All the Wrong Incentives

That old saying, “Everyone talks about the weather but no one does anything about it,” could be changed to ”Everyone talks about the ever-increasing cost of going to college, but no one does anything about it.” Americans have been complaining about the fact that college expenses go up faster than the rate of inflation for decades. All that complaining has had precisely zero effect.

Zero effect on controlling costs, that is. Politicians have tried to placate voters by increasing government student aid so the rising cost is more affordable, but that seems just to cause further increases.

If a doctor is going to cure a disease, he first has to have a sound diagnosis. In that spirit, Robert E. Martin has written an illuminating paper for the Pope Center, “The Revenue-to-Cost Spiral in Higher Education.” An emeritus professor of economics and long-time observer and analyst of higher education, Martin finds the cause of the college cost disease to be built into the incentives facing decision-makers.

To put it bluntly, since college leaders have nothing to gain by controlling costs and improving efficiency, they don’t.

In Martin’s own words, there is “a perverse irony” in higher education: “Higher revenues induce higher costs, and those higher costs are used to justify future calls for more revenue.”

One of the most discussed problems in the corporate world is the “principal/agent problem.” That is the tendency of business managers to act in ways that are personally beneficial, but harm the interests of the stockholders. That leads to some waste and inefficiency in business. But the problem is much more severe, Martin shows, in higher education. While the “stakeholders” in a business usually can get accurate information about the spending of executives, it’s far more difficult for the “stakeholders” in higher education (taxpayers, trustees, alumni) to obtain similar information about administrators.

The system for controlling and disciplining the managers in higher education is very weak, so they can get away with a lot of self-interested behavior. A major example is that they spend money on things that do nothing to improve educational efficiency but aim at enhancing institutional reputation.

In the business world, there is a universal test for good management: profit. To achieve profit, managers search for ways of making the product or service better and for ways to produce it more efficiently by eliminating unnecessary costs. Most colleges and universities, however, are non-profit institutions. Educational quality is almost impossible to gauge, and cutting costs, far from benefiting administrators, can actually make them worse off.

That is because institutional reputation is overwhelmingly depends on spending. It shouldn’t, but it does. The more a college or university spends on its faculty, library, buildings, and amenities, the more prestigious it becomes in the beauty pageant known as the U.S. News & World Report annual rankings. Saving money and improving efficiency count for nothing in the U.S. News scheme—which I discussed here.

Rationally analyzing his situation, therefore, a higher education leader will devote far more time to fund raising than to cost control. In fact, the characteristic that nearly all college presidents have in common today is that they’re accomplished fund raisers. They’re good at persuading alumni to write big checks and at persuading legislators to appropriate more money for them. And they never forget about the most obvious source of additional revenue, tuition.

Even if taxpayers, alumni, and other interested parties might prefer to have college leaders concentrating on ways to get more educational bang for the existing bucks, the leaders concentrate instead on raising and spending more money.

The problem is that almost every college and university is engaged in the same quest—more prestige. Because it’s impossible for everyone to gain in prestige, the ongoing battle means that there is no resting point. However much a school is currently spending, that is just the baseline in its constant race to “keep up with the Joneses.”

Martin therefore concludes, “There is thus a never-ending spiral effect between revenues and cost.” Given the current structure of our non-profit higher education system, we have a black hole that cannot be filled.

Martin proceeds to draw out a couple of detrimental implications from his analysis. One is that college reputation, the object of all that spending, is both hard to gain and hard to lose. That means that schools that have a strong reputation can coast. Money keeps pouring in even when an elite university allows its standards to slide and its curriculum to be dominated by narrow, trendy, and politicized courses.

Another implication is that colleges are extremely hard to reform. Businesses quickly shift resources from areas of low demand to areas of high demand, but colleges rarely do. Internal politics make it hard and painful to take resources from shrinking programs and give them to expanding ones. Administrators prefer to avoid controversy because it might damage reputation and so they finance shifts in student preferences by raising additional revenue.

I think that Martin has accurately plumbed the causes of the “revenue-to-cost spiral,” but a piece of the puzzle is still missing. Why have Americans been willing to part with more and more of their wealth in the pursuit of college education? Normally when the cost of something goes up, demand goes down, but for many years, the demand for college went up right along with the price tag. (That has leveled off in recent years.)

The answer is that college leaders are not just good fund raisers, but also good at convincing students and their families that a degree is, if not priceless, at least worth emptying out the family savings and going heavily into debt.

If that “You must go to college” trance wears off, as I believe it is starting to, consumer resistance will begin to slow the upward revenue/cost spiral. Whether or not it does, however, Martin has some suggestions on how to accelerate that eventuality.

He advocates objective measures of productivity and cost control, greater financial transparency, and governance reform to weaken if not defeat the revenue-to-cost spiral. In his view, change won’t come from inside the education establishment. It will have to come from outside forces.

We can’t do much about weather we don’t like, but after reading Robert Martin’s paper, people will at least have some ideas about what to do about the steady rise in the cost of college.