Food for Thought: Information Asymmetries and the Market for Higher Education

July 30, 2012

Our president, Scott Hodge, testified last week in front of the Senate Finance Committee regarding the effectiveness and consequences of education tax incentives. This spurred an interesting thought—the higher education market is one that is plagued by very asymmetric information. Education is the only market that comes to mind in which the seller of the good has complete financial information about the buyer. In other words, the consumers of higher education – students and their families – are at an extreme information disadvantage over the universities.

Here is how it works. Each year, a student (or more likely, their family) fills out the Free Application for Federal Student Aid (FAFSA). In this cumbersome, complicated process, families report income and other related assets. Essentially, this reports to the government the family’s estimated ability to pay for higher education—not willingness to pay, but ability to pay. This is an important point. The government then calculates what is known as the “expected family contribution,” which is sent to colleges, reporting what exactly the government deems a family can devote to their student’s education.

Let’s step back for a moment and frame this problem a little differently. Imagine you are on the market to purchase a new car. When a salesman approaches, you (the buyer) have an information advantage. You know exactly what you are willing to pay for the car based on your own personal preferences and your personal belief as to how much of your family budget you can realistically devote to purchasing the car. With this knowledge, you are in the driver’s seat on negotiating the price of the car.

Imagine, now, that prior to you visiting the car lot, the dealer has been able to review your entire family finances. He knows how much you earn, what your assets are, how much you owe on your home, how much money is in your savings account, and how high your credit limit is. Furthermore, based upon this information, the government already told him just how much you should devote to purchasing the car, if you decide to do so. Now who has the upper hand? The car salesmen can effectively extract the highest possible amount from you that you can afford.

That doesn’t sound like a very good deal for the buyer, does it? But this is the current structure of the U.S. federal financial aid program and the “market” for higher education.

Former Secretary of Education William Bennett once postulated that increased federal aid just makes it easier for universities to raise their tuitions—the so-called “Bennett hypothesis.” While the empirical evidence supporting Bennett’s theory is mixed, the incentives are clearly there and tuition costs show no signs of slowing down. According to the National Center for Education Statistics, over the last twenty years, tuition prices have increased for public and private institutions alike. More specifically, aggregated price for tuition, room, and board increased 25 percent at private colleges and 37 percent at public institutions between 2000 and 2010.

In his testimony, Hodge suggests that higher education pricing is following the same path as health care and housing for the very same reasons. These are the sectors of the economy that are suffering from the greatest amount of government intervention, ranging from direct subsidies to cheap credit to targeted tax expenditures. We are already seeing bubble-like conditions in the market for higher education. Accompanying the growing prices is growing student loan debt, which now tops $1 trillion and exceeds the total amount of outstanding consumer debt. Washington can help the market for education by doing less.

More on education here.

Related Articles