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Should Price Reflect Cost? (Part 1)

January 14th, 2013 by dfarish

In a major front-page, above-the-fold article on Sunday, 23 December, The New York Times told of the widening gap in college completion rates for high-income versus low-income students. The Times illustrated the broader story with specific examples, including one of a student who was admitted to Emory University on what she thought was a full-need scholarship – but, because of problems in completing her financial aid forms, she arrived to find she had no institutional aid, and needed to borrow $40,000 just to enroll for her first year. Ultimately, her financial problems reached the point where her grades suffered, and she was suspended in her senior year. She now has an educational debt of almost $60,000, but no degree.

Sadly, this story is all too common. Only 29 percent of the students from the lowest quartile of family income even start college, and just 9 percent complete their degrees. (Conversely, 80 percent of the students from the highest quartile of family income start college, and 54 percent complete their degrees.)

The Times devoted more than two full pages to this story, but it ends with no suggestions for remediating this worsening situation.

I have a suggestion that would at least be a start to a solution. If college tuition (“price”) only reflected what the college spends to provide a year’s worth of education (“cost”), tuition would be substantially reduced, and students would need to borrow less, would be more inclined to remain in school, and would graduate with less debt.

But wait, you ask. Do you mean to say that colleges actually charge a student more than what it costs to educate him or her?

The answer is “yes.” The listed tuition of a substantial majority of colleges is not just more, but significantly more, than what the colleges expend in providing the student’s education.       

So let me return to the title of this blog post. The answer to the question it poses would seem obvious: of course price should reflect cost. After all, market forces will, in a competitive environment, presumably force prices to reflect cost – competitors will undercut each other’s prices in order to gain market share. To be sure, in the for-profit world the need to have a profit prevents price from being driven down to the actual cost – but in the nonprofit world, shouldn’t we expect price to be virtually the same as cost?

Well, we might reasonably expect that to be the case, but, if we’re speaking about higher education, we would be disappointed. In the world of higher education, tuition prices have at best a casual relationship to cost.

A stronger relationship to the tuition sticker price of a given college is the price charged by its competitors: colleges argue that charging less than their peers sends the undesirable message that the college’s educational value must also be less. That is the reason that the prices of colleges that actively compete with each other are remarkably similar – but generally quite different from the prices of colleges with which they do not compete.

But perhaps this may not be as significant a problem as it might at first seem. If a given college is charging less than what it spends (by augmenting tuition dollars with drawdowns from large endowments, for example), then the fact that cost does not directly determine price is of no practical concern: all of the students in that instance are getting what amounts to a subsidy.

The rebuttal to this argument, however, is that some of these colleges are spending astronomical sums per student per year, and it is not always apparent that these higher expenditures add corresponding value. If one can pay $30,000 per year to receive a quality education at a campus that spends $30,000 per student per year, then is it really a bargain to pay $40,000 at a campus that says it is spending over $100,000 per student per year? In the second instance, the student is paying $10,000 more – but is he or she receiving $10,000 more in educational value (let alone $70,000 more) than the student in the first instance?

Regardless of how one might answer that question, the situation I describe is true only for a relative handful of campuses: those with very large endowments. At the great majority of private colleges, the sticker price for tuition is much higher than what the colleges are actually spending to educate the student.

Why? Why do colleges charge more – much more – than they actually spend?

Most private colleges subscribe to what is called a “high cost/high aid” model. Money for institutional financial aid – be it merit aid or need-based aid – comes largely from the students themselves, through inflated tuition prices – and the gap between what is charged and what is spent (the so-called “discount rate”) has been widening.

In the last academic year, the average discount rate at private colleges nationally was over 42 percent. That means that a college with a tuition sticker price of $40,000 was, on average, dedicating 42 percent (or $16,800) to the pool of dollars available for financial aid, leaving just $23,200 for educating each student.

Next time: how to change the system.