The Net-Price Myth

The concept of “net price”—what students actually pay for college after financial aid is subtracted from published tuition rates—has become increasingly important  in discussions of college affordability. It was prominently featured in last month’s annual College Board pricing report and accompanying news-media coverage, and has been promoted through tools like the U.S. Department of Education’s net-price calculator.

The fact that many students pay substantially less than sticker price is significant, and deserves to be part of the conversation. But it shouldn’t give anyone false comfort about the magnitude of the long-term college-affordability problem.

Most colleges are nonprofit and spend all the money they get, so there are three big numbers to watch here: (1) how much colleges spend per student; (2) how much money comes into the system from sources other than students; and (3) how much students and their families pay out of pocket. Colleges prefer to ignore (1) as a contributing factor to unaffordability and focus on the broadly correct argument that (2) and (3) vary inversely: If state subsidies decline or endowments take a hit, then student charges must rise in order to maintain spending. Similarly, if Pell Grants go up, then students pay less out of pocket.

That’s all generally true. But ignore (1) at your peril because college spending is the driving force behind affordability or lack thereof in the long run. External subsidies and student charges are both limited in how much they can increase over time by a combination of overall growth in economic output (particularly as it’s distributed among families of college-age students) and the political economy of government fiscal policy.

In other words, people have only so much money to pay for college, endowments can earn only so much of a return in the financial markets, and, practically speaking, state and local governments will provide only so much in the way of subsidies given how people think about taxation and government spending circa 2012.

Institutional spending, by contrast, is limited only by the ambition of institutions, which is to say not at all. And as this report shows, per-capita institutional spending on education and related expenditures continued to rise from 2000 to 2010, even after accounting for a huge influx of new students, inflation, and the revenue shock of the Great Recession.

Inflation-adjusted per-student spending at private research universities, in particular, increased sharply, and private universities set the aspirational standards for the industry as a whole in terms of what scholars and administrators should be paid, what campuses should look like, and what the general higher-education experience for students and faculty should be. (And that’s only spending on education; the numbers cited above don’t include research, athletics, and the administration to support them.)

All of that spending has been accompanied by a huge run-up in published tuition rates. But as the College Board and others have noted, the average net price has grown more slowly, particularly in recent years. Does this mean that steadily increasing college spending is manageable in terms of the bite it takes out of students’ wallets, that the news media and the Occupy protesters and all the rest have got the story wrong?

In a word: no.

That’s because the recent stability of average net prices is mostly a function of three temporary phenomena that cannot, under any likely scenario, continue to offset increased college spending in the long run. They are: price discrimination, federal tax policy, and Pell Grants.

Price discrimination is an economic concept that describes a business’s maximizing revenue by charging customers different prices for the same product. Recall from Econ 101 that the demand curve for a product slopes downward from left to right. As a rule, there are a few people willing to pay a lot of money for a given product, and a lot of people willing to pay a little money. The supply curve slopes up, and where the twos lines intersect is the market price, where you, the producer, can sell X number of products for Y price.

But if you’re the producer, that’s not your best-case scenario. Instead, what you want to do is fit your prices exactly onto the demand curve, by selling one item to the guy in the very upper-left corner who’s willing to pay a lot of money for it, and then one product to the next guy down the curve, and so on.

The tricky part of pulling this off is convincing a bunch of people to pay different prices for the same thing. There can’t be much of a resale market because, if there were, Guy No. 2 would play arbitrage and sell his product at a profit to Guy No. 1. Price discrimination exists in lots of markets—grocery-store coupons, for example.

A form of quasi-price discrimination happens when people make small alterations in the quality of service but charge huge premiums in exchange. Front-row tickets to an NBA basketball game aren’t really that much better than second-row tickets in terms of the viewing experience, but they cost a lot more because they give very rich people an excuse to shell out the thousands of dollars they’re willing to pay to watch a live basketball game, and confers a kind of status in the bargain. Airlines discriminate by selling identical seats for widely varying prices based on algorithms that take into account scarcity and the amount of time remaining until the service must be used.

Colleges engage in price discrimination via tuition discounting. Full sticker price is the equivalent of what a business passenger pays for a last-minute ticket bought at the airline counter. Over the last decade, colleges have gotten very good at price discrimination, with the aid of expensive consultants who employ the same kinds of algorithms the airlines use. That’s why real-dollar “spending” on institutional aid has almost doubled over the last 10 years. (I put “spending” in quotation marks here because it’s very strange to think of revenue nominally foregone in pursuit of revenue maximization as an expense; the net result is more money, not less. I’m pretty sure airlines don’t allege in their accounting books that every dollar they charge less than the highest ticket price on a flight constitutes spending.)

But the thing about price discrimination is that, eventually, its power to increase overall revenues comes to an end. If you have a limited number of customers and everyone is paying exactly the most they’re willing to pay, then they will pay no more. And it’s very clear that a number of colleges have run out the string on price discrimination. That’s what it means when someone says, “We need to bring down our average discount rate.” What they’re really saying is, “Our attempts to raise additional money by grasping for a higher point on the demand curve by increasing our sticker price and discriminating back from there have failed.”

Net prices have also been kept down by major new investments in federal financial aid, some through the tax code via laws like the $14-billion American Opportunity Tax Credit, and, most important, through a vast and unprecedented expansion of the Pell Grant program, which in the space of the last five years has tripled in size, to roughly $40-billion a year. That’s a huge amount of money, and all of it gets subtracted from published tuition rates in the College Board’s calculation of average net price.

Neither the Pell program nor the tax credit are on firm budgetary footing at the moment. The credit was a temporary measure and is due to expire. The epic Pell expansion was substantially financed by “one time” appropriations made through the federal economic-stimulus package. It will require some serious fiscal heavy lifting to extend them both at current levels for the long term. I expect that, for the most part, this will happen nonetheless (although at a cost to other education programs) because college affordability is such a potent political issue.

But the odds of additional huge investments of federal money to offset future increases in college spending and state disinvestment are long indeed. Even the federal government doesn’t have enough money to bankroll the combination of constant college-spending increases and perpetual state-budget cuts forever.

All of which means that net price will prove to be a temporary palliative to the college-affordability crisis. Structural changes in the industry’s underlying cost and revenue structures remain as needed as ever before.

Kevin Carey is director of the education-policy program at the New America Foundation.

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