Wednesday, September 12, 2012

A different perspective on financial aid

When I wrote my last post that referenced John Cochrane's description of the incentives of financial aid, I had a nagging feeling that I left something out.  I had thought about financial aid and higher education recently, but it was out of context, so I didn't make the connection.  I made the connection again this afternoon and it is instructive about the debate on financial aid and government's role.  

Last week, I read this interesting perspective on the topic by Steve Landsburg:

Every year, I tell my Principles students with confidence that “You and the student on your right are probably not paying the same tuition rate”. Universities have detailed information on students’ academic records (which tells them where else those students are likely to be admitted) and detailed information on student’s (and their family’s) financial statuses. They exploit this information to tailor individual aid packages.
That’s important here, because, unlike an ordinary monopolist, a good price discriminator doesn’t leave seats in the classroom unfilled just to keep prices high. Instead, the price discriminator fills empty seats at bargain prices while still keeping prices high for those who are willing to pay full fare.
In other words, many of the bad incentives discussed by Cochrane have a purpose: to extract as much consumer surplus from college students as is possible.  In retrospect, what's interesting about the Landsburg post is the hidden assumption that price discrimination is efficient.  Certainly, we learn in first course on microeconomics that perfect (1st degree) price discrimination yields the efficient outcome, but if price discrimination is not perfect, the price discriminating monopolist faces a tradeoff.  On one hand, it wants to enhance efficiency (Landsburg's point) because it can imperfectly gain from more total surplus, but on the other hand, it will still have a tendency to raise price and restrict quantity because it is a monopolist.  

Furthermore, there's another issue called allocative inefficiency that results from firms charging multiple prices for the same product (In short, if multiple prices are charged to different groups, the highest value consumers might not get the product, but that's the topic of another post.).  In the current system, there are other inefficiencies that resemble transaction costs,.  And, this brings us full circle back to Cochrane's post and the fact that there is a section-sized article in the Wall Street Journal teaching people how to "game the system."  Real resources are being used in administering this system of financial aid, both by universities and applicants.  

This doesn't completely undermine Landsburg's argument that more government intervention is bad in the higher education market, but it does suggest that there is more to the issue of financial aid in higher education than the theory of price discriminating monopoly.

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