December 5, 2023

Notebook | Spending: The Price of Perception

The reason is simple, and not just semantics. It’s explained in every Econ 1 textbook: supply and demand.

Market strategists know that costs are usually irrelevant in determining prices. The optimum price is the one the market will bear, the price at which demand and supply are matched. Tuition in the private higher-education industry is a classic example of price leadership — the “top players” define the sticker price and all others follow suit. Each year, tuitions increase by 1 percent to 3 percent over the previous year’s inflation rate, and still more during recent years of low inflation and modest endowment returns.

Consider the announced tuition and fees for this academic year at these market leaders: Harvard ($38,416), Princeton ($36,640), Stanford ($39,201) and Yale ($38,300). They are not tightly clustered because their costs are identical. Why would it cost almost exactly the same to operate any two institutions as complex as a university?

Further, differences in endowments seem to have little or no effect on how much tuition they charge. Stanford and Yale have almost identical tuition, and yet, with Yale’s greater endowment and smaller enrollment, its endowment per student is almost 70 percent greater than Stanford’s.

Indeed, they are so tightly clustered because the prospective students and their families who are their customers consider all four institution to be tops, and equal in prestige and quality.

If my argument holds, then prices should reflect perceived quality, with emphasis on “perceived.” They do.

Consider the pricing decision at universities just below the super-elites. To charge well below the acknowledged leaders might signal lower quality, not at all the message they wish to convey. So Duke ($40,575), Emory ($39,158), University of Southern California ($41,022), Notre Dame ($39,919), Cornell ($39,666) and Washington University in St. Louis ($40,374) price themselves right with or even slightly above the leaders.

Tuition and fees at top liberal arts colleges — Pomona ($39,394), Amherst ($40,862) and Swarthmore ($39,600) — are similarly grouped.

“Prestige” and “quality” are in the eyes of the beholder. Wannabes price themselves accordingly. Ursinus College acknowledged, when it sharply raised tuition, that it did so to build the perception of quality. Claremont McKenna, neighbor to Harvey Mudd College, where I served as president, raised its tuition when it realized it was gaining nothing by being priced below its competition.

The fact that tuitions are set to five significant figures implies precise calculation. But pricing is a marketing, not a cost accounting, decision.

My lunch companions protested: these are nonprofit colleges, not for-profit enterprises.

But neither, said I, are they expense-minimizing enterprises.

Administrators strive to avoid losing money, while achieving only a small excess of revenue over expenses. Once tuition is set, costs are controlled — or permitted to grow — to match the maximum revenues each institution believes it can get. One assumption is safe: colleges spend all they can get their hands on. No administrator or faculty member I know is short of ideas on how to spend more.

Consider the cost of educating students at two liberal arts colleges with similar missions, Pomona and Earlham.

For 2009-10, Earlham reports having spent about $40,650 for each of 1,113 full-time equivalent students. Pomona spent just under $77,420 per student, with 1,540 full-time equivalencies. Though its tuition is less than 10 percent higher than Earlham’s, Pomona manages to spend almost twice as much.

Now, Earlham’s rural Indiana location is unlike Pomona’s suburban Southern California location, but geography doesn’t begin to explain the difference.

Could Earlham — current tuition and fees: $36,694 — charge a lot more? Probably not. For all its fine qualities, it is not perceived as a top-tier college, and the market likely would not bear it. Could Pomona charge more? Yes. But it could also charge less — and spend less.

Interestingly, if Pomona’s per-student spending were the same as Earlham’s, it could charge zero tuition and not even have to draw 5 percent from its endowment (a typical annual payout rate).

But why should Pomona spend less as long as the market continues to bear the current rate?

Well-endowed institutions lament that even their high tuitions cover only half the cost of educating undergraduates.

Here’s a question for another luncheon engagement: Institutions may be able to spend twice the amount of tuition, but do they need to spend so much? If Ponoma spent the same as Earlham, faculty members might have to teach more than two courses a semester, and dorms and recreational centers would be less luxurious. Of course, not all of this spending is trivial. Spending less means financial aid policies would be less generous and the student body therefore less diverse and stellar.

As sticker prices have increased, so has scholarship aid offered. In effect, prices are discounted just sufficiently to “clear the market” — match supply and demand — for the students the college wishes to enroll. Many of these scholarships are financed through tuitions paid by wealthier students. To date, parents don’t seem to be rebelling against these Robin Hood activities.

But those responsible for setting tuitions at prestigious universities have for years worried that they might soon hit the wall — that is, price themselves out of the market. Perhaps there isn’t an upper limit, or wall, or perhaps that worry has less to do with what a family can afford than with perceptions of price gouging and frivolous spending.

With the demand for top-end colleges and universities only growing, and a finite supply of slots, my bet is that tuitions will continue for some time to rise at a pace well above inflation.

Rich institutions will get richer, dishing out more financial aid, hiring the best teachers, receiving more gifts, amassing bigger endowments and building more fancy rec centers.

The rate of increase in the number of applications in recent years has been more than double that of tuition increases. Obviously, the “buyers” believe that the extra investment in tuition has a positive return on investment.

Thus: Who is to blame for escalating tuitions, the “suppliers” of higher education or the “demanders”? Check, please.

Henry E. Riggs is president emeritus of Harvey Mudd College and the Keck Graduate Institute.

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