Higher Education Higher Education is Big Business In the Fall of

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					                                      Higher Education

Higher Education is Big Business

In the Fall of 2009 7.7 million students were enrolled in public universities and 4 year colleges.1
These institutions spent $225.36 billion, or $36,707 per full time equivalent student (FTES) in
the 2008-2009 academic year. Not only is public higher education expensive, it is getting more
expensive all of the time. From 2003-4 to 2008-9 expenditure per FTES increased by 21.6%.
The annual rate of increase in expenditure/FTES was almost 5% greater than the annual rate of
increase in the general price level.

Tuition is on the Rise

Tuition revenue is not the only source of revenues colleges and universities use to cover their
costs. They have access to government grants, endowment income, funded research activities,
revenues from auxiliary enterprises, such as athletic events, student housing and food services,
etc. In 2008-2009 tuition and fees only accounted for 20% of the total revenues of public, 4
year institutions. This was a smaller percentage of revenues than was provided by
appropriations by state governments directly to these institutions. Nevertheless, while tuition
represents only a fraction of the revenues received by public universities and 4 year colleges,
tuition rates at these institutions have risen more rapidly than the consumer price index for
the past three decades. This is placing a significant hurdle in front of children of families of
modest means, even as the job market for people who lack a college degree has gotten
progressively worse. As of now, however, increases in tuition have not reduced the percentage
of recent high school graduates who are attending our colleges and universities.

Because they are not private enterprises with stockholders who are interested in how much
surplus revenue they can generate and distribute in profits, universities and colleges do not
necessarily set their tuition charges and admission policies to maximize the total net income
they can derive from educating undergraduates. Indeed, the fact that enrollments have not
declined as tuition rates have risen is a clear indicator that colleges and universities can secure
more net income, if need be, from increasing their tuition rates further. Of course, colleges and
universities compete for students. They are concerned with how their charges affect their
ability to attract the kind and number of students they wish to have. So competition prevents
any one institution from charging whatever it wants. But when there is a change in policy that

    Another 5.2 million were enrolled in private 4 year universities and colleges.
affects the over-all market for higher education then all institutions are likely to alter their
tuition rates in the same direction. So, when governments reduce their appropriations for
public universities, and increase scholarship, loans and other student aid, as they have been
doing, it is not surprising that public universities increase their tuition rates.

Is Undergraduate Instruction A “Cash Cow”?

 State universities do not simply educate undergraduates. They are major centers of research
and of graduate training. From 2000 to 2008 R&D expenditures at universities and colleges
grew from $3.01 billion to $5.9 billion, or at an average rate of growth of 6.95%/year. 2 It is not
only funded research that is increasing. Much of the research done by regular, tenure stream
faculty is not financed by external grants. Indeed, in many disciplines only a very small portion
of the scholarly research done is externally financed. At research universities there has been a
decrease in the percentage of regular faculty time devoted to classroom instruction and a
commensurate increase in time devoted to research that is not externally funded. So, some of
the increased cost per student is attributable to the research activities of our public
universities. This raises the question as to whether public universities have been using their
undergraduate programs as ‘cash cows’ that subsidize graduate training and research.

 Just how much it costs a university to operate its undergraduate program is not an easy
question to answer. The reason for this is that at universities tenure stream faculty are
expected to be engaged in both teaching and scholarly research. Tenured members of the
faculty provide the leadership in their respective departments. They can only be dismissed for
cause, or if the department with which they are associated is closed for financial reasons. Those
individuals who are eligible for tenure, but not yet tenured, have several years to demonstrate
that they are recognized within their discipline as scholars of some prominence. Those who fail
to do so are dismissed from the faculty. That is, they must ‘publish or perish’. Tenure stream
faculty represent the core of a university’s faculty. The requirement that tenure stream faculty
both teach and conduct research reflects an assumption that the quality of the educational
experience of undergraduates is enhanced by exposure to scholars who are actively engaged in
research. But, because promotion and receipt of outside offers depend upon research records,
faculty members have incentive to engage in research that is quite separate from its
contribution to the education of undergraduates.

The research conducted by faculty presumably contributes to the quality of the education of
undergraduates. How much it contributes is an unanswered question. The decline in the
participation of tenure stream faculty in classroom instruction has been offset by the increased
use of adjunct faculty who may be hired by the course or by the term. There is also increased
reliance on graduate students as instructors in undergraduate classes and increases in use of
very large lecture classes for instruction of first year courses. So, the direct exposure of
undergraduates to research-active faculty at our research universities has declined over time.
Of course, undergraduates may be the indirect beneficiaries of the presence of the research

being conducted by the faculty via exposure to graduate students who are working at the
direction of their professors.

In addition, the prestige of a university is enhanced by the research its faculty conducts and by
the national standing of its faculty within their respective disciplines. Schools proudly advertise
Nobel Prize winners and members of National Academies who are, or have been on their
faculty. The prestige, or reputation, of a university is important to potential students. They
expect to derive some benefit from being known as a graduate of a particular university.
People are clearly willing to pay more to attend a more prestigious institution than a less
prestigious one. Within Pennsylvania, for example, institutions that are part of the Pennsylvania
System of Higher Education, are primarily teaching institutions whose faculty have large
teaching loads and who do little, or no research. The Pennsylvania State University is, by
contrast, a highly ranked research university. Penn State competes with universities that are
part of the Pennsylvania System of Higher Education for students. It is able to attract students
even though its tuition and fees for in-state students is approximately double that of
universities in the State University System. Since universities compete for students, they have
the incentive to expend resources on faculty who will enhance the reputation of the institution,
and to provide faculty with the opportunity to engage in research that will further add to the
reputation of the university.

Does the higher tuition and fees that research universities charge reflect a higher cost of
producing the kind of education undergraduates get at a research university? Or does it simply
reflect the value that people place on being associated with a prestigious institution,
independent of the quality of the education they actually receive? For an individual who
chooses to attend a research university the answer to this question may not matter. For the
individual, what matters is the value of the package, the education combined with the prestige
associated with being a graduate of that university. The two things come as a bundle to be
presented to potential employers. Employers, in turn, can evaluate some aspects of a potential
employee’s education directly. But the institution from which the applicant graduated also
carries information of significance to an employer about the unobservable characteristics of the
job applicant. Therefore, a potential student might not believe s/he will get a better education
at Penn State than at one of the State System universities, but will still choose to pay the higher
tuition at Penn State because Penn State graduates have typically earned more money.34

  While the student may be unconcerned whether it is the quality of the education or the value
of being associated with a prestigious institution that increases the market value of graduating
from a particular institution, as we will discuss later, society ought not to be indifferent.
  The University of Florida has a SAT score cut-off for admissions. Hoekstra found that individuals who were
admitted to the University of Florida with an SAT score just above the cut-off earned about 20% more than
individuals who had SAT scores just below the cut-off and attended one of the 5 next most prestigious florida state
supported universities. Mark Hoekstra, “The Effect of Attending the Flagship State University on Earnings,” Review
of Economics and Statistics, Nov. 2009, pp 717-724
Pursuing Excellence: A Rat Race

Administrators in higher education are motivated to pursue excellence, to have their institution
be a “leader in education”. The degree of excellence achieved by a university is reflected in its
status in the educational hierarchy. There are good economic reasons for a university to
“pursue excellence”. Because potential students do not have the ability to determine just how
good an education they will receive at one university relative to another, they use the prestige
of the university as an indicator of its quality. Universities, in turn, have a greater incentive to
direct their resources to those activities that will enhance their prestige than they would if
students could accurately judge the quality of the education they receive. A school which can
raise its attractiveness to students by improving its rankings on various external measures can,
in turn, become more selective in its admission process. Schools that are successful in
admitting students of higher average ability will, in turn, make its graduates more attractive to
potential employers, further enhancing its prestige and the value of the school to potential
applicants. The better the income earning prospects of its graduates, the more likely is the
school to receive financial support from its alumni. Alumni support, in turn, is an indicator of
quality that other potential donors consider. So, through various channels, investments that
universities make in research which may not have any direct effect on the quality of the
education their undergraduates receive, provides both additional financial resources to the
university and indirect benefits to its students through their identification with the institution.56

  Most universities operate their intercollegiate athletics programs at a loss. The race to field nationally ranked
teams, even if inter-collegiate athletics do not pay for themselves directly is based on the same argument as
seeking excellence through greater emphasis on internally funded research. These programs enhance the
university’s visibility and attractiveness to students and alumni donors which, in turn, provide additional revenues
to the institution.
  The logic of making investments in activities that raise the prestige of the university is akin to what George
Akerlof characterized as participation in a rat race. See, George Akerlof, “The Economics of Caste and of the Rat
Race and Other Woeful Tales,” Quarterly Journal of Economics, Vol 90, No. 4, Nov. 1976, pp. 599-617
The more prestigious a university the more selective is its admission standards. Consequently,
in the face of significant growth in the number of high school graduates who are seeking post-
secondary education, there has been relatively little growth in undergraduate enrollments at
private universities and public research universities. The graph below indicates that the
greatest growth in enrollment is in community colleges. This reflects a trend that started in the
1980s with the rise in the so-called college wage premium.7 Associated with this trend is a
greater degree of sorting out of students by ability. The most able students are increasingly
concentrated in the most selective institutions while the least able students are increasingly
concentrated in the least selective institutions. The more selective is the admissions policy of a
college, the higher is both the expenditures made per student and the amount of expenditures
not covered by tuition. For students who attend the most selective institutions, the percentage
of costs covered by tuition is quite low. Similarly students at community colleges or the least
selective public colleges and universities have much of their costs covered by non-tuition
subsidies. But for students who do not attend either of these types of institutions, tuition
covers a majority of the costs of the institutional resources devoted to their education.8

                 Source:Trends in College Spending 1998-2008, A Report of the Delta Cost Project

  The college wage premium is the difference in expected life-time earnings of people with a college degree and
the who only have a high school degree.
  See, Caroline Hoxby, “The Changing Selectivity of American Colleges”, Journal of Economic Perspectives , 23, No.4
(Fall 2009)
The likelihood that a student who enrolls in a post-secondary program will get a BA degree
varies markedly with the type of program the student first enters. Not surprisingly, Bound et al
found that among a sample of 1992 high school graduates who entered a 2 year post-secondary
program less than 20% had received a BA degree within 8 years. What is surprising is the
difference in completion rates between those who start at a top-15 public university and those
who entered a non-top 15 public university. More than 90% of those who entered a top 15
completed college within 8 years. But only 54% of those who entered a non-top 15 public
university received a degree within 8 years. Top tier public universities had significantly lower
student/faculty ratios than did non–top 15 public universities. At top tier public universities the
completion rates increased and the student/faculty ratio decreased from 1972 to 1992, while
the opposite was true of the non-top tier public universities. Therefore, some of the difference
in completion rates may be attributable to differences in resources/student. Bound, et al, also
found that an increased percentage of those entering college in 1992 had relatively low math
achievement test scores in their senior year than did the 1972 cohort. They estimated that
increased enrollment of this type of student could account for about 50% of the decrease in
college completion rates. With rising tuition and less rapidly rising family incomes, the financial
burden of college education was (and still is) growing. They found students at non-top tier
institutions responding to financial constraints by significantly increasing their hours of
employment. They report, “While the magnitude of the effect of increased employment on
degree progress is hard to ascertain with precision, the direction of the effect is

 Undoubtedly, the continuing stratification of higher education, budgetary pressures on state
allocations to higher education, and the growing gap between the economic prospects of
college graduates and high school graduates will produce an increased concentration of all
college applicants in less selective public universities and two year institutions where
completion of studies is both less likely and less rewarding than in our top-tier universities.

Should Government Subsidize Higher Education?

 In the United States, government subsidization of higher education originated with the Morrill Act of
1862. That Act gave to every state that had remained in the Union a grant of 30,000 acres of public land
for every member of its congressional delegation to be used to establish colleges in engineering,
agriculture and military science. After the Civil War this program was extended to the southern states.
These colleges expanded into our state university system. The basic economic arguments made for
government subsidization of education are two: (1) Increased levels of education raise an individual’s
productivity and should be considered an investment. However, because individuals may lack collateral
for a loan they may under-invest in education relative to the level that maximizes the potential social

return from all investment opportunities; (2) An increase in the level of education in a community
increases the rate of technological progress in the community, so that such investments generate social
returns that are greater than the returns to those individuals who have invested in their own

 Since 1980 there has been a steady increase in the college wage premium, or difference between the
lifetime earnings of college graduates and high school graduates. Goldin and Katz attribute the increase
in this premium to a slowdown in the rate of growth of the supply of college educated Americans
relative to the growth in demand for people with a college degree. 10 Peter Orzag, when he was
Director of the Office of Management and Budget, argued that this slowdown in the rate of growth in
average educational attainment is a problem both because it attenuated economic growth and because
it increased economic disparities among Americans.11 The federal government ‘s response has been to
promote policies that would increase the dollar amount of government Pell grants available to
individuals who are enrolled in post-secondary programs and whose families meet the income limits. Is
this a worthwhile public investment?

Alison Wolf, in a book with the provocative title, “Does Education Matter? Myths About Education and
Economic Growth,” argues in the negative. She notes the case for public financing of higher education
rests upon the assumption that individuals who get post-secondary degrees generate benefits to
society that are not reflected in the higher incomes that individuals who hold such degrees can
command in the workplace. This assumption implies both that (1) additional years of schooling
increase an individual’s productivity and (2) the increase in an individual’s productivity when that
individual completes more years of schooling is smaller than the expected increase in output society can
produce as a result of that individual’s additional years of schooling. Wolf argues that neither of these
implications is supported by strong empirical evidence.

 Her challenge to the first assumption rests on the argument that employers are interested in innate, but
unobservable characteristics of job applicants. They know, or believe, that these attributes also
contribute to the level of academic achievement that an applicant has attained. Therefore, they use
years of schooling completed as a screen to locate applicants with desirable, but not observable
attributes which contribute to a worker’s productivity. Wolf’s argument is that much of the productivity
of an individual that is attributed to academic achievement ought, properly, to be attributable to these
innate characteristics that have nothing to do with what the individual may have learned in school.
Students, in turn, seek ever more education credentials, not to make them inherently better qualified,
but rather to be able to pass through the employer’s screens. If more education were only a signal that
lets innately qualified people pass through an employer’s screen then it would generate higher incomes
for individuals who pass through the screen, but would not raise total national output. Similarly,
attending a more prestigious, higher cost institution might be profitable to an individual if it only serves
as a signal of higher ability. The individual benefits from the higher expense, but society would get no
additional benefit from the added expense unless the individual becomes more productive by getting
more schooling and/or attending a more prestigious school.

     See, inEducationandHealthCare/
Is Schooling Only A Screen?

Economists have long been interested in finding ways of factoring out the effects of innate, but
unmeasured, attributes on an individual’s earnings. One way of doing this is by studying the earnings
experience identical twins who completed different years of schooling. This is the approach taken by
Orley Ashenfelter and Cecilia Rouse. They find that when statistically appropriate controls are used,
there is a strong correlation between the difference in years of schooling of each member of a pair of
identical twins and the difference in earnings of the same pair members. Since identical twins share
common genetic and familial endowments, this is strong evidence that additional years of schooling
produce an increase in an individual’s productivity. 12 Similar results are found by Oreopoulos when
studying the difference between the earnings of individuals from cohorts of individuals who left school
just before and just after a change in laws governing the mandated years of school attendance.13 14

So, the evidence supports the claim that education is not simply an indicator of innate ability. More
education enhances productivity.

 The fact that people with more years of schooling are more productive than people with fewer years of
schooling does not mean that everyone should be encouraged to get more schooling. People with
more years of schooling are different from people with fewer years of schooling in ways that must be
influencing their decisions as to how much schooling to secure. Some individuals who do not choose
additional years of schooling beyond high school would undoubtedly make a different choice if they had
access to credit to finance the expense. This is an argument for government loan guarantees for those
who would otherwise be precluded from making a profitable investment in additional years of
schooling. Nevertheless, one must also recognize that post-secondary education, and especially pursuit
of a college degree is not necessarily a good investment decision for everyone. It takes both academic
ability and personal traits that not all individuals are likely to possess in order to successfully complete a
college program of studies. Providing financial incentives to attend college to people who will not
successfully complete their program of studies is wasteful.15 It can also increase political pressure on
publicly supported institutions to ‘water down’ their requirements in order to maintain a politically
acceptable rate of completion of studies within a four year period. So, a careful balancing of objectives
must be made when considering the expansion of public support for investments in post-secondary

Does Education Increase the Rate of Technical Progress?

   Ashenfelter, O. and C. Rouse, Income, Schooling and Ability:Evidence from a New Sample of Identical Twins,
Quarterly Journal of Economics, Quarterly Journal of Economics, 113, No.1 February, 1998, 253-284
   I know of no similar studies that effectively identify the effect of quality of education associated with more
attending prestigious universities on productivity.
  While the percentage of high school graduates who enroll in post-secondary education programs has
increased, there has been a decline in the percentage of these students who complete their program of
studies. For an analysis of the factors contributing to the decline in completion rates see, John Bound,
Michael Lovenheim, and Sarah Turner, Why Have College Completion Rates Declined? An Analysis of
Changing Student Preparation and Collegiate Resources, NBER Working Paper No. 15566, December
The rate of technical progress depends upon how rapidly new ways of doing things are discovered and
upon how rapidly these new ways of doing things are adopted. When a new process is discovered, large
profits may be made by early adopters. But these profits will attract additional adopters, expanding
output and driving down the price of the product or service being produced. So, ultimately, much of the
benefit of the new way of doing things is captured by the consuming public as a whole, rather than by
those who invest in the new technology. Therefore, if a better educated population increases the rate
of discovery and diffusion of new ways of doing things, investments in education do not simply increase
the earning capacity of the individuals who acquire that education. By increasing the rate of technical
progress, investments in education also produce benefits that spill over to the population at large.

T.W. Schultz was awarded the1979 Nobel Prize in Economics for his work the role of investments in
human capital on economic development. He was among the first economists to emphasize the
productivity of investments in education. He argued that the value of education came from its
enhancement of problem solving abilities, and coping with new situations. For this reason, he was
particularly interested in how the level of education of individuals affected the speed with which they
adopted new techniques, particularly in farming. His interpretation of the evidence from a number of
studies is that “ the ability to deal successfully with economic disequilibria is enhanced by
education and that this ability is one of the major benefits of education accruing to people
privately in a modernizing economy.”16

While Schultz focused on the role of the level of education in the general population in
speeding the process of adoption of new techniques, modern theories of economic growth
have emphasized the effect of the level of education in the population on the rate at which new
techniques of production are discovered. Since ideas are easily copied and built upon, the
producer of a new idea cannot reap all of the benefit of its discovery. This provides a second
channel through which the education of individuals is assumed to produce benefits that extend
beyond the increased income secured by any individual who becomes better educated.

While one can think of good reasons why increasing the average level of education in the population
produces gains beyond the increase in income of those in who become better educated, Wolf asks
“Where’s the evidence?”. It is Wolf’s position that, as a matter of fact, there is no evidence that
significantly increasing the percentage of the population that has a post-secondary education would
benefit anyone other than those people who receive the additional years of schooling. Since we are
talking about increasing the rate of productivity growth by raising the average level of education, we
must look for the effect at the level of national data. This makes it very difficult to find convincing
evidence that either refutes, or supports Wolf’s position. It is true that nations with high rates of growth
of income tend to have populations in which the average number of years of schooling has been
increasing. But one would expect people to spend more on education as their incomes increased. So it
is difficult to identify the direction of causation. Furthermore, the concept of a year of schooling is
ambiguous when making either cross-national comparisons or comparisons at different points in time
within a given country. It is implausible to claim that a year of schooling in Africa is the same as a year of
schooling in Southeast Asia, or than a year of schooling in either of these areas is comparable to a year
of schooling in South America. Similarly, a year of high school is not necessarily comparable to a year of
college. But an increase in the average number of years of schooling in the United States in 1900 would
mean an increase in the percentage of people who go to high school, while in 2000 it would mean an

     Schultz, T.W., 1975. The value of the ability to deal with disequilibria. Journal of Economic Literature 13, 827-846
increase in the percentage of people who go to college. . So, the question as to the empirical
significance of the spillovers of the education of an individual to the productivity of other individuals is
far from settled. 17 This raises the obvious question as to whether a nation should expand its financial
commitment to higher education on the basis of an expectation of getting a productivity growth boost
for which there is little evidence.

   See, A. Krueger and M. Lindahl, “Education for Growth: Why and for Whom?, Journal of Economic
Literature, December 2001

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