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The Socialist Economics of College Tuition

Why elite universities charge $38,000 per year, and why they don’t expect you to pay it.

This is the season of college commencements, a time of immense relief for parents who are finishing tuition payments, and of dismay for younger parents who wonder how they’ll ever afford to send their kids to good schools.

By any measure, the price tag is staggering: $38,000 per year (including room and board) at Harvard, Yale, Princeton, Amherst, Williams, et al., and nearly as much at colleges down the academic food chain. And since tuition always rises faster than inflation, “saving” for four years of college looks like an impossibility for any parent who’s not a hedge-fund manager. 

So, how do other parents manage to pay for tuition? The (perhaps reassuring) answer is:  Most don’t.

Thirty years ago, most students at private colleges paid full tuition. Today, only one-quarter do. The rest receive financial aid in the form of scholarships and loans. These discounts are substantial: 50 percent, on average, at the elite private colleges—the 25 most selective and best-endowed private colleges and universities, including the Ivies—even higher at many less-selective private colleges. In other words, most students at good private colleges pay only half the list price or less.

So, why do colleges persist in charging sky-high tuition that causes sticker shock for applicants yet is irrelevant for most of them? 

For second-tier schools (the schools ranked below the top 50 in U.S. News & World Report’s annual rankings) the answer is that a high tuition, even if few students pay it, is a signal of value—positioning the school in the market of high-quality colleges. For the elite private colleges, the answer is more complicated. Schools like Harvard, Yale, and Princeton don’t use a high tuition to signal value; their names alone do that. Nor do they maintain high tuitions to maximize revenues. Just as increases in taxes don’t always yield increased revenues, increases in tuition do not necessarily translate into revenue windfalls. Harvard’s 2001 tuition hike, for example, resulted in only marginally higher revenues, according to Sheryl Hoffman, Harvard’s associate dean for finance.

The elite private colleges use gargantuan tuition to do what is usually thought to be the province of governments: redistribute wealth by “taxing” the families of rich students in order to subsidize the less rich and the not rich. Like for-profit corporations, elite colleges engage in “price discrimination,” applying different prices to different students in order to extract the most money that each student is willing and able to pay, explains Henry Hansmann, professor at Yale Law School and expert on charitable organizations. But unlike for-profit corporations, colleges engage in this quintessentially capitalist behavior in the service of an egalitarian ideal.

While second-tier colleges offer merit scholarships to top students in order to lure them away from the best schools, most of the elite private colleges claim to offer need-based discounts exclusively. Indeed, for the elite private colleges, it is a point of honor that they do not give merit discounts. This policy serves their redistributionist instincts. Wealthier students, no matter how smart they are, subsidize needier classmates by paying full price.

One surprising result of this social policy is that the real cost of private colleges hasn’t increased in the last two decades—contrary to the conventional wisdom that tuition inflation has priced the most selective schools beyond the reach of middle-class families. In a study of admission and financial-aid decisions at Williams College from 1988 to 2001, economists Gordon Winston and Catherine Hill found that the real cost of tuition stayed essentially constant across all income groups.

Middle-income families paid a discounted tuition of $10,794 in 1988 (in year 2000 constant dollars); the same families in 2001 paid $11,024, an increase of just 2 percent in 13 years. Low-income families actually experienced a reduction in tuition, from a 1988 net of $7,667 to $5,907 in 2000. Only families paying the sticker price saw a big increase in tuition in real terms. But even their tuition cost represented about the same share of family income in 2001 as in 1988, according to Winston and Hill.

The colleges’ experiment in wealth redistribution has been sustained over the years by their reluctance to compete with each other on price (as distinct from non-price matters, like course selection and celebrity professors, over which competition has always been intense). Although the Ivy League was busted by the Justice Department’s antitrust enforcers in the late 1980s, the elite private schools continue to behave like a de facto cartel in the areas of tuition and  financial aid. It is not just coincidence, after all, that despite huge disparities in their cost structures and financial resources, the top private colleges year after year charge nearly identical tuitions.

But price competition may be inevitable, no matter how hard the schools try to resist. The sweet scholarship deals offered by rival schools may start eating into the best colleges’ applicant pools. An omen was Princeton’s decision in 2000 to enhance financial aid packages by replacing loans with outright grants. Yale, Harvard, and other top schools quickly followed suit. A decision by a Harvard, Yale, or Princeton to offer a merit scholarship—that is, a tuition discount having nothing to do with a student’s financial circumstances—may not be far behind. That might begin to change the purpose of scholarships from redistribution to incentive.

The elite college cartel will probably collapse. Most eventually do, even cartels that are—in their own eyes, at any rate—benevolent.