Changing Market Explains Higher College Costs

Summary of working paper 6323

An increasingly competitive market drove colleges to raise their quality, their tuition, and their expenses.

Many American parents are deeply worried about the soaring cost of college tuition. With good reason, since the price of a sheepskin has risen considerably faster than inflation in the post-World War II period. What accounts for the price spiral? NBER Faculty Research Fellow Caroline Hoxby says that both the price and quality of a college education have been strongly influenced by momentous changes in the market structure of college education from 1940 to the present. "Over this period, the market for baccalaureate education became significantly more competitive, as it was transformed from a collection of local autarkies to a nationally integrated market," she writes.

Hoxby argues that the scale of structural change among colleges was equal to or greater than that of other businesses. In How The Changing Market Structure of U.S. Higher Education Explains College Tuition(NBER Working Paper No. 6323) she "advances a theory of industrial organization of college education. Her research suggests that changes in market structure can explain tuition increases of 50 percent or more in real terms since 1950 for selective private colleges, and tuition increases of about 15 percent in real terms for public colleges and less selective private colleges.

Hoxby finds that an increasingly competitive market drove colleges to raise their quality, their tuition, and their expenses. Heightened competition was also a force for colleges to develop different styles and specialties, as colleges felt impelled to create a more differentiated or "niche" product. At the same time, the distribution of student ability within any college narrowed as classes became more homogenous.

In an especially intriguing twist, Hoxby notes that students have a complicated relationship to the college market. Students are both consumers of college services and inputs into the production of education; they must consume at the same college where they are inputs; and students who want to consume a high quality education are typically high quality inputs themselves. These three related facts amplify the traditional predictions of industrial organization theory. High demand students are the same people whose "wages" (the entire subsidy to attend college) benefit the most from the loss of monopoly and monopsony power. Moreover, a multiplier effect is at work: high quality colleges attract high demand students, and highly desirable students further enhance college reputations. "Theory predicts that opening trade raises average quality; the multiplier magnifies this increase in quality," says Hoxby.

Of course, economists, legislators, and popular commentators have all put forward various explanations for steep tuition price hikes. Hoxby notes that her research, based on panel data on 1,121 baccalaureate-granting colleges, does not conflict with economic theories that focus on the changing demand or supply conditions for a college education. However, her theory, based on delving into the impact of heightened competition, does conflict with the popular notion that colleges are in cahoots to raise tuition prices faster than the rate of overall inflation.

-- Chris Farrell