AusPol / Economics / Policy

What drives increases in University fees?

Sean Leaver, a PhD colleague of ours at RMIT, has an interesting post on his personal blog—The MisBehaving Economist—about competing hypotheses of rising education costs. You should read the full post on his blog, but below is some copy-paste to sum up his point.


First he sets the scene:

Over the last 15 years, increases in higher education fees have accelerated and are now rising faster than any other part of the economy. Outstripping even the rising cost of medicine and health care. And yet we see no meaningful improvements in productivity or GDP growth over the same time period. …

What we see in the wider economy does not justify an explanation that fees are increasing in line with improved earnings expectations. There is some improvement in earnings overall but productivity and GDP are not rising anywhere near as fast…

What explains this divergence? I agree with Sean that this probably comes down to signalling:

Instead, graduates have better outcomes compared to non-graduates as a result of job-signalling/screening effects. This is where employers use education credentials as a way to screen for desirable behavioural traits (e.g. self-control) or social background. …

This leads to an arms race of over-education. Education as a signal is a lot like the Red Queen effect, you have to run to stay in the same place and run even faster to actually go somewhere.

Signalling dynamics are common to a lot of markets and while goods and services linked to prestige can be expensive it is rare to see prices increase to the same extent as we have seen with university /college fees.

What could be done about this arms race? Well, nothing (at least, not by government). But things could be undone. The ramping up of credentialism and educational inflation is (at least partially) the result of government intervention in education markets. Now there could likely be other factors contributing to this—speculation, opportunism, and the like—but let’s focus on the ‘price distortion, malinvestment, and correction’ pattern.

This is a familiar Austrian story: intervention to artificially lower the ‘shopfront’ price of education (or rather to artificially introduce soft budget constraints) causes people to make malinvestments in human capital, which then manifests as booms and busts in the implicated education and labour markets. So now in Australia we have shortages in tradies and surpluses in arts grads, because of distortions in price signals. Government-led ever-expanding access to higher education caused an overproduction of degrees (boom) and inevitably precipitated a loss of degree-value in job markets and poor employment outcomes for graduates (bust).

Low-level jobs that were once available to those who didn’t finish high school now require degrees. So the fact of high educational attainment (and cost) and not-so-high-as-perhaps-expected productivity and income, makes sense. The flip-side of educational inflation is devaluation of qualifications: you need a bachelor degree to work in low-productivity, low-wage jobs and conversely, your bachelor degree is only worth a low wage. Added to this is a misallocation of talent, which has likely contributed to sluggish productivity and growth. We’re working our way through that now. Come the correction.

My point is that the hand of government is firmly affixed to the controls of the Red Queen treadmill, and speeds it up a couple notches. And moreover, because prospective students can afford to use any treadmill in the gym they less have to—and are less able to—make informed decisions about which piece of equipment best suits them. What happens when someone is in the wrong place, using something they probably shouldn’t, and going way too fast? Failure happens.

Anyhow, moving on. Two theories are usually put forward to explain why fees are increasing so much:

The first is the Bennett Hypothesis (‘Our Greedy Colleges’, 1987): increases in university fees are directly related to increases in financial aid. That is, any loosening in individual budget constraints through the availability of financial aid (government or philanthropic) will  feed into higher prices.

The second is the Baumol’s Cost Disease hypothesis: that increases in fees are related to the cost of low growth in teaching productivity compared to the wider economy. Where over time, the cost of maintaining service levels becomes increasingly more costly as salaries increase in line with the broader economy.

Which hypothesis is correct?  In a recent NBER paper ‘Accounting for the Rise in College Tuition’, modelling suggests that the Bennett Hypothesis is the key driver explaining rises in university fees and not Baumol’s Cost Disease. Baumol’s Cost Disease is shown to actually lead to lower fees not increase fees.

So fee increases mostly come from increases in financial aid. In Australia, then, fault falls at the feet of programs like the Higher Education Contribution Scheme (HECS) and its successor the Higher Education Loan Programme (HELP), it would seem.

But in any case, the costs of higher education provision have still increased, not only the price. If this is not explained by low productivity growth in delivery of teaching, then why?

The answer maybe found in Bowen’s Revenue Theory of Cost. When an institution’s dominant goal is prestige (excellence and influence) there is virtually no limit to the amount of money it will spend to achieve this goal.  The institution will raise as much money as it can and spend all that it raises. Consequently as spending builds prestige and prestige raises more fees to spend, the end result is ever increasing expenditure.

Sean thinks this explains the cost increase: universities will spend up big on research, scholarships, branding, and “nice big fancy buildings of little productive value” as all these boost prestige/reputation. It seems plausible to me. But then, is it really undesirable on its own? Surely it is manipulation of prices and the artificial expansion of education-specific student debt that enables such behaviour.

UPDATE: has published a nice piece by Scott Burns about malinvestment in higher education in the US context “The college bubble and the Austrian business cycle“:

What can economics tell us about the unintended consequences that might result from massive influx of financial and intellectual resources into higher education?

There is another compelling way to think about the unintended consequences of these policies, derived from a more heterodox theory: the Austrian theory of the business cycle.

He starts with a nice account of Austrian business cycle theory:

Boom-bust cycles arises when central banks print too much money, artificially lowering interest rates below their equilibrium, or “natural,” rates. This cheap credit induces investors and businesses to engage in more investment projects — particularly longer lasting ones that tend to be more interest-sensitive like housing construction or building capital-intensive plants. The boom turns to bust once investors realize that there are not enough real savings to sustain all of these longer lasting projects. As a result, some of their projects — or “malinvestments” — must be liquidated.

This “bust” stage represents the recession. The economy temporarily slows as entrepreneurs try to reallocate labor and capital back in line with underlying consumer preferences. This readjustment process can take time. But this short-term pain is necessary for the economy to return to sustainable long run growth.

How does Scott think this applies to higher education?

Just as government policies distorted the structure of relative prices and interest rates in the real estate market during the housing boom, they have also disrupted relative prices and interest rates in the market for higher education.

The federal government has drastically increased its student loan programs by offering larger loans and keeping their interest rates well below private market rates.

The federal government has also artificially stimulated investments in higher education through a variety of grants, subsidies, and tax deductions.

He then drives the point home, drawing the parallel between educational malinvestment and ‘traditional’ malinvestments—human capital forms part of the overall capital structure in an economy:

Economists often talk about the importance of higher education for enhancing students’ knowledge and skills, allowing them to become more productive workers. They refer to this as an investment in “human capital” — a direct parallel for labor to the concept of physical capital. What they often times neglect is that human capital can be malinvested just like physical capital.

By making college artificially cheap via grants and subsidized loans, the government distorts the relative price signals that guide current and prospective students. On the margin, these false price signals can induce too many students to enter college and embark on unprofitable investments in degrees that employers don’t demand. The human capital structure of production is thereby “lengthened,” as more students engage in these time-consuming investments in their human capital that all often don’t pan out.

It is unsurprising that an increasing number of these human capital investments have proven to be outright malinvestments. Graduation rates have steadily declined since 2005, even as critics argue grade inflation has made college increasingly easier; today, nearly half of college enrollees will either drop out or not complete their degree within six years.

Malinvestments can show up in other ways, too. Many graduates have been unable to find a job in their area of study. Other students have had to change majors, go back to school, or enroll in graduate programs to retool their skills to what employers really want. As with physical capital, this readjustment process can be painful and time-consuming. However, liquidating these malinvestments is absolutely necessary if graduates want to land sustainable jobs.

Read the whole thing here.


One thought on “What drives increases in University fees?

  1. Pingback: What drives increases in University fees? Bennett hypothesis vs Baumol’s cost disease « The misBehaving Economist

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