A four (to five) year vacation: Why the market for higher education is too perfect in the U.S.

I have always envied Europe's little to no cost higher education systems. While I envied it, however, it always amazed me that such a system was sustainable. With recent tuition hikes in the UK and the ensuing protests, it shows that nothing good lasts forever.

So which system is better? One where education is funded by taxpayers or one where students pay their own way? Because of my current circumstances I’d be inclined to want taxpayers to pay off my debt, but this is unsustainable and most importantly inefficient.

I have little knowledge of comparative higher education systems, but can’t help myself from attempting to answer this question.

Let’s start with full disclosure. Under the American system, I have easily been able to obtain loans to pay for my extremely high education costs. I was lucky enough that my parents were able to pay for my first two years as an undergraduate, while I took out personal loans to pay for the last two years and my year of graduate school. This has totaled to somewhere around $100,000, half provided privately and half by the government.

$100,000! This is an amount of debt that I can hardly comprehend and honestly seems surreal. But, it is not all that uncommon and many of my friends have incurred similar levels of debt. We are trying to pay off a mortgage before we have a house.

A typical European will incur nowhere near this amount of debt and in countries like Sweden higher education is practically free of costs. 

To examine this question I'll call on, quite possibly my favorite book, The Undercover Economist by Tim Harford whose lessons in economics can easily be applied to higher education. The first is that a free market reveals the truth.

Privatization of higher education in the U.S. has revealed student preferences perfectly. So perfectly that universities have moved away from their original mission of education provision to provision of other services. The increase in recreational facilities, football stadiums and cafeterias that rival four star restaurants clearly shows that students prefer these goods/services over education.

How do we know this? Because universities compete amongst each other to enroll the best students and to attract the best they must respond to student demands. And what we have been demanding is more of a Club Med experience rather than modest facilities filled with the best professors money can buy.

This brings us to our first problem: excessive-signaling or advertising by colleges and universities. Karsten Mause (2009) reviews the academic literature and remarks on this concept determining that effective tools to measure the effect excessive-signaling has on social welfare have yet to be developed. 

I fell victim to signaling. The picturesque campus of my university sold me. I was still unsure what I was going to major in, but couldn't resist the thought of spending four years on such a beautiful campus and ignored looking into universities that held the highest reputation for what I was interested in studying. I am not saying that everyone is as gullible as me and likely to succumb to signaling as I am, but it without a doubt plays a factor. I also value my education and experience at my university very highly, whether or not I value it at $100,000 is yet to be seen.

Onto other problems. Harford points out three market failures that afflict healthcare that also hold true for higher education: scarcity power, externalities, and adverse selection caused by asymmetric information.

Scarcity power is not that troubling. Potential students have so many choices when it comes to selecting a college or university that it is overwhelming. The rise of online institutions has made competition even fiercer, providing yet another option.

To make competition perfect, the accreditation system could be removed. This would affect the marginal price as institutions could offer lower quality, cheaper education outside accredited colleges and universities, increasing supply. It would be then up to employers to recognize and investigate the value of a student's education if they attended one of these marginal institutions.

Next let’s look at how externalities impact higher education. When a person obtains a degree they create a positive externality for society as a whole by increasing human capital. Externalities and public goods (see older post) are not properly priced in an open market, so government intervention is needed. Negative externalities, such as the traffic that a new football stadium brings to a town, should be taxed, while positive externalities should receive a subsidy, evident when a person studies immunology and helps develop HIV/AIDS treatments. 

How much of a subsidy should be given to a person that invests in their human capital? This is the most difficult question to answer. European states have chosen to subsidize this cost much like the U.S. does for primary and secondary education. The U.S. subsidizes higher education differently. Both public and private higher education institutions exist and receive a fair amount of federal and state funding, but this funding is then redistributed on a need basis. The most common subsidy comes in the form of low fixed rate loans, the type of aid I received. 

The question of how much to subsidize investment in human capital is closely linked with the third market failure, adverse selection.

When applying to colleges and universities there are many different people and organizations that have to act as actuaries and attempt to determine risk, including you. First, you have to evaluate the riskiness of taking out a loan, choosing the right school, etc. and try to determine if this going to pay off through increased job opportunities. The school admissions office also has to look into the material you submit with your application: high school transcripts, SAT scores, essays, etc. and evaluate whether you are going to be an academic flop or star and increase the school’s prestige. Lastly, there are financial organizations that decide whether you eligible for federal aid based on need. If not, and you decide to apply for private loans, banks must try to predict the future and determine whether or not you will be able pay off the money they are lending you.

Adverse selection occurs because we lack an important technology, crystal balls. The private sector will underinvest in human capital because it cannot be sure, especially since most potential students are unsure of what they want to major in, that the person will be able to repay their debt.

Complete private financing of higher education will lead to discrimination against some disciplines. Mine, political science, will likely go the way of the dinosaurs under such a system; banks simply won’t finance disciplines that don’t lead to the most profitable careers. Students who choose engineering, medicine, and other “hard” sciences will receive the most financing.

Exploring some possible solutions...

1. Excessive-signaling

This is difficult to solve since there is no effective way to measure the impact signaling has on social welfare. A cap could be set on expenses that aren’t directly related to increasing teaching and research capacity. The government could also compel institutions to spend an equal on signaling and those that  add value to education. In both cases, a large increase in spending that adds value to education would occur as institutions competed with one another. It would be more difficult for the institutions to compete by buying commercials or recruiting a star basketball player because of the caps.  The only place left to compete would be on teaching.

Its also hard to determine what expense are signaling and what are adding value to education. Does a state of the art dorm facility, that makes living conditions more comfortable, increase the productivity of students?

2. Externalities

It’s difficult, but not impossible (see average earnings for persons with degrees) to evaluate how much a degree should cost. Harford points out we shouldn’t subsidize something that the market can regulate. People will continue to seek college degrees because of the increased income they will receive. People who otherwise wouldn’t seek an education require a subsidy to push them into the market, since this will increase social welfare by raising human capital. This is how the system currently works, on a need basis. While the poor are largely left out, this is a poverty problem, not a problem with the system.  

3. Adverse selection

Under a completely private financing scheme, some disciplines will lose, and the less privileged will find it difficult, if not impossible, to find financing. Banks, with no knowledge of your future, will be less inclined to invest in human capital, which will lead to under investment, a fact of the U.S. system (Jacobs et al., 2006). Jacobs et al. (2006) suggest a graduate tax. This would act exactly like an income tax, and be used to fund higher education. A radical change I cannot see coming to fruition in the U.S. or Europe.  With more and more people attending higher education institutions, it would also be unsustainable.

Which system better deals with these issues? U.S. institutions consistently dominate world rankings. Whether this is because of the way the system is structured or our overall wealth will be revealed as the developing world catches up and it becomes easier to study abroad. But, the more market based approach in the U.S. leads to a highly competitive, and as we’ve seen probably too competitive, market that will push colleges and universities to offer the best services, education or other, at the lowest cost.  The European system, on the other hand, looks as if it is going to shift closer to the American way, as a shrinking population cannot afford the huge subsidies that colleges and universities receive.

While it has flaws, the U.S. is the clear victor.

For now the focus should be on determining the effect that signaling has on social welfare. I have a feeling (intuition, no empirical evidence) that the massive inflation of higher education costs has a lot to do with excessive signaling. If this can be measured, it can be fixed, and the other, more difficult problems can be dealt with accordingly.  

References

Jacobs, Bas and Sweder van Wijnbergen. 2006.”Capital-Market Failure, Adverse Selection and Equity Financing of Higher Education.” Public Finance Analysis 63 (1): 1-32.

Mause, Karsten. 2009. “Too Much Competition in Higher Education? Some Conceptual Remarks on the Excessive-Signaling Hypothesis.” American Journal of Economics & Sociology 68(5): 1107-1133.