The Role of Government in Higher Education

Abstract

In this chapter, we explore the economic justifications for the role of government in supporting postsecondary education. Although many refer to education (particularly public education) as a public good, the teaching function of colleges and universities does not meet the economists’ definition of a public good. Perhaps the only product from postsecondary education that may be thought of as a public good is basic research. Instead, the economic rationale for governmental financial support of postsecondary education rests on the argument that students produce positive externalities when they go to college. We will outline the main economic concepts behind public goods and externalities, and show how they relate to governmental support for higher education. We also provide an extension of the model of public choice, and consider two higher education policy issues with regard to the appropriate level of state support for higher education and the debate between need-based and merit-based financial aid.

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Introduction

Every economy has to answer questions about what will be produced, how much will be produced, and how will it be distributed. Economic theories and concepts dating back to Adam Smith and others have asserted that in most situations, decisions about these issues are best left to competitive markets. In a sense, markets are the ultimate form of democracy in that buyers and sellers “vote” with their dollars and resources on how to answer these fundamental questions. If a society is producing too many DVD players, for example, then the actions of consumers and producers will cause the supply and demand curves in the DVD market to shift, which in turn will reallocate resources away from DVD player production and towards something else that is collectively deemed more valuable. These changes are made without any form of central coordination among actors in the economy, but rather through the supply decisions of firms and the purchasing choices of consumers in markets.

An important aspect of markets that is not often given sufficient attention is that the decisions of buyers and sellers are presumed to be made purely on the basis of their self-interest. Consumers choose what to buy and how much to buy according to the utility or value they think they would get from their purchases. Accordingly, buyers are not concerned with how their purchasing decisions might affect others in society. Likewise, sellers make decisions about what and how much to sell based on how they alone will benefit. Also note that both the buyer and the seller each get something of value from the voluntary exchange of goods and services that occurs in competitive markets. Through the pursuit of self-interest on the part of buyers and sellers, however, markets enable resources to be distributed in the optimum way for individuals and society, and therefore self-interested decision making benefits society as a whole.

As discussed in Chap. 3, students make decisions about whether or not to go to college based on their perceptions of the costs and benefits they face in doing so. Students are presumed to consider only those benefits that they will personally receive, which are the private (internal) market and non-market benefits that they get from going to college. Understandably, they may not take into account how their decision to go to college will affect others in society such as their neighbors and residents of their state and nation. The private benefits from going to college—such as increased lifetime human capital, earnings, and consumptive benefits—are fully captured by the students themselves, and therefore, these private benefits are naturally internalized by students and used in their decisions about postsecondary education.¹

The interactions of buyers and sellers in a competitive marketplace can help the economy move toward an efficient allocation of scarce resources and determine what should be produced and in what amounts. However, there are a number of well-known instances or conditions when the private market alone may not lead to the optimum allocation of resources from society’s point of view. In these situations, it is said that a market failure has occurred. For example, if consumers cannot be prevented from using a good or service if they do not pay for it, then they will have an incentive to use the good/service without paying. The problem with this, of course, is that if too many consumers reach the same conclusion, then how will the good or service be provided? This is the “free rider problem” that must be addressed with goods and services that economists refer to as public goods. An example of a public good is national defense because specific individuals cannot be excluded from benefiting from the service, and the use by one individual does not diminish anyone else’s use of the service.

Another form of possible market failure arises when the consumption of a good or service creates benefits or costs for others not involved in the trade. This leads to what economists call an externality.² An externality can be bad, as in the case of cigarette smoking where second-hand smoke may harm others around them; this harm would constitute a negative externality. Or the consumption of a good or service may impart benefits to others, in which case it is referred to as a positive externality. It is often asserted that education produces positive externalities in that when people acquire more education, others around them benefit as well in financial and non-financial ways. In fact, the social rates of return discussed in Chap. 4 reflect both the private and public (non-private) benefits from postsecondary education.

The problem with goods and services that create externalities is that according to the traditional model of market behavior, consumers do not take into account how their actions affect others when deciding what to consume and how much to consume. If this is true, then those things which lead to negative externalities will end up being overproduced from society’s perspective, and likewise goods/services that create positive externalities will be underproduced. In the case of higher education, this means that if college produces positive externalities, then under the classical model assumptions a purely competitive market—if left to its own accord—would provide college education to too few students.

In both instances of market failure—for public goods and those goods/services which lead to positive externalities—an argument can be made that governments should intervene in these markets to help achieve more socially-desirable outcomes. For public goods, this intervention typically takes the form of the government requiring individuals to contribute to their production through taxation. Consumers are not given the choice whether or not to pay for the service.³ In contrast, governments intervene in a different way in markets where the good or service leads to positive externalities. Rather than require people to fund production of the good, the government uses financial subsidies to individuals or suppliers to entice students in the market to make different choices. In this way, decisions in the competitive market are still made by individuals and suppliers based on their perceived self-interest, and yet the resulting production outcomes are more consistent with broader societal goals and objectives.

In this chapter, we explore the economic justifications for the role of government in supporting postsecondary education. Although many refer to education (particularly public education) as a public good, the teaching function of colleges and universities does not meet the economists’ definition of a public good. Perhaps the only product from postsecondary education that may be thought of as a public good is basic research. Instead, the economic rationale for governmental financial support of postsecondary education rests on the argument that students produce positive externalities when they go to college. We will outline the main economic concepts behind public goods and externalities, and show how they relate to governmental support for higher education. We also provide an extension of the model of public choice, and consider two higher education policy issues with regard to the appropriate level of state support for higher education and the debate between need-based and merit-based financial aid.

Background

Concepts and theories from public sector economics and welfare economics provide the primary rationale for government intervention in competitive markets. Welfare economics and public sector economics contain ideas and theories that constitute a useful analytical framework with tools for examining the role of public policy in higher education markets. This analytical framework provides a model for how to examine and evaluate:

• the private benefits to students as consumers due to economic activity in markets for higher education;

• the private benefits to institutions as producers due to economic activity in markets for higher education;

• the external benefits to society—i.e., received by those third-party beneficiaries of the market, even though they’re not direct participants in the market—due to economic activity in markets for higher education;

• the rationale for government intervention in higher education markets in the presence of external benefits;

• the relationships between private benefits to students and institutions and external benefits to society;

• the optimum level of investment in higher education;

• the effects of government intervention and policy on market dynamics, student and institutional behavior, and the level of students’ investment in higher education;

• the costs of the government policy;

• the effects of government intervention and policy on ‘welfare gains’—i.e., gains in society’s well-being or welfare;

The phrase public good has a very specific meaning in economics. It is defined as a good or service that is both non-excludable and non-rival in nature. Something is said to be non-excludable if the supplier cannot easily prevent some individuals from using the good or service. Likewise, a good or service is non-rival if its use by one person does not diminish another person’s ability to derive value from the same good or service. Examples of public goods are national defense, lighthouses, and fireworks displays, since they would seem to meet both of these criteria.

The notion of public goods dates back many centuries, emerging from the need of societies to provide security to its members. The protection of citizens, in the form of armies and police or guards, for example, is difficult to apply to only a portion of a state’s or nation’s population. As large-scale health epidemics such as the Black Plague began to threaten societies, the need increased for other public goods and services such as medical facilities to protect the general public. In fact, as a society becomes more complex, the demand for public goods will likely grow as well. The problem is that if citizens cannot be excluded from benefiting from the service, then they have little incentive to pay for it. Accordingly, governments must intervene in the market to compel or require citizens to contribute to the provision of the service.

Despite the fact that societies have had to address problems with public goods for a long time, the economic analysis of public goods is a relatively recent phenomenon. Paul Samuelson is largely credited with being the first to articulate the economic issues with public goods in his 1954 article “The pure theory of public expenditure.” Other economists such as Musgrave (1939), however, had also previously discussed issues relating to collective goods that may be thought of as public goods.

In addition, another set of economists have expanded the concepts of goods beyond the simple public / private dichotomy. This work recognizes that public and private goods are but two extremes along a continuum of options depending on the degree of excludability and rivalry that characterized the good or service. It has been argued that there are actually four categories of goods and services:

• Private Goods = Excludable and Rival

• Club Goods = Excludable and Non-rival

• Common Goods = Non-Excludable and Rival

• Public Goods = Non-excludable and Non-rival

Club goods, for example, are those goods and services that are shared by a certain number of individuals. The supplier can limit the number of people using the good or service (and hence they are excludable), but among those who do consume the good, there is no rivalry in consumption. An example of a club good might be a neighborhood swimming pool. More importantly for our purposes, it has been argued that a college or university could also be thought of as a club good.⁴ On the other hand, natural resources such as forests and lakes are described as common goods because it is difficult to prevent some individuals from using them (non-excludable), but if left unchecked the use of the resource by some may diminish others’ ability to use the same resource.

The notion of externalities dates back to the work on neo-classical economic theory by Henry Sidgwick (1887), Alfred Marshall (1890), and later Arthur Pigou (1920). An externality is a spillover benefit or cost that occurs when a good or service is exchanged in competitive markets. Much of the literature on this topic has focused on problems where the consumption of a good or service imposed harm on a third party (“negative externality”). Frequently-used examples of negative externalities include air and water pollution and second-hand smoke from cigarettes. The problem with negative externalities from an economic perspective is that the cost imposed on the third party is not taken into account by the buyers and sellers when they engage in trade. As a result, more of the good or service is produced than would be socially optimal. Although positive externalities have received less attention from researchers, they also create problems in competitive markets. In this instance, the spillover benefit that a third party would receive from the transaction is not taken into account by the buyers and sellers, and less of the good/service is produced than would be socially desired.

Public Goods and Externalities in Education

In policy and academic circles, education (particularly public education) at various levels is often referred to as a public good. However, in the absence of government intervention, the education of students does not meet the strict non-excludability and non-rivalry requirements of the definition of public good favored by economists.⁵ Primary and secondary education in the United States is sometimes considered to be non-excludable because there are laws requiring communities to offer education services to all students in their area, and laws that students must go to school until they reach a certain age. If left to their own devices, though, education suppliers could prevent individuals from taking advantage of their services. There is nothing inherent about education that would make it impossible to prevent some from consuming it. In fact, even today a person could not simply walk in off the street and into a classroom and receive the service without permission. In addition, schools and colleges can exclude individuals from consuming education services through expulsion.

Likewise, it has been said that education is non-rival because all students in the class can receive education services regardless of whether other students are also in the classroom. However, there is some degree of rivalry in education if we focus on the quality of education received rather than simply access to services. Because learning depends in part on the interaction between students and instructors, changes in the size of classrooms may affect the amount of learning that students receive. For example, if one student continually asks questions in class, then the consumption of education by this student has a rivalry effect on other students in the same class who have less time to ask their own questions.

On the other hand, an argument could be made that the knowledge produced from basic research at colleges and universities is a public good. The research knowledge in this sense is not patented or produced exclusively for an organization or entity. For example, research that is conducted by faculty members and disseminated through books and journals would be considered basic research. The knowledge from basic research is non-excludable because once the findings have been published, it is very difficult to prevent others from reading it and benefiting from it. In addition, basic research is non-rival in that the use of it by one person does not prevent another person from also using it.⁶

Without some form of market intervention, the free rider problem would present a significant threat to basic research. Given that it can take substantial time and resources to conduct research and there is a risk that the research will not be successful, then there is an incentive for individuals and institutions to simply let others produce research and then use the results from their work. However, if everyone reached the same decision, then too little basic research would be produced for society. The government therefore chooses to intervene in competitive education markets and provide support for basic research through federally-funded research grants. The funds for these research grants, of course, come from individuals through taxes, and in this way the government compels individuals to contribute to the provision of this public good.

Turning to externalities, a stronger case can be made that there are positive externalities associated with the teaching activities of colleges and universities. As noted earlier, there have been many empirical studies that have sought to determine whether education produces positive benefits for others. As an example, Lochner and Moretti (2004) examined whether increases in educational attainment resulted in reductions in incarceration rates, which then would have positive benefits for communities. States and governments often look to education as a means for increasing economic growth and raising the standard of living in their region. Due to the connection between education and earnings (see Chap. 4), increases in education result in greater tax contributions to governments, that in turn can be used to benefit others. In fact, when people say that education is a “public good,” what they most likely mean is that education produces external benefits for the public at large.

Externalities may also come into play in the classroom. Colleges that have highly-selective admissions believe that by increasing the quality of students at their institutions, they can provide students with a richer learning environment. In a sense, they feel that such “peer effects” create positive externalities in instruction. If a student asks thoughtful questions in class, then it may not only benefit the student who asked the question but others in the class as well. Of course, it is equally possible that students who are disruptive in class or take up too much instructional time with questions and comments that are not productive will impose negative externalities on other students in the classroom.

A number of scholars have reviewed the literature on the nature and extent of public benefits from higher education. Researchers have concluded that when students go to college, it results in economic, health, and social benefits for others.⁷ The economic spillover benefits for society may include higher tax contributions which are then used to provide services for the public, enhanced economic growth, reduced unemployment, and a higher quality workforce. Some of the health benefits that emerge from higher education are reductions in second-hand smoke (due to lower cigarette consumption among college-educated people) and increased blood donations. Finally, there is also a range of possible social benefits for the public from college, such as improved civic participation, increased donations to charities, greater rates of volunteerism, reduced crime rates, and increased racial tolerance.

A major challenge associated with determining the share of the total benefits of higher education that are public versus private is the inherent difficulty in measuring these benefits—especially the external (or public) benefits. One of the most comprehensive efforts to measure the various benefits of higher education, with a particular emphasis on the value of public benefits, is Walter McMahon’s book, The Private and Social Benefits of Higher Education: Higher Learning, Greater Good (2009). Building on the work of many other scholars in this area, McMahon tackles the conceptual and measurement challenges posed by this task. He statistically analyzes both time series and cross section data for not only the United States but also for many other developed and developing nations. Through this approach, McMahon (2009) estimates the benefits of higher education, including the contributions of higher education to social benefit externalities across a wide range of general areas. Based on his work, he concludes that the public benefits of higher education are roughly similar in size to the private benefits from higher education. Accordingly, he argues that substantial financial support from the government for postsecondary education is warranted.

Positive Externalities and Higher Education

We now explain how the presence of positive externalities affects the pricing and output in postsecondary education markets. In particular, we will show that when there are positive externalities created by higher education, competitive markets will not produce enough education from the perspective of society. Although we focus here on the positive externalities created by education, keep in mind that there may also be negative externalities produced by higher education that would result in the opposite effect.⁸

Consumer and Producer Surplus

To begin the discussion of how positive externalities affect education markets, it is helpful to first consider the concepts of consumer and producer surplus.⁹ These represent the surplus or extra benefits for buyers and sellers that are generated when they engage in voluntary trade with each other in markets. Consumer surplus is the total benefit that consumers receive by participating in the competitive marketplace and was introduced in Chap. 3. Graphically, it represents the difference between the maximum price consumers are willing to pay for a product—which is indicated by the height of the demand curve at each quantity demanded—and the equilibrium price they actually pay. Similarly, producer surplus measures the total excess benefit that suppliers obtain when they sell their goods and services in the competitive marketplace. Producer surplus represents the difference between the equilibrium price that producers actually receive and the minimum price they need to cover costs—which is indicated by the height of the supply curve at each quantity supplied.

These two concepts are depicted in Fig. 6.1, where point A corresponds to the market equilibrium at tuition price P _pri and quantity Q _pri . The subscript ‘pri’ is used to denote that the equilibrium price and quantity are based on the decisions of students and their families in higher education markets. These values are found where the private demand curve (D _pri ) intersects the market supply curve (S). Consumer surplus is depicted by the area of the triangle BAP _pri . This triangle corresponds exactly to the area above the market tuition price P _pri and below the private demand curve. When interpreting consumer surplus, it is important to remember that the aggregate value consumers obtain from their participation in the market is based entirely on the private or internal benefits they receive. In higher education markets, the students and their families are consumers and they gain private benefits from completing an academic year of college. The external or public benefits of postsecondary education accrue to other members of society and are not part of consumer surplus.

Fig. 6.1

Consumer and Producer Surplus in Higher Education Markets

Likewise, producer surplus is represented by the area of the triangle P _pri AC. This triangle corresponds to the area below price P _pri and above the supply curve S. Keep in mind that the aggregate value that producers acquire from their participation in higher education markets represents private benefits that institutions receive due to their sale of their services. Therefore, any public benefits that accrue to society in general due to the educational services provided by colleges and universities are likewise not part of producer surplus.

Positive Externalities

Research suggests that higher education may generate a number of positive externalities or public benefits. These are benefits that are received by third-party members of society who do not actively participate in higher education markets. However, the direct participants in the market—students and institutions—do not think about these benefits when they are engaged in transactions. That is, students only look at their private benefits when deciding whether or not, and how much, to invest in higher education; while institutions consider only their private benefits when making decisions about how many and which students to admit. The public benefits of higher education are ignored by students and institutions, yet these same benefits are of great value and in high demand by society.

Once we introduce the possibility of public benefits into the competitive market model, it leads to a situation where the market without government intervention would provide too little of the good or service from the perspective of society. In our example, the amount of higher education produced by a competitive market would fall short of the socially-optimal level. Public sector economic theory refers to this as a market failure due to the presence of positive externalities. In Fig. 6.2, point A still represents the competitive market equilibrium for consumers without considering external benefits. The value that society places on the public benefits arising from each student enrolled in college is denoted by the line D _pub , which for simplicity is assumed to be the same for all students (i.e., a horizontal line). Total social demand for higher education is represented by D _soc , which is the sum of public and private demand (D _soc  = D _pri  + D _pub ).

Fig. 6.2

Private and social demand in higher education markets

Equilibrium from the point of view of society occurs where the social demand curve intersects the market supply curve (Point B). Because D _soc reflects the combined values of both the private benefits valued by students and the public benefits valued by third-party members of society, the socially-optimal amount of higher education occurs when Q _soc students enroll in college. Technically, the difference between quantity enrolled Q _pri and Q _soc indicates the quantity of educational services that would be underproduced from society’s perspective in a competitive market for higher education, when only the private benefits of college were considered.

Government Intervention and Externalities

If the voluntary choices of students and institutions in competitive markets result in less higher education being consumed by students than is desired by society, then the government may try to do something to address this problem. There are several options available for government intervention, each of which will have varying costs and benefits and different impacts on consumers, producers, and the public. This is important because economists assert that every decision maker—even a government—should take into account the costs and benefits of their actions when choosing a strategy.

In general, the government options can be grouped into demand-side and supply-side interventions. Demand-side interventions are government subsidies to consumers that cause the demand curve to shift outward to the right. Similarly, supply-side interventions are subsidies given to suppliers which lead to a rightward shift in the market supply curve. In each instance, the new equilibrium quantity of postsecondary education in the market will be higher and hopefully equal to the socially-optimal quantity. We now use welfare economics and public sector economics to examine these government intervention options.

To begin, it is helpful to define two additional concepts that are used in this analysis. The first concept is social surplus, which represents the sum of the surplus values for consumers, producers, and the public that occurs due to transactions in markets. The social surplus is found by adding together the consumer surplus, producer surplus, and the positive externalities realized by the public. The second concept defined here is welfare gain. The welfare gain denotes the change in social surplus that occurs when there is a change in the market. It is hoped that when the government intervenes in a competitive market, the various entities affected are better off due to the intervention. Of course, the welfare gain would also have to take into account the cost to society of the government intervention. These concepts can be illustrated with diagrammatic analysis using the framework developed and applied here.¹⁰

In Fig. 6.3, point A represents the initial competitive market equilibrium for consumers without considering external benefits. Now, let’s assume that the government intervenes in higher education markets by providing all students with a grant or subsidy equal to P _soc – P ₀ dollars. This is a demand-side intervention because the subsidy is given to student consumers. In this illustration, the subsidy to students is equal to the public benefit shown earlier. As a result, the private demand curve shifts upward and to the right from D _pri,1 to D _pri,2 . If the subsidy equals the public benefits, then the new private demand curve will be the same as the social demand curve. This raises the equilibrium price to P _soc , but reduces the net price paid by students from P _pri to P ₀ . As a result, the surplus value for students (consumer surplus) increases by the dark shaded area P _pri AHP ₀ because those students who previously enrolled in college now receive more benefits from paying a lower price, and the Q _soc – Q _pri additional students who enroll due to the subsidy likewise receive some benefits. Colleges and universities also gain from the subsidy because the new equilibrium price that they receive (P _soc ) is higher than the old equilibrium price, and more students enroll in college than before the subsidy. The increase in producer surplus is represented in Fig. 6.3 by the light-shaded area P _soc BAP _pri . Finally, there is a gain to third parties from government intervention because more students enroll in college, and each new student generates public benefits. The increase in public benefits in Fig. 6.3 is shown as either the change in enrollments times the public benefit per student ((Q _soc – Q _pri ) * (P _soc – P ₀ )), or the area ACBH.

Fig. 6.3

Demand-side government intervention in higher education markets

The change in social surplus due to the subsidy equals the sum of the change in consumer surplus, producer surplus, and public surplus. The welfare gain from the government grant is defined as the change in social surplus before and after the grant, minus the cost to the government from the policy. Because the government provides a subsidy to every student in the market, the cost of the subsidy is represented by the rectangular area P _soc BHP ₀ . Given that the change in the social surplus exceeds the cost of the program, the welfare gain from the grant is positive, corresponding to area ABH. This indicates that the total benefits of the grant outweigh the cost of the grant program.

Another way in which the government can intervene in postsecondary markets is by giving a financial subsidy to colleges and universities, as shown in Fig, 6.4. This policy is directed at the supply side of the market. The financial subsidy enables institutions to offer spaces to students at lower prices, which translates into a rightward shift of the market supply curve from S ₁ to S ₂ . The vertical distance between the old and new supply curve is the amount of per-student subsidy to institutions. Equilibrium in the market is still determined by where the private demand curve intersects the market supply curve, which now occurs at point C. As a result, more students would want to go to college due to the subsidy given to colleges. In theory, there is a subsidy level that would lead to the exact increase in enrollments needed from the perspective of society (i.e., Q _pri  = Q _pub ).

Fig. 6.4

Supply-side government intervention in higher education markets

Marginal Cost and Benefit Analysis of Government Intervention

In the preceding discussion, government intervention in higher education markets is viewed as a good thing because the net addition of surplus value to society exceeds the cost. It is important to note, however, that in this scenario the government considers the surplus values received by consumers, producers, and the public as benefits to them. An argument can be made, however, that government should be concerned with only the public benefits and public costs when evaluating policy options. In this instance, the government would want to compare the cost it incurs from the subsidy to the public benefits due to the subsidy. From Fig. 6.3, it seems clear that providing a uniform subsidy to all students is not a cost-efficient strategy for the government. The cost of the subsidy to the government exceeds the gain in public surplus because the first Q _pri students who receive the grant would have gone to college without the subsidy. Therefore, the government expenditure did not lead the first Q _pri students to change their behavior, and society would have received their public benefits without the policy.

Another way to examine the different options available to governments for intervening in higher education markets is through marginal cost and benefit analysis. There are many situations where economists posit that a decision maker should take into account the cost and benefit of an action when deciding on a course of action. In their most general forms, the marginal benefit represents the change in total benefits from an action, while the marginal cost denotes the change in total costs from an action. Given suitable assumptions about marginal costs and benefits (usually that marginal benefits fall and marginal costs rise), the decision maker would find it to be in his or her best interest to pursue the action up to the point where the marginal benefit equals the marginal cost.

It is important to distinguish between who is receiving the benefits and incurring the costs. Marginal private benefits (MPB) denotes the change in benefits received by the consumer, which in our case is the student. In contrast, the marginal social benefit (MSB) is the increased benefits received by both the consumer and others in society. On the cost side, the marginal social cost (MSC) represents the change in costs incurred by the student and others in society. Finally, the marginal private cost (MPC) is the additional cost incurred by only the student and not the rest of society from higher education.

We now use these concepts to examine in more detail the impact of governmental policies on the decisions of students. Let’s begin in Fig. 6.5 with the case where all costs of going to college are borne by the student. Figure 6.5 looks very similar to Fig. 6.2, except that the demand and supply curves are replaced by marginal benefit and marginal cost curves for students, and the vertical axis measures marginal costs and benefits rather than price. To make the presentation parallel with the supply / demand discussion earlier, we assume here that the marginal private and social costs rise as more students go to college. If the government does not provide any subsidy to students or institutions for higher education, as in Fig. 6.5, then the marginal private cost curve will be the same as the marginal social cost curve.

Fig. 6.5

Private and social marginal costs and benefits from higher education

There are also two marginal benefit lines to consider. The line MPB denotes the marginal private benefit for each student from going to college. As before, we assume that different students receive different marginal benefits from going to college, where the benefits include everything discussed in Chaps. 3 and 4 and converted to dollars. Finally, the line MSB shows the marginal social benefit from each student going to college. A simplifying assumption is made that each student in this example generates the same public benefit or externality when they go to college, and thus the two lines are parallel.

Students in postsecondary markets are assumed to make their decisions about college based on a comparison of the marginal private benefits and costs that they face (a behavioral assumption). As a result, without government intervention of some kind, students would want to go to college as long as MPB > MPC. The resulting equilibrium would occur at point A and the first Q _pri students would opt to go to college because their private benefits exceed their costs. For all remaining students, it would not be in their personal interest to go to college because their marginal private costs exceed their marginal private benefits. From society’s point of view, however, students should enroll in college as long as the marginal social benefit exceeds the marginal social cost. The socially-optimal point is at B where MSB = MSC. The problem facing the government is how to entice the additional (Q _soc – Q _pri ) students who should go to college to do so, even though it is not in their personal best interest.

This concept can also be illustrated with a hypothetical example. Consider the following five students in Table 6.1. Each student has estimated the benefit and cost they would personally face if they went to college, and the corresponding difference (net private benefit). For example, student A feels that she would receive a $30,000 benefit per year from going to college, and that it would cost her $15,000 to do so. As a result, she would receive a $15,000 net private benefit. In contrast, student E would expect only a $14,000 private benefit from college and incur a $31,000 cost, leading to a $17,000 net loss if he attended college. If these students based their willingness to attend college solely on whether the net private benefit is positive, then only the first two students (A and B) would decide to go to college without government intervention in this example.

Table 6.1 Hypothetical example of marginal private costs and benefits for five students

In Table 6.2, we return to the same five students and assume that each would create $10,000 in public benefits for others (i.e., positive externalities) if they were to go to college. Accordingly, the marginal social benefits for each student are shown in the third column. On the cost side, the marginal private cost is the same as the marginal social cost when there are no subsidies for higher education (in other words, the marginal public cost is zero). From society’s perspective, a student should go to college as long as the marginal social benefit exceeds the marginal social cost. This would mean that the first four students in the list (A through D) should go to college. However, because students base their decisions solely on their private costs and benefits, only the first two students would do so.

Table 6.2 Hypothetical example of marginal social costs and benefits for five students

There are several approaches that the government could use to entice students C and D to go to college. Using marginal cost/benefit analysis, each of these approaches focuses on reducing the marginal private cost paid by students, regardless of whether the subsidy is given to the student or the institution. The government’s objective is to lower the price paid by students in such a way that some of them will switch from having negative to positive net private benefits, and therefore decide to go to college.

Uniform Subsidies

The first intervention option is a uniform subsidy, where all students are offered the same reduction in marginal private cost. A uniform subsidy could be supply-side in the form of funding given to institutions that reduce prices for groups of students by the same amount. The subsidy could also be a demand-side intervention if the government were to give all students in a given category the same amount of financial aid. The effect of a uniform subsidy is depicted in Fig. 6.6, where the marginal private cost curve shifts downward and to the right by a constant amount. The new equilibrium point where the marginal private benefit equals the marginal private cost occurs at point C, which corresponds to the socially-optimal enrollment level Q _soc identified earlier.

Fig. 6.6

Effects of uniform government subsidy on marginal costs and benefits

To see how this would look in our illustration, in Table 6.3 let’s assume that each of the five students is offered a $10,000 scholarship from the government that can only be used for going to college. Because the dollar subsidy is the same for everyone, it is a uniform subsidy. The fourth column of figures shows the new marginal private costs for students if they went to college and the fifth column contains the net private benefits. From this column, it can be seen that students A through D would now all have net private benefits that are positive, and thus the students who choose to attend college are the same as the students that society would say should go to college. Note that the marginal social costs are not affected by the subsidy, because the added cost to the public is offset by the lower cost paid by students.

Table 6.3 Hypothetical example of uniform subsidy on private marginal costs and benefits for five students

The example most familiar to readers of a uniform subsidy is state appropriations. In principle, state funding to public institutions is in turn used to reduce the price they charge to all state residents by the same amount, regardless of their ability to pay, their academic performance, or any other criteria. Broad-based state financial aid programs are another form of uniform subsidy when all students who meet the merit criteria receive the same scholarship or grant. Indiana’s Twenty-first Century Scholars program, for example, provides qualifying students from Indiana with a grant sufficient to cover the in-state tuition and fees at public institutions within the state’s boundaries. Likewise, Georgia’s HOPE scholarship awards in-state students who qualify for the scholarship with funding to cover 90 % of the tuition at 4-year, in-state public institutions.¹¹

The uniform subsidy has the appeal of being relatively easy to implement because each student receives the same subsidy, and the government does not have to determine the criteria for how much subsidy to award individual students. One downside to the uniform subsidy is that it may result in aid being given to some students who would have gone to college without it. In this sense, it might be argued that for some students the subsidy was unnecessary and therefore a bad use of public funds. Recall that in Table 6.3, $20,000 in subsidies were given to students A and B and yet they would have gone to college even without the subsidy.

Non-uniform Subsidies

Due to concerns with uniform subsidies, a government might instead consider using a non-uniform subsidy, where the level of subsidy varies across students. Typically, non-uniform subsidies are designed so that smaller subsidies are given to those who are the most likely to go to college, and larger subsidies for those who are the least likely to go to college.

There are a number of different options for implementing a non-uniform subsidy. One way in which this might be done is shown in Fig. 6.7. The size of the subsidy per student is represented by the vertical distance between the marginal social cost and the marginal private cost lines. Note that the shift in the MPC curve is not uniform or parallel, in that the gap increases along with MPC. In theory, the subsidies could be distributed in such a way that the new equilibrium enrollment level after the subsidy is the same as the socially-optimal level determined earlier. The appeal of this approach is that the students who would have gone to college anyway receive smaller subsidies than in a uniform subsidy approach, and more subsidies can be given to those students with greater need.

Fig. 6.7

Effects of non-uniform subsidy on private marginal costs from higher education

Returning to our illustration, in Table 6.4 let’s assume that the government replaces the uniform subsidy of $10,000/student with a non-uniform subsidy that ranges from $1,000/student to $13,000/student. Furthermore, the subsidy is structured so that students with higher marginal private costs are offered larger subsidies. In this example, student A only receives a $1,000 subsidy instead of the $10,000 uniform subsidy, but she would still want to go to college because the net private benefit is positive. Although student C receives a smaller subsidy than in the previous example, it is sufficient to change the student’s mind about going to college. An interesting case in this example is student E, who is offered a $13,000 subsidy even though the public benefit to society would be only $10,000 if he decided to enroll in college. In fact, society would have lost value if this particular student had chosen to enroll in college.

Table 6.4 Hypothetical example of non-uniform subsidy on marginal cost and benefits for five students

Non-uniform subsidies occur most often in the form of need-based financial aid, where the level of financial aid is set higher for students who are less able to afford to go to college and thus less likely to enroll. The main challenge with implementing this approach is how to determine the right relationship between marginal private cost and the level of subsidy. There are many different values that we could have used in Table 6.4, for example, and the wrong choice could lead to either too many or too few students going to college. To illustrate, if student E had been offered an $18,000 grant, then he would have wanted to attend college even though the net public benefit from doing so would be negative.

Alternatively, non-uniform subsidies could be given in such a way that the marginal cost of going to college does not exceed a designated level. This is shown graphically in Fig. 6.8, where the government provides a subsidy to each student so that the marginal private cost does not exceed a certain value (labeled ‘Cap’ in Fig. 6.8). The new marginal private cost curve faced by students is the same as the original marginal private cost curve up to point A, after which the line pivots and becomes horizontal, representing constant marginal private cost. The government will then make up the difference between the student’s MPC and society’s MSC.

Fig. 6.8

Effect of subsidy capping private marginal cost of higher education

In our illustration, suppose that the government gave each student a subsidy sufficient to ensure that the student did not have to pay more than $17,000 for college. Table 6.5 shows that the first student (A) would not receive any subsidy because her marginal private cost was already less than $17,000. The subsidies offered to students B through E increased with their marginal private cost to the point where the new marginal private cost for each of them equaled $17,000. In this scenario, students A and B would continue to want to go college, and students C and D would now find that it is also in their financial interest to do so as well. The last student E, despite the larger subsidy, would not attend college because his marginal private cost still exceeds the marginal private benefit.

Table 6.5 Hypothetical example of subsidy capping marginal cost for five students

The federal need-based financial aid system in the United States is an example of this type of governmental approach to subsidies. Students who apply for federal need-based aid must complete the Free Application for Federal Student Aid (FAFSA). The data are then used to calculate the student’s expected family contribution, which can be thought of as the portion of costs that the student and their family should in theory be able to afford. The remaining difference between price of attendance and expected family contribution is the student’s unmet need. In theory, the government would then provide financial aid in an amount to cover the unmet need.¹² As with the previous non-uniform aid example, an advantage of this approach is that less government money is given to students who would have gone to college without the subsidy. The difficulty, however, is determining how to set the appropriate subsidy level for each student.

Finally, the most cost-effective non-uniform subsidy approach for the government would be to provide funding to only those students for whom MSB > MPC > MPB and limit the subsidies to the amounts needed to make their net private benefits positive. Returning to the numerical illustration in Table 6.6, suppose that the government implemented a targeted subsidy where they only provided subsidies to students C and D. Furthermore, the subsidies were set at levels that are just high enough to lead to positive net private benefits for these two students, which would then entice them to want to go to college. Student C would still change his or her mind about going to college even though the subsidy is much lower in this case than it was in the prior two illustrations.

Table 6.6 Hypothetical example of targeted grants on marginal cost and benefits for five students

In Table 6.7, we provide a comparison of costs and benefits to the government for these four different approaches to higher education subsidies. The first column shows the gain in public benefits that occur due to subsidies. In each case, the numbers were chosen so that two students (C and D) who did not attend college prior to the subsidy changed their minds and decided to go to college after the subsidies. Because each student generated $10,000 in public benefits, the total benefit from each policy was $20,000. The second column of figures provides the cost of the subsidies to the government. Note that costs are not incurred for those students who do not go to college. For the uniform subsidy, the total cost to the government is $40,000 because four students who were offered the subsidy enrolled in college. It can be seen that the uniform subsidy approach is the most expensive option of the four shown here in this illustration. The last column contains the net benefit to the government, defined as the benefit minus cost. For these examples, the targeted subsidies are the most cost efficient because fewer subsidies are given to those students who would have gone to college without them. What is not shown here, however, are the implementation costs with each option. These costs are likely to be higher for non-uniform policies, which lowers their net benefit. We return to this issue in the Policy Focus section of the chapter.

Table 6.7 Comparison of costs and benefits from hypothetical examples

Extensions

Up to this point in the chapter, we have focused on the idea that when students go to college, they produce spillover benefits for the public at large and that government intervention could be used to help entice more students to go to college for the good of society. What we have not yet discussed is what happens to these spillover benefits once they are produced, and should it matter to governments. In this extension, we argue that both the production and retention of public benefits shape governmental higher education subsidy policies.

To see why the retention of public benefits is important, note that the spillover benefits from college are not likely to be evenly distributed over the population. Economic positive externalities from higher education, such as an improved standard of living and higher tax collections, will be more highly concentrated in the community, state, and nation where the student resides. A person who moves to Iowa City, Iowa with a Bachelor’s degree in finance, for example, may create financial benefits on others living in the town of Iowa City, Johnson county, and the state of Iowa, but would have very minimal financial impacts on communities in New Hampshire. Similarly, the non-financial positive externalities from higher education such as improved civic participation, lower crime rates, and so on, also would occur most often in the area close to where the individual lives.¹³ It is likely the case that most of the positive externalities created by going to college follow the student to wherever he/she resides.

As a result, governments may be worried that some of the public benefits that they financed go to help people in other jurisdictions. This concern is particularly true at the state level in the United States because students can easily move from one state to another and take their positive externalities with them. Of course, the same problem could occur at the national level; however, it is typically more difficult for individuals in the United States to move across national borders, and thus less risk that a nation’s higher education subsidy will instead be used to benefit another nation. Incidentally, this risk is higher in many other parts of the world. The creation of the European Union and the Bologna Process, for example, has made it easier for students from one country in the region to study and live in other countries in the same region. And given the substantial numbers of students who come to the United States from other nations to study, there is understandable concern from the home countries that they will experience “brain drain” if the students do not return following graduation from college. Accordingly, the positive externalities from a nation’s higher education system may end up being captured by other nations.

One way in which governments try to keep a greater share of the public benefits that they finance is by requiring that the subsidy be used at an institution within the jurisdiction of the government (Toutkoushian & Hillman, 2012). Such restrictions apply to state appropriations because in order to receive the subsidy in the form of lower in-state tuition rates, a student has to attend an institution in the state. This means that the student (normally) lives within the state during college, and thus most of the positive externalities that are created during their postsecondary education stay within the state. Similar restrictions are usually placed by states on the use of non-uniform subsidies such as need-based and merit-based aid programs. As noted earlier in this chapter, Indiana’s Twenty-first Century Scholars program requires scholarship recipients to attend an in-state institution. State policy makers also hope that by tying the subsidy to attending an in-state institution, students who use the subsidies may be more likely to live in the state following graduation, thus providing even more positive externalities to the state. There is always the risk that a student may move to another state or nation and take their spillover benefits with them. Of course, this is offset to some degree by the benefit states receive when college-educated individuals from other states and nations move into their state. From a state’s perspective, attracting college-educated workers from other places is a benefit because it can derive positive externalities from the mover’s higher education without having to pay for it.

Many states share similar concerns and preferences that their own state’s citizens will be the beneficiaries of the positive externalities generated by state subsidies to their public institutions. In 2014, the Iowa Board of Regents approved a new performance-based funding (PBF) formula for allocating state appropriations among its several public universities. The most distinctive feature of the PBF formula is that the plan bases 60 % of each year’s allocation of state funding on each university’s enrollment of in-state students (http://www.regents.iowa.gov/). This policy is consistent with the assumption that positive externalities generated by in-state students are more likely than those generated by out-of-state students to stay in the state.

Policy Focus

We now consider two examples of policy relating to government intervention in higher education markets. The first example focuses on the philosophical approach used by states to financially support higher education for its citizens. The debate centers around whether it is better to keep prices low for everyone (“low-tuition / low-aid”) or allow for higher prices and corresponding higher levels of financial support for designated students (“high-tuition / high-aid”). The second policy example is the debate around the proper share of social costs for higher education that should be borne by the government.

High-Tuition/High-Aid vs. Low-Tuition/Low-Aid

As discussed in this chapter, there are a number of different ways in which states may choose to intervene in higher education markets. States must decide how much total support to give, whether to give the support to students, institutions, or both, and how to distribute the support among various entities. Most of the approaches used by states for financially supporting their public 4-year systems can be arranged into two broad policy categories: (a) low-tuition / low-aid model, and (b) high-tuition / high-aid model. Although some states still espouse commitments to low tuition at its public 4-year institutions, many students now face systems of public 4-year institutions in which a much higher tuition rate than in the past has become the norm. A growing number of states must wrestle with evolving high-tuition, public, 4-year systems and engage in efforts to provide either need-based or merit-based grants to students, with an eye toward addressing the accessibility of their public 4-year institutions in light of their rapidly-rising tuition price tags.

These two approaches rely on different philosophies regarding the best way for states to financially subsidize their higher education systems. In the low-tuition / low-aid model, the notion is that charging a relatively low tuition rate for in-state students will encourage more to go to college, and will treat all citizens in a similar manner. These states rely more heavily on uniform subsidies to institutions and/or students. In contrast, the proponents of the high-tuition/high-aid model argue that the best approach for encouraging college-going behavior among citizens is to direct more financial subsidies to those students who are least able to pay. By using non-uniform subsidies, these states can in theory produce more positive externalities for the state at a lower cost.

Although the potential effectiveness of the high-tuition, high-aid policy approach sounds promising when practiced under ideal circumstances, scholars have observed that thus far, some states’ experiences with such policies have revealed challenges with efforts to coordinate and implement broad-based aid programs.¹⁴ It is also interesting to note that despite the potential efficiency arguments in favor of using non-uniform and targeted subsidies, more than 90 % of state government subsidies in the United States are uniform subsidies in the form of block grants to institutions.

There are several explanations that may help us understand this disconnect between theory and practice. First, governments face different costs of implementing approaches to higher education subsidies. It is easiest—and thus less expensive—for a government to simply provide a block grant subsidy to institutions than implement a non-uniform subsidy because fewer procedures must be put in place to figure out how to distribute the subsidies. In contrast, to implement a non-uniform subsidy program the government would have to develop more extensive procedures for figuring out how much money to give specific students. Resources (time and money) are needed to review each student’s financial information and then determine how much subsidy is required to change each student’s mind about going to college. Because this information is unobservable to government policy makers, they must use proxy variables that are thought to be related to the amount of subsidy needed. Such proxy variables might include family income, number of family members in college, academic ability, race/ethnicity, and so on. The gathering, processing, and verification of this information is a costly activity that would reduce the net financial benefit for the public from a targeted (non-uniform) subsidy program.

There are political considerations that also help explain the popularity of uniform state subsidies for higher education. According to the median-voter model of political behavior, politicians will act in ways to try and appease the average, or median, voter within their jurisdiction. As a result, policies that provide benefits to more voters would tend to receive more political support than other policies. In higher education, state appropriations provide benefits to a large number of students and their families, whereas targeted need-based financial aid programs would tend to help fewer individuals. This means that if a state government attempted to replace block grant appropriations that benefit many students with larger and targeted need-based financial aid for fewer students, this policy would likely encounter political resistance from more constituents than would support the change. The political difficulties of changing subsidy policy may be even greater if it is true that the families who would receive need-based aid are less politically active than the larger population of college-going students who benefit from state block grants to institutions.

In addition, public colleges and universities themselves may be resistant to changing the structure of governmental support for higher education away from block grant subsidies to institutions. State appropriations represent a relatively stable source of revenue that helps these institutions with financial planning, whereas replacing block grants with student-based aid would introduce more variability into its revenue streams. As a result, public colleges and universities on the whole would be likely to put pressure on legislative bodies to maintain the current subsidy structure over a non-uniform and targeted subsidy program.

Sharing the Cost of Higher Education

Finally, we return to perhaps the most important and vexing policy question on this topic: who should pay what portions of the social costs of delivering higher education services? Based on the benefits-received principle of equity that is part of public sector economics, the answer is: “Each party who benefits should pay a portion of the cost”. In the case of postsecondary education, if there are positive externalities created when students go to college, then both the student and society benefit to some degree from the service and each should share the financial burden.

However, there is a longstanding debate about the relative size of benefits received by private individuals and the public at large when students acquire postsecondary education.¹⁵ Better and more accurate estimates of the value of public external benefits are essential to moving this debate forward. In the first decade of the 2000s, the ongoing—and largely de facto—privatization of the public sector of higher education is one vivid indication that even though society and policy makers in general understand that the value of private benefits to students is substantial, neither society nor policy makers have yet reached agreement about exactly how large these benefits are, and what their relative shares of financial support should be.

In theory, if half of the total (social) benefits from higher education accrue to students and the other half is in the form of spillover benefits to the public, then the benefits received principle would dictate that higher education costs should be divided equally between students and governments. In practice, however, it is hard to determine the “right” shares of costs that should be borne by these two parties because it is very difficult to measure the public and private benefits due to students going to college. Recall from Chap. 4 that there are numerous challenges with trying to quantify the private and social financial benefits from college. As a result, higher education policy makers cannot pin down with any measure of precision the correct shares of costs that should be paid by individuals and governments.

The lack of sufficient information about public and private benefits from higher education has contributed to the debate in the United States about how much governmental financial support for higher education is needed. The funding of higher education in the United States has been steadily shifting over time from public to private sources. Slow growth (or in some cases actual reductions) in state appropriations per student to public institutions, in combination with growth in the costs to institutions of educating their students, has led to large yearly increases in tuition. The College Board (2012) reports that for public doctoral-granting institutions, for example, net tuition as a percentage of total expenditures has increased from 37 % in 1999–2000 to 53 % by 2009–2010. Similar increases were reported for other public colleges and universities as well. At the same time, although the level of state funding for public institutions has usually increased each year, the share of total revenues from state funding has fallen steadily over time.¹⁶

Those who feel that most of the benefits from higher education are private and not public would argue that this trend is appropriate, while others would argue that the opposite is true. The debate is particularly relevant for Europe, where students often pay small or zero amounts of tuition and fees for higher education. But is this the right mix of funding? An argument can be made that if some of the benefits from college are captured only by the student, then it would be more socially efficient and equitable to have the student pay a portion of the cost of their education.

And it should be understood that higher education can never be truly “free” even if no tuition is charged to the student. There is still a social cost of higher education that must be paid by someone, otherwise the service could not be provided. Government subsidies are paid through taxes that are levied against citizens, businesses, and other entities. In essence, these entities end up paying for the free education of others. If the public benefits from higher education are very large, then one would argue in favor of a mix of funding more heavily tilted towards the government. The debate as to what is the right mix will certainly continue as long as academics have difficulty measuring the private and social benefits form higher education.

Final Thoughts

Free and competitive markets are the cornerstone of much of microeconomic theory. Nonetheless, economists have identified situations under which an unfettered market may not lead to the socially-optimum allocation of goods and resources in the economy. This argument is often made about higher education, in that there is the belief that not only do students themselves benefit when they go to college, but so do those around them. If this is true, and if students only base their postsecondary decisions on the private costs and benefits that they face, then the market system would lead to too few people enrolling in college from the perspective of society.

In this instance, it may be justifiable for the government to intervene in the competitive market. This intervention takes the form of financial incentives that reduce the cost paid by students. The hope is that by reducing the net price to the student, there will be some at the margin who would then decide that it is now in their best interest to go to college because their private benefit exceeds the new cost. We outlined how governments may provide these subsidies in either a uniform or non-uniform manner, and discussed some of the implementation and political issues that governments must address when choosing an appropriate strategy.

Glossary

Symbol	Definition
P pri	Equilibrium price based on private demand
Q pri	Equilibrium quantity based on private demand
D pri	Private market demand curve
S	Market supply curve
D pub	Public market demand curve
D soc	Social market demand curve
P soc	Equilibrium price based on social demand
Q soc	Equilibrium quantity based on social demand
MPB	Marginal private benefit
MPC	Marginal private cost
MSB	Marginal social benefit
MSC	Marginal social cost