Do colleges charge high prices because they have to, or because they can?
Runaway tuition inflation over the past four decades raises key issues about the future affordability and sustainability of the American higher education system.
The chart above shows what’s happened to tuition and fees at public and private institutions over the past 50 years. Three trends stand out. First, tuition in both public and private institutions grew more slowly than prices in general in the hyper-inflationary 1970s. Second, since 1980, tuition and fees have shot up more than twice as fast as inflation. Finally, over the full half century shown on the chart, tuition in real terms has grown at roughly twice the rate of GDP per capita, meaning that students and their families have lost a great deal of purchasing power on America’s college campuses.
The Two Basic Theories about Why College Charges Have Increased So Fast.
What’s going on? Two basic and competing theories have been postulated to explain this phenomenon. One is the so-called ‘cost disease’ which posits that higher education and other labor-intensive sectors cannot capture much in productivity gains over time. The other is a demand-pull explanation — the revenue theory of higher education suggests colleges raise all the money they can and spend all the money they raise.
The Cost Disease. Also known as “cost-push,” this explanation is based on the observation that higher education is a labor-intensive activity requiring ever-rising funds to pay for expensive labor — professors and administrators, for instance. In the 1960s, economists William Baumol and William Bowen argued that service industries like the performing arts, health care, and higher education suffer from a “cost disease” because they are so labor-intensive. Unlike manufacturing, higher education benefits very little from productivity gains that come from, say, automation. In fact, the cost-push argument is that productivity in the higher education sector tends to decline over time as spending per student must rise more rapidly to accommodate the growing costs for labor.
The Revenue Theory of Higher Education. The so-called revenue theory of higher education was first suggested by economist Howard Bowen in 1980. It is the most prominent example of a “demand-pull” hypothesis about college costs. According to this theory, colleges and universities raise all the money they can and spend all the money they raise. In other words, the revenues they can raise dictate how much they can spent, rather spending needs dictating how much they need to charge.
There are other theories, such as the growing cost of regulatory burdens on colleges, the impact on prices from the bundling of services, the impact of state funding cutbacks on public sector prices, and the role of federal student aid, particularly loans, on what colleges charge. But these are all variants of the basic concepts of cost-push or demand-pull inflation.
Those adhering to these two different theories vary in how they look at the world. Those with a cost-push view believe that growth in tuition is a direct function of institutional spending decisions: the more it costs to educate students, the more colleges must charge to offset those costs. Thus, cost-push adherents tend to look for cost drivers — the ways in which colleges spend their money determines how fast their prices rise.
In contrast, those who believe in the revenue theory tend to focus on trends over time in the amount of various revenue streams in the belief that these trends will determine how much colleges can spend. I am in this camp. I believe that the revenue theory has greater validity than cost-push in explaining pricing patterns over the past half century.
A principal reason for my belief is that spending per student tends to go up the fastest when revenues are most plentiful and has tended to increase more slowly or even shrink when revenues are most constrained, in recessions.
If the cost disease were more dominant, then one might expect the spending to grow both when revenues were plentiful and when they were not. In many ways, this is similar to health care where the cost curve only started to bend downwards in the past decade when federal revenues began to dry up.
But asserting that higher education is governed more by demand-pull than cost-push pressures does not explain why tuition and fees have increased so rapidly and why they have grown so much as a share of spending per student over the past four decades. Those of us who believe more in the demand-pull explanation would say the decision about where officials set tuition rates creates the framework for how much can be spent but that does not explain why prices have increased so fast.
Under either view, the story about why tuition and other charges have increased so rapidly in recent decades is best told separately for the public and private sectors of higher education. Subsequent blogs will explore the history of public and private sector tuition growth and the reasons for it.