with a simplified financial aid calculator.
This article on the costs of a college education was produced by The Hechinger Report, an independent, nonprofit news organization focused on educational inequality and innovation. Register for Hechinger’s newsletter.