Tuesday, May 5, 2015

How subsidies for higher education contribute to the higher cost of tuition

The rising cost of college is routinely noted by politicians, college administrators, reporters, college kids and parents. Politicians often insist that the solution for rising costs is more government aid. Many of them insist that increasing the amount of Pell Grants and subsidizing student loans are necessary in order to make college affordable for most people. But basic economic theory shows us that while subsidies can increase the amount of education that people consume and lower the cost to the people who get the subsidies, the subsidies also raise the true cost and can create a feedback effect that involves granting increasingly larger subsidies.

Research by economists Claudia Goldin and Stephanie Riegg Cellini looked at the cost of for-profit colleges that are eligible for federal financial aid and the cost of for-profit colleges not eligible for aid.

"They found that for-profits that get federal subsidies charge, on average, 78 percent more than for-profit institutions that are not eligible for aid. The price difference is almost identical to the value of the subsidy. “It’s hard not to infer that federal student aid system is kind of allowing that to happen,” Professor Cellini told me."

So how does a subsidy contribute to higher tuition? Lets analyze this starting with the diagram below.


Ignore the MB + subsidy line right now. Without a subsidy, a person will consumer education up to the point at which their marginal benefit of another unit of education is equal to their marginal cost. In the diagram above that is at the price of P1 and the amount E1. If we want this person to consume more education, we can give them a subsidy. In this case the subsidy is the amount Ps - Pc. The effect of the subsidy is that it shifts the marginal benefit curve up by the amount of the subsidy (MB + subsidy line). Now the person will consume E2, they will pay a price of Pc, but the cost of supplying E2 is Ps. The difference of Ps - Pc is the portion of the cost that is paid for by the subsidy. So the subsidy increases the amount of education that this person consumes by lowering the cost to them, even though the marginal cost of supplying the education has gone up from P1 to Ps.

If a lot of people are awarded a subsidy and start consuming more education, say by going to college rather than getting a job after high school, the total demand for college can shift to the right like in the diagram below.


The original demand for college, prior to the subsidy, was D1. Tuition cost was T1 and quantity Q1 was supplied. After the subsidy, as more people attend college, demand shifts to the right to D2. The new tuition cost is T2 and Q2 is supplied. So the subsidy can raise the cost of tuition by increasing the demand for college. How does this new higher tuition price impact the recipients of the subsidy?



I know there is a lot going on in this diagram but bear with me. Prior to the demand shift and immediately after the subsidy our college attendee was paying Pc and consuming E2. After a lot of other people start doing this as well the demand curve for college shifts to the right and tuition goes up. This impacts the individual college attendee as it increases the cost of more education. This is depicted in the diagram as a shift in the marginal cost curve from MC1 to MC2. When the costs curve shifts up the subsidy is no longer large enough to help the attendee consume E2. In fact, as drawn the subsidy recipient only consumes E1 again (where the MB + old subsidy line intersects the MC2 line). The price is P2 but they only pay P1 as the subsidy makes up the difference.

If E2 is a college degree and that is the goal of providing the subsidy, then with the new higher cost curve (MC2) the subsidy has to be increased to get a person to consume E2 again. The new subsidy amount is Ps2 - Pc. The larger subsidy increases the marginal benefit curve from MB + old subsidy to MB + new subsidy. The person will consume E2 again and they will pay Pc with the difference being covered by the subsidy (Ps2 - Pc).

This is a stylized example but it helps explain how subsidies contribute to the rising cost of college. The initial subsidy led to an increase in demand for education, which raised the cost, which meant a larger subsidy was required. If the new, larger subsidy induces some additional students who were not affected by the original, smaller subsidy to purchase more education then the process will start all over again. The new students will increase the demand for college, which will increase tuition, which will then need to be covered by a larger subsidy etc.

This video from Learn Liberty talks about the effect of subsidies and other reasons for why college costs keep rising.

So the next time you hear a politician say that we need larger subsidies to offset the cost of college, remember that those subsidies are partly to blame for the rising costs.

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