U.S. Universities Feast on Federal Student Aid

December 13, 2011

Any serious higher education policy reform has to start by considering a heretical idea: Federal subsidies intended to make college more affordable may have encouraged rapidly rising tuitions, says Virginia Postrel, the author of "The Future and Its Enemies" and "The Substance of Style."

It's a phenomenon familiar to economists: If you offer people a subsidy to pursue some activity requiring an input that's in more-or-less fixed supply, the price of that input goes up.  A 1998 article in the American Economic Review explored an example: federal research and development subsidies.

  • The supply of scientists and engineers is fairly fixed, at least in the short run.
  • So instead of spurring new activity, much of the money tends to go to increase the salaries of people already doing such work.
  • From 1968 to 1994, a 10 percent increase in research and development spending led to about a 3 percent increase in incomes in the subsidized fields.

In the short-term, the number of slots at traditional colleges and universities is relatively fixed.  A boost in student aid that increases demand is therefore likely to be reflected in prices rather than expanded enrollments.  Over time, enrollments should rise, as they have in fact done.  But many private schools in particular keep the size of their student bodies fairly stable to maintain their prestige or institutional character.

On the whole, it seems that if the government hands their customers the equivalent of a discount coupon, the institutions can capture at least some of that amount by raising their prices -- especially when demand for their product is increasing independent of aid, because a college degree promises to pay off in higher wages.

This doesn't mean that colleges capture all the aid in higher tuition charges.  But it does set up problems for two groups of students in particular: those who don't qualify for aid and who therefore have to pay the full, aid-inflated list price, and those who load up on loans to fill the gaps not covered by grants or tax credits only to discover that the financial value they expected from their education doesn't materialize upon graduation.

Source: Virginia Postrel, "U.S. Universities Feast on Federal Student Aid," Bloomberg, December 8, 2011.

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