By Chris | June 21, 2010
Ever wondered why college sticker prices are so high? I have. Part of the explanation is that universities price discriminate and the most palatable way to do so is to charge a high price and offer discounts based on ability and income. But how do universities choose the price that they do? When I was in high school I seriously considered attending Willamette University in Salem, OR. Tuition there is currently $35,000 per year. Over 95% of freshman receive aid. The average need based scholarship is $15,000.
I used to think that high sticker prices were an effort by schools to signal quality. If a school charges $50,000 prospective students may perceive it as high quality and a great value after a $20,000 scholarship. I figured that colleges weighed this quality signal against the real threat of scaring off prospective students with sticker shock.
However, after reading this Econometrica paper on price discrimination in education, I’ve come to an alternative explanation for high tuition. Tuition can be thought of as a price cap on education. Applicants differ in their income and their ability. Because of peer effects, students are both inputs and customers. Colleges want to admit gifted students because they make the school more valuable to other students. However, they are willing to accept lower quality students if those students pay a higher price. This revenue can be used to buy other higher quality students, pay for higher quality teachers, or simply increase the school’s endowment.
A school’s sticker price tells you the extent to which a school will sacrifice student quality for additional revenue. The sticker price is inversely correlated with the quality of the lowest student. A school with a high sticker price is advertising that it will accept really low quality students as long as they pay enough. A school with a low sticker price is constraining itself from admitting low quality, but rich, students. This runs contrary to the price as a signal of quality theory. In this context, a low price actually reflects that a school is unwilling to sacrifice student quality for more money. This explains why Ivy League schools charge tuition that is much lower than what the market would bear.