Normative Narratives

Economic Outlook: Neo-Classical Economics, Perfect Competition, and the Cost(s) of Attending College

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Student loan debt in America is a controversial subject. Some countries subsidize higher education, the U.S. does not. In the context of the past decades in America, marked by increasing inequality and decreasing social mobility, the issue has become even more controversial. Yong adults, often without parental support, are sold the panacea of higher education as a means to a better future. While it is true that college graduates make more and experience lower unemployment rates, simply “getting a degree” can often be counter productive. If the degree is in a field with very limited job opportunities, or due to cyclical economic factors outside individual’s control (i.e. a prolonged recession), a young adult may be saddled with student loan debt; far from enabling social mobility, an ill planned college decision can leave a person with a lifetime of debt and actually push them into a “poverty-trap”. Further exacerbating the problem, the importance of a college degree has drastically increased the demand of a college education, pushing up the average cost of attending college.

In America, public student loan debt is somewhere between $900bn and $1 trillion dollars–most economists agree that student loan debt and poor job prospects have caused young adults to put off moving out, depressing overall consumption and further prolonging the (growth) recession. Against this backdrop, the Obama administration has attempted to stymie the rapidly increasing costs of college education. Obama’s plan is essentially two fold, 1) subsidize student loan debt with fixed preferential rates, and 2) rank institutions–based on tuition, graduation and retention rates, student makeup and graduates’ earnings–and then tie federal aid to those rankings.

The Obama administration has already passed a watered down version of its proposed student loan plan. The plan will tie rates to the government borrowing rate (T-bill) plus a premium depending on the level of the degree being pursued. While a short term fix while the economy stagnates, a capped rate of 8.25% does not provide the stability or low costs of fixed subsidized rates that many were hoping for. The Obama administration kicked the can down the road; how far down the road remains to be seen and is largely independent of the merits of a college education.  Hopefully this short-term fix remains a fix for a while, and only becomes an issue again in a less contentious economic and political climate.

The second part of Obama’s plan, revealed yesterday at the University of Buffalo, proposes to publish information to make the decision process more transparent for prospective college students. Ultimately, Obama wants to tie federal aid to these rankings, creating an incentive for schools to keep costs down. If this part of the plan does not pass through congress, at least the information campaign segment of the plan is isolated from political gridlock. Opponents of the plan say that and results based plan will compromise the integrity of a degree, causing schools to make graduation easier. I find it hard to believe that a school would give up quality control over its most valuable asset–a degree–simply for student loan money.

Opponents of both of these plans contend that the government should get out of the student aid business and allow market forces to determine the price of a college education / student loan. At the root of this argument is the belief of neo-classical economics that perfect competition produces optimal outcomes for consumers, producers, and society as a whole. However, empirical evidence suggests a different outcome–rising costs of a college education without a related increase in the benefits of that education (and arguably decreasing benefits, as an undergraduate college degree becomes more commonplace and therefore less of a differential in hiring decisions). How could this be? Have people been duped into believing college is more valuable than it really is? While poor decision making by borrowers and lenders has surely exacerbated the problem of student loan debt and college tuition increases, the real culprit is in the assumptions underlying neo-classical economics and perfect competition. While no market in the real world completely fits these assumptions, the markets for college education and student loans are particularly ill matched.

Neo-Classical Assumptions:

  1.  People have rational preferences among outcomes — This could not be further from the truth. I have never met someone who is 100% rational (think Spock from Star-Trek). Some people are mostly rational, but in general people tend to be very short-sighted with consumption and investment decisions (or lack-thereof)–particularly those at the bottom of society who have little reason to be optimistic about their futures;
  2.  Individuals maximize utility and firms maximize profits — Well it is certainly true that firms (in this case schools) move to maximize their profits. However, maximizing utility is more difficult to evaluate–everyone values things differently, has different discount rates for consuming now vs. saving for later, different values work vs. leisure time, etc. This assumption cannot be refuted, but really does not tell us much because of its ambiguity (peoples preferences are different and cannot be compared);
  3.  People act independently on the basis of full and relevant information — Far from full and relevant information, often times power and knowledge asymmetries lead to very poor decision making. The second part of Obama’s plan intends to overcome this information gap.


Perfect Competition:

Perfectly competitive markets exhibit the following characteristics:

  1. There is perfect knowledge, with no information failure or time lags.  Knowledge is freely available to all participants, which means that risk-taking is minimal and the role of the entrepreneur is limited. — The role of the entrepreneur (in this case the student) is not minimal. The availability of information and guidance can make the difference between a “good decision” (for example going to a public college for a STEM degree) vs. a “bad decision” (for example going to a private party school for a poetry degree). The time-lag is particularly pronounced in education decisions, college often requires a large upfront cost based on the belief that the net benefit (higher earnings – college costs – student loan fees – opportunity cost to attend college) will be positive. Even with perfect information today (which is very difficult to obtain) due to uncertainty about future borrowing costs (argument for fixing student loan rates) / job availability / degree obsolescence (the field advances or becomes irrelevant), the decision to attend college is largely a leap of faith–a leap that is continuing to fall short for many people (which is why college costs must be reigned in, to align the costs and benefits of a college education);
  2. There are no barriers to entry into or exit out of the market. — While there are no real explicit barriers to entry, the implicit barriers to entry are huge. Colleges require huge start-up costs, and take time in order to establish “prestige”. The best colleges have an implicit oligopoly (this is not necessarily a bad thing, but it should be noted); while they may partner with public institutions / community colleges, their demand for their services are rival, demand inelastic, and constantly in short supply. Public Colleges, technical schools, community colleges, and more recently online schools or “MOOCs” have become cheaper alternatives;
  3. Firms produce homogeneous, identical, units of output that are not branded. — Related to the previous point; while alternatives to “traditional schooling” are now available, they are generally not seen as comparable to University education (Public colleges are, but community colleges / MOOCs typically are not). Part of this has to do with the stigma attached to these alternative channels of education. Guidance counselors, college advisers, unemployment trainers  and even employers should all promote these differentiated services based on the needs and desires of potential applicants. Sometimes going to a technical college / pursuing an associates degree is more beneficial and (always) costs less than going to a traditional 4 year college–sometimes these options can be “stepping stones” to more advanced degrees as the young adult matures and reevaluates his/her priorities;
  4. Each unit of input, such as units of labour, are also homogeneous. — Each “input” is not homogenous–people go to college to explore their potential and study any number of diverse fields. Neither “inputs” nor “outputs” of colleges are in any way homogenous;
  5. No single firm can influence the market price, or market conditions. The single firm is said to be a price taker, taking its price from the whole industry. — No “market price” for colleges; inelastic demand, imperfect information and a shortage of spaces allow certain colleges to essentially charge whatever tuition rate they want;
  6. There are a very large numbers of firms in the market. — True, but this has not led to true competition due to increasing demand;
  7. There is no need for government regulation, except to make markets more competitive. — Well that’s the point…
  8. There are assumed to be no externalities, that is no external costs or benefits. — Certainly not true; there are undeniable positive externalities of college education for both individuals and society as a whole.
  9. Firms can only make normal profits in the long run, but they can make abnormal profits in the short run. — There is no end in sight to the rising cost of schooling without government intervention.

Empirical evidence and a baseline analysis of neo-liberal economics refutes the idea that the costs of college should be left for the markets to decide. One would hope our elected officials would be more educated on the subject, and could offer an alternative other than unfettered belief in the power of markets to produce optimal outcomes. Obama’s proposals seem to hit at the root causes of rising college costs; lets hope his plans are implemented. Even if they are not fully implemented, the short-term student loan rate fix and upcoming information campaign should provide temporary relief and begin reversing the trend of rising college costs.

Please do not get me wrong, I am a strong proponent of higher education. But it is no panacea and it can actually be counter productive if not addressed within a C-B framework. It is the job of the government to keep costs down (as self-regulation of college tuition simply does not exist), and subsidize college education (both loans and tuition) to reward the positive externalities of higher education. It is the job of people, aided by advisers, parents, and in the near future government collected data, to consider the benefits and costs of college, and make appropriate decisions for themselves. Underlying this C-B analysis should be fixed loan rates, otherwise a robust analysis is impossible.

Note: The inspiration for this blog is “Development Economic Through the Lens of Psychology” , an excellent journal article I highly suggest to my readers.

3 thoughts on “Economic Outlook: Neo-Classical Economics, Perfect Competition, and the Cost(s) of Attending College

  1. Please discuss how lowering the cost(via below market interest rates on loans) will not result in higher demand, and a shifting of the demand curve outward therefore increasing price?

    As you astutely noted, online programs are not on par with brick and mortar institutions, the supply curve is rather vertical and supply cannot keep up with demand necessitating higher prices to achieve market clearing conditions.

    Please explain why lower rates will NOT result in overal higher cost in the short to mid term.

    -tele

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  2. Good Question Tele, I am glad you brought that up.

    I cannot say unequivocally that subsidizing student loan rates will not increase demand, resulting in a higher cost for college in the short run. However, due to the inelasticity of the demand of a college education (over the past decades tuition has gone up, demand has not dropped), the effect of lowering the price of college will probably not cause as drastic an increase in demand; in general those who want to go to college are going now despite high costs.

    That is why I propose subsidizing loans combined with Obama’s information campaign. The campaign will put pressure on schools to keep their costs down, because market forces only lead to rising costs without an associated increase in benefits (the aggregate result being a trillion dollars in student loan debt in the U.S.).

    Certainly cyclical economic downturns exacerbate this issue, but student loan debt was a problem before the Great Recession. Aligning the costs and benefits of college should be help solve this problem (via subsidized loans and Obama’s plan). Furthermore, companies and colleges should engage in partnerships with industry leading companies when designing curriculums, in order to address any “skills gap” that may exist.

    These policies attempt to correct the power-asymmetry between schools and students (particularly low income students with minimal guidance), by giving them the information and certainty they need to make an informed decision.

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  3. Excellent article. I’m experiencing many of these
    issues as well..

    Like

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