How College Pricing Undermines Financial Aid

Despite vast increases in financial aid over the years, the cost of attending college has continued to soar. It appears that colleges often deliberately raise their prices when aid is available, in essence “capturing” the aid. The end result is that higher financial aid does not produce an improvement in college affordability but rather an increased ability on the parts of colleges to fund other programs which are not related to fulfilling their educational missions. This study finds that growth in colleges’ costs and associated spending is the main obstacle for improving college affordability and that while external factors do contribute to the increase in costs for colleges, it is the decisions of colleges themselves that are the main driver of higher costs, particularly the desire to increase prestige.

To demonstrate the negative impact of this dysfunctional financial aid system, consider the hypothetical benefit to students if all aid was used to lower the financial burden for students rather than being captured by colleges. Under such a scenario the net price at public four year institutions would be only 13% of median income, rather than the 20% actually observed (a dramatic improvement in affordability) and higher education as a whole would spend $59 billion less per year.

By Robert E. Martin and Andrew Gillen | March 2011

Download the entire report (pdf, 20 pp.)

Bookmark and Share

The primary purpose of government provided student financial aid is to increase college access by bringing the out-of-pocket price of attendance within reach of more students. The basic idea is quite straightforward. If a good or service costs $100 to buy and the government gives consumers a $50 subsidy, then consumers need only spend $50 of their own money instead of $100. Since the price has effectively been cut in half from the perspective of consumers, consumers who could not afford to buy the product before the subsidy can now afford to do so. This is all quite logical, but it rests upon the assumption that the seller does not change the price because of the subsidy. If the seller increases the price to $150, then the item’s affordability has not been increased by the subsidy. Instead, the subsidy merely increases the price and the seller’s income.

For items provided in competitive markets, the assumption that a seller cannot respond to the subsidy by raising the price is likely valid. An example of this would be food stamps–while a retailer certainly wants to raise prices, competition ensures that they cannot do so without losing customers. But in higher education, colleges and universities set their own prices. Indeed, colleges and universities have considerable pricing power which is evident by their ability to raise prices when state governments reduce public support. (See, for instance, the 2010 edition of the College Board’s “Trends in Higher Education” series or the 2008 report from the National Center for Public Policy and Higher Education, “Measuring Up 2008: The National Report Card on Higher Education.”)

In this article, we argue that the price of higher education does not remain fixed when most types of aid are provided. Rather, the price of higher education increases as universities and colleges “capture” increases in ability to pay, with the end result that college affordability does not improve. (Note that an increase in ability to pay can occur either from an increase in government subsidies or an increase in household income.)

For the individual student, access to a college degree depends on natural ability, preparation, motivation, personal financial resources, and the price of attendance. In what follows, we consider only the marginal impact of financial resources and the price of attendance on college access while holding all the other determinates constant. In other words, we assume the student has sufficient natural ability, preparation, and motivation to be accepted to the institution of choice and the only residual issue is the relationship between his financial resources and the cost of attendance. Under these assumptions, declining affordability means less college access. Higher attendance prices force some students to choose a “lower quality” college, resulting in a decline of college affordability and a reduction of access.

Download the entire report (pdf, 20 pp.)

Robert E. Martin is emeritus Boles Professor of Economics at Centre College and author of The College Cost Disease: Higher Cost and Lower Quality, Edward Elgar, Ltd, forthcoming.

Andrew Gillen is the Research Director at the Center for College Affordability and Productivity. He received his PhD in Economics from Florida State University.