Episode 2

Individual Pricing of Private Colleges Leads to Higher Charges

How is it that private colleges can charge so much for tuition and why do they charge different prices to different people?  We’ll answer these questions on today’s episode.  I’m Larry Bernstein and welcome to Charging U.

In this episode, we look at individual pricing.  This is a very important topic because it is probably the biggest contributor to the rising tuition sticker price at private colleges and universities.

While tuition at public colleges is set by state government, private higher education institutions are free to set their tuition at any amount and, most important to our discussion, they can charge different amounts to different people.

As we approach this topic, there are a couple of commonly held assumptions to reject.

First, we usually think about the price charged for an item or service, or college education as being related to the cost of making that item or providing that service plus a profit margin. Forget about it. This is not relevant when talking about private college pricing. The actual tuition and fees charged are not directly related to the cost of providing an education.

Second, we usually think of the price of an item or service as being the same for all consumers.  This is not the case with respect to college tuition.  All students at a school do not pay the same price for the same education. Pricing is individualized based on what each specific consumer is willing to pay.  This is a key point which we will dive into a bit later in the podcast.

But first, we need to do a quick review of a couple of concepts from Economics 101 which will be important to understanding college pricing.  The first is the concept of economic surplus. Economic surplus is the difference between how much consumers would be willing to pay for an item or service minus what they actually pay for it.

Let’s use an example.  Say you’re at an outdoor concert in the summer.  It's 90° and sunny. You might be willing to pay five dollars for a bottle of cold water, so there's no reason for the people selling water to charge one dollar.  They charge five dollars and keep the economic surplus.  If they charged one dollar, the buyers would be getting a lot of the surplus since many buyers were willing to spend up to five dollars for the water.  

We can take this example further.  Now, imagine it's near the end of the event and the person selling water has some left over. At this point no one is willing to pay five dollars. They will be home soon. But some people will pay two dollars, so the seller can lower the price to two dollars and sell the remaining water. The salesperson has extracted as much money from the public as the public is willing to pay for water.  Notice that we never mentioned how much the water cost the salesperson.  It is completely irrelevant, as long as the seller sells it for more than he or she paid for it. 

Now let's introduce another concept: market segmentation. Market segmentation is when a large group of consumers is divided into smaller groups that can be specially targeted.  When producers of one standard product or service are selling it to a broad market, they have to appeal to everyone.  They have to appeal to those who want low price and care less about quality, those who value good quality and some convenience and are willing to pay a bit more for it, and those who prioritize very high quality and service and are willing to pay a lot more for it. So, in order to be attractive to everyone, the producers have to provide excellent service and top quality at a relatively low price.

But what if they offered three types of service? They could offer lower quality for slightly less than they were charging before, better service or quality and charge moderately more, and they can offer very high-quality for a lot more than they charged before. The more they charge, the more of the economic surplus they will take and the more money they will make.

We can use hotels as an example. If there were only one kind of hotel in the city, it would have to be somewhat luxurious, clean, and well located.  It might cost the hotel company $100 a night to provide that room.  It could charge $125 a night and make a $25 profit. But if the hotel company offered multiple brands, it could charge $100 for a basic hotel with small rooms in a less popular area which costs the company $80 a night.  It would make a $20 profit.  It could charge $200 for a hotel with larger rooms in a more desirable area which costs the company $120 per night thereby making $80 in profit.  Or it could charge $500 for a luxury hotel with lots of marble, large rooms, and spectacular panoramic views of the city which costs the company $250 per night to provide, and make a $250 profit. So the more the hotel company charges, the more money it will make.  Visitors to Manhattan who just needed a roof over their heads and a clean room could choose a Super 8 in Queens.  Others with a little more money or desire for upgrades could stay at a Hilton in Manhattan for a higher price. Hedge fund managers get to stay in regular rooms at The Plaza.  If they want a view of Central Park, they can pay extra.  If they want a suite and they have an expense account, then they can pay even more.  And if right before the date of an event there are empty rooms, then the hotel company can lower the price to attract someone to fill it.  The company can also provide a discount to a media influencer who will increase visibility and make the hotel more desirable in the future.  So not only are there price differences between hotels, but even at the same hotel, people are paying different rates on the same day for similar rooms.

The more variables you have, the more difficult it is to compare options. How do you compare the cost of a hotel room in Ann Arbor in July with the cost of that same room on the weekend of a home football game against Ohio State? It’s difficult.  How do you compare the cost of a Hilton in Cupertino, California with a Sheraton in Syracuse, New York?  It’s even harder.  It’s like comparing apples and oranges.

The smaller and more fragmented the market, the higher the price a group will pay for small differences in products and services. When it is difficult for the customer to compare different services or products, you do not have a fair market but rather one where the seller has the upper hand.

But we’re supposed to be talking about colleges so let’s get back to that.  Most public colleges fall into the category of one standard service with good quality provided for one relatively low standard price. It has to appeal to all residents of the state.  The state realizes a much smaller fraction of the economic surplus as some citizens that enrolled would have been willing to pay more than the state is charging for such a fine education.  On the other hand, at private colleges, different people pay different prices. The sticker price is not necessarily the price a student will pay. The average discount at U.S. private four-year nonprofit colleges is 56% and rising, so that while the list price is rising much faster than inflation, the actual amount paid by students is variable and, on average, the school only collects 44 cents for every dollar of the sticker price. Over 90% of those attending private institutions receive aid or a discount, the exception being those with high family income attending highly selective colleges and universities.

How do the financial aid and admissions offices know how much financial aid or merit discount to give? Enter the enrollment management company which has been lurking in the shadows. 

First, it is important to know a little bit about the history of enrollment management companies. In the early to mid-1970s, Boston College was at a crossroads. Its enrollment was declining, its reputation was declining, and its revenues were declining. It could not afford to maintain its buildings.  This made it hard to attract students and bring in money, perpetuating the downward spiral.  Its future looked bleak.  It searched for a way to turn around the slide. It decided to make Dr. John Maguire, a physics professor, the head of the admissions and financial aid.  He thought that through proper planning, the college could have some control over its destiny and have a more favorable outcome.  In order to accomplish this, the college had to integrate all areas of marketing, recruitment, admissions, financial aid, and retention of students.  Then it had to track the results of its policies.  He called this proactive process “enrollment management.”

So, Boston College shed its passivity, and went after what it wanted, namely good students who could pay.  The first step was no longer just to sit back and wait for local working class applicants to come to it.  It went out beyond the Boston area spreading the word of its academic and geographic strengths.  It also encouraged students dissatisfied elsewhere to transfer to Boston College and made the process smooth.  It collected data on what was tried and what worked and used this feedback to fine tune its actions.

The most innovative part of enrollment management was “to implement financial aid strategies that will optimize our ability to attract and retain an appropriate socioeconomic mix of students.”  That mix included some full-paying students to subsidize those who could not afford the full sticker price.  Maguire was quite successful at Boston College.  The number of applications tripled leading to increased enrollment, improved selectivity, and financial stability.  In 1983 he used what he learned in his capacity as Director of Admissions to found Maguire Associates, an enrollment management company.  Today, there are numerous enrollment management companies.  Lest you think that they are small mom and pop operations, back in 2014 The Advisory Board purchased Royall and Company, an enrollment management company with 350 colleges as customers, for $850 million. 

Enrollment management companies have evolved.  They are paid consultants who have assembled troves of big data from various sources. The enrollment management company can combine this with very detailed personal financial information, including income and the value of savings and investments, submitted in the applicant’s financial aid application. They can factor in the information that the admissions office provides about how much interest the applicant has demonstrated in that particular college. They compare all this information to what families similar to the applicant’s have paid in the past to predict how much this specific student will be willing to pay in tuition. The goal of the enrollment management company is to figure out the highest amount of current wealth and future earnings that the applicant and family are willing to give up to pay for the education at that specific college. They want to offer the least amount of discount necessary, and not a penny more, to get the student to enroll.  They want to keep as much of the economic surplus as possible.  

While this is happening, the college has broken down the qualities of the applicants by grades, athletic ability, likelihood of contributing money in the future, interests, demographics, ability to pay, and leadership qualities.  The college prioritizes what qualities it wants or needs in the incoming class, but at least as important is the total amount of money the college needs to bring in to pay for its operations. The school will use or leverage its financial aid to entice the students it wants and to turn off students it is less interested in enrolling, for whatever arbitrary reason.  

How might all this play out in an admissions process?  Let’s look at some hypothetical applicants to a fictional college in order to demonstrate some important concepts.  Fictional Bucolic College is a private liberal arts college in rural Ohio founded in 1870.  It has a modest endowment thanks to F. J. Smith, a benefactor who made a small fortune in oil before being forced to sell to John D. Rockefeller.  It has 1800 students enrolled.  The middle range (25th to 75th percentile) of the SAT scores of matriculated students is 1000-1160.  Tuition sticker price is $40,000 per year and room and board runs $15,000 per year.  Baseball is its flagship sport, with the much feared Goldfinches a conference power.

Consider the following 7 applicants.  Don’t worry about remembering specifics.  We’ll go over them again.

Ed is a resident of Wyoming with mostly Bs and some As on his high school transcript.  His SAT score is 1080.  His family’s income is $110,000.

Michael is the best high school first basemen in his rural county in nearby West Virginia.  He has mostly Bs on his transcript, his SAT score is 1040, and his family’s income is $50,000.

Connor is a good shortstop with a mixture of As and Bs in his high school courses and a SAT score of 1100.  His family income is $60,000.

Chloe has had her heart set on going to Bucolic College since her visit to the campus.  She received Bs and Cs in her high school courses, her SAT score is 960, and her family’s income is $200,000.

Nora is an A student, has a high SAT score of 1240, and a family income of $160,000.

Maya is eligible for a Pell Grant her family income is $35,000.  Her high school transcript has mostly Bs and her SAT score is 1040.

Maria is originally from Venezuela.  She was the lead in her high school play.  Her goal is to go to law school.  Her transcript shows As and Bs.  Her SAT score is 1200 and her family’s income is $38,000.

Now, how might the admissions office with the help of the enrollment management approach this scenario:

Ed from Wyoming is appealing because he represents geographic diversity. His grades and scores fall into the middle of the pack at Bucolic. Family income is good so they should be able to pay for a good part of his education. He might be offered a $20,000 discount to entice him to come east.

Michael, the all-state first baseman, is the baseball coach’s choice as the most desired recruit. His family income is not high. He might qualify for $5000 dollars in Pell grants. This can be combined with a loan for $4000, a work-study job with income of $1600 during the year, summer earnings of $3200, and a scholarship for $37,200. This would leave his family responsible for paying $4000 a year. 

Connor, the shortstop, has better grades than Michael but the college already has a very good sophomore shortstop. It would be nice to have Connor on the team but there isn’t enough money in the athletic scholarship budget for him. He can be offered a discount of $20,000 and perhaps he would piece together other financial aid and come.

The admissions committee has decided to accept Chloe.  Though her grades are low, she has demonstrated great interest in the school and the committee is confident that she will enroll if accepted.  Her academic credentials are not strong enough for admission to a more selective college.  In fact, they are barely strong enough for Bucolic. Her family is wealthy. There is no reason for Bucolic to offer her any discount. Chloe’s family will pay the full $55,000 per year which, along with any donations from the appreciative family, will help fund programs and financial aid at the college. 

Nora, has high grades and a financially secure family.   The admissions committee might offer her a F. J. Smith Merit Scholarship of $10,000 recognizing her high school achievements. The enrollment management company has determined that this is the minimum amount of discount that will flatter her enough to get her to enroll at Bucolic rather than another college.  There is no reason to offer a $15,000 discount.  Bucolic is happy because she raises the average SAT score of matriculated students while she and her family would still be paying more than most of the students at the college.

Maria, originally from Venezuela, is the admissions committee's choice for a high scholarship student. She is from an underrepresented group and has good academic credentials.  She would contribute to campus life by participating in theater productions.  Her goal is to go to law school. She may become financially successful in the future and donate money back to the school after she graduates.   She would qualify for $6800 in Pell scholarship and a work-study job for which she will earn $1600 per year.  With summer earnings of $3200 and a loan of $5000, the school can then offer her a $38,400 discount.

Maya, on the other hand, has less impressive credentials.  The school would love to have her enroll but their modest endowment does not enable them to offer her a significant scholarship or discount. They have already given money to Ed, Michael, Nora, and Maria.  They may offer her a $10,000 scholarship but the remaining cost would still be prohibitive and it is unlikely that she would enroll.

The scenario we just presented is meant to demonstrate how a college can use its financial leverage to entice or discourage different students to enroll and how the amount of revenue that the school will bring in is important.

Early Decision programs, that is, when an applicant applies and agrees to attend a college if accepted, is lucrative for a private college.  The college has no incentive to offer an attractive financial aid package since the student must enroll if accepted, unless the applicant chooses a public university.  The school gets to keep the economic surplus.  This is a reason why many selective colleges fill their incoming class with a large number of early decision applicants.  The institutions are assured early on of a larger amount of guaranteed revenue for the following academic year.  This makes it easier to plan a budget and adds more dollars to the budget.

International students are also attractive to colleges because, for the most part, they are not offered tuition discounts.  Enrollment management companies may include recruitment of these students in the master plan they present to a college.  These full paying students allow the college more leeway in offering generous financial aid packages to other applicants they deem desirable.

How does a student and his family know if the price they are being offered is similar to what other people are paying at that institution?  They don't. How do they compare the value of price 1 at college A with the value of price 2 at college B?   There is no standard way to compare. We will also discuss this important point further in the podcast about rankings. 

Notice the inequality in the applicant-college relationship. The college has test scores, grades, personal statements, tax returns, bank statements, data about the spending habits of similar families, and a high tech company telling it how much to charge.  And the applicant has… a picture of four students sitting under a tree. The applicant has no measure of a college’s value relative to other colleges and no idea what similar students pay at that specific college.  What we have is an asymmetric market. It's a one-on-one auction where the consumer is inexperienced and does not have much information.  As for the sellers, this is their business and they have the savvy and all the information. This is somewhat similar to the direct negotiation when buying a house, but at least when buying a house, one can find comparable properties to get a sense of value. A buyer also has an agent who presumably can help with information and an inspector to evaluate the structural integrity of the dwelling. In determining a fair tuition, most applicants and families do not have allies or resources.

Why have colleges been able to get away with this? For the most part, while sticker price for tuition has increased greatly, the actual amount of tuition paid to private universities has not risen quite as much. This is a dirty little secret that neither the school nor the student broadcasts. Most students have received discounts. And they feel that they have gotten a deal. 

But highly selective schools are a different case. They have been able to charge AND collect more. Here it is a simple case of supply and demand. The number of seats at selective schools has remained constant but the number of applicants seeking those seats and willing to pay a high price for them has increased. This is due to a growth in the population, in general, but particularly a growth in income of the top 5 to 10%, both in the United States and abroad.  There are two measures that have gone up nearly as fast or faster than the sticker cost of college. One is income of the top 5 to 10%.  Between 1975 and 2019 inflation adjusted median household income rose 45%, but income for the top 5% grew 150%. The other measure which increased dramatically during that time period is stock market returns including reinvested dividends which have skyrocketed over 3200%! Wow!  Even looking at a shorter timeline shows impressive gains.  $100 invested in the S&P 500 in 1990 would be worth $1200 today.  That is huge!   And who owns stocks?  92% of households in the top 10% of income own an average of $425,000 in equities.  Just over half of households in the median quintile own stocks and they have an average balance of only $15,000, and only 15% of those in the bottom quintile own stocks and their average balance is $7,000. If the stock market goes up 15% one year, the top 10% add $63,750 in wealth but those in the middle and lowest quintiles who even own equities only add $2,250 and $1,050 respectively.  $63,750 vs $2,250 and $1,050.  Of course, those who don’t own stocks receive no boost at all.  And if those who own stocks have some of them in a 529, then at least part of the $63,750 is tax free.  All this leads to the top 5-10% having more disposable income and they choose to invest it in human capital, namely their children. Also add in the huge rise in home values, and you see why they are able to pay the high tuition price. And, of course, the enrollment managers know all this and they want at least a chunk of that money. 

Prior to the 1970s, the vast majority of students attended colleges close to home.  Now, those with higher credentials and more money are willing and financially able to travel across the country to attend selective colleges. For those who are exceptional but less affluent, wealthy selective colleges have more money at their disposal to give for financial aid to help defray tuition and travel costs.  This translates to more applications at those top tier schools, that is to say, increased demand for a constant number of places. Caroline Hoxby, a Professor of Economics at Stanford who studies higher education, feels this increased ability to travel may account for as much as 50% of the increase in tuition at selective schools. 

In addition, those from wealthy families can apply early decision and not be concerned with whether the financial aid package will be generous. Many alumni are loyal and willing to spend more to have their child attend the same school they did. The college does not need to offer a discount or as much of a discount to attract them so it keeps more of the economic surplus from these groups.

There is an impression, mostly correct, that attending selective colleges improves lifetime income and quality of life. Various studies show that when cost is not a major limiting factor, wealthy families tend to choose schools based on the level of absolute achievement of the graduates rather than the value added by that school.  They are willing to pay a lot more for a small amount of perceived benefit. And they have the disposable income to do it.  They do not need to be offered discounts at highly selective colleges.  Just like the hedge fund manager choosing to stay in the five-star hotel in our example of market segmentation, these wealthy families are willing to pay a lot more for a modest increase in perceived quality.  If those schools have large endowments and large numbers of full paying students, they can use that money to cross-subsidize and substantially reduce the cost for the limited number of less affluent students they desire to enroll.  On the other hand, students who have limited financial means and are not at the top of their class academically may opt for an approach that maximizes their return per dollar spent.  They might choose a slightly less prestigious institution that costs a lot less over of a more prestigious college which costs a lot more.  

A student’s peers will greatly influence him. The 1966 Coleman Report which looked at educational opportunity in public schools also emphasized that a peer group was more of a predictor of student performance than resource spending.  Other studies have shown that having a roommate with a high GPA resulted in higher GPAs for others in the same living environment.  These facts contribute to the desire of many to attend the most selective college that accepts them.

The college years are a time to make professional, social, and perhaps romantic associations. Many families are willing to pay for exposure to a desired group of people. One study showed that 28% of married college graduates on Facebook have married someone who attended the same college or university.  That doesn’t necessarily mean they met in college, but rather that they tend to travel in the same social circles.  Nevertheless, it does lead to more people now than in the past marrying someone with a similar level of education and similar earnings.  Today, 81% of those with a college degree who marry, choose a person who also has a college degree.  There is further sorting of those with advanced degrees.  One quarter of female physicians marry other physicians.  When two people with high levels of education and high earnings marry, there is more disposable income available to be spent on their children’s education.

So we have larger numbers of richer families that are willing to have their children travel greater distances from home looking for colleges with the highest absolute achievement level attainable and peers with whom they desire to have those children associate.  Add in a common application process which makes it easier to submit numerous applications and you get a tidal wave increase in the number of applications submitted to selective colleges.  Then factor in the nearly 400,000 undergraduates from wealthy international families willing to pay large sums of money for an American diploma and immersion in American culture and you have a further imbalance of demand exceeding the static and limited supply of seats available at highly selective colleges.  When demand exceeds supply, prices tend to rise.

So why don’t very prestigious colleges charge $200,000 a year for tuition?  There are undoubtedly a lot people that can afford the price and would be willing to pay it.  I think there are 2 main reasons it doesn’t happen.  One is because the colleges don’t want to scare away the middle and upper middle income students they feel are the best.  The other is to remain under the radar of public scrutiny.  I think Harvard and the University of Pennsylvania have seen recently the damaging consequences of bad press and congressional hearings.  I think one of the reasons that there has been no action taken to combat high tuition is because despite some grumbling, universities have been able to remain under the radar.  That, and the fact that the focus is on finding ways for others to pay the high price.

Rising college tuition sticker prices may be driven by the most selective schools but there is a ripple effect throughout higher education. So while a specific college may not be competing directly with the Ivy League, it is competing with a school which is competing with a school which is competing with Princeton. Johns Hopkins University competes with Ivy League schools. Boston University sees Johns Hopkins as its competition and Southern Methodist University (SMU) sees Boston University as its competition. Pepperdine competes with SMU. So is Pepperdine competing with the Ivy League? Not directly, but there are only a few degrees of separation from very selective colleges, and in a world where there is no objective measure of quality, cost becomes a measure of quality.  This causes consumers to be suspect of an education provided at a lower cost. In 2000, Ursinus College raised its tuition 17%.  It also increased its financial aid.  In four years, the number of freshman increased 35%. So Johns Hopkins raises its tuition to compete with Ivies.  If Johns Hopkins raises its tuition, then Boston University feels it must, too.  Then SMU and Pepperdine follow.  So down the line, nearly all private colleges raise their sticker prices.  One can say that he is not going to play the game of competing for admission to a selective college, but he will still feel the effect of their higher tuition.

”If we charge what it appears to be worth we'd be lucky to get sixpence,” he admitted. “Good business is when people perceive something to be valuable, and the best way to encourage this perception is by guiding their thinking.”

“You mean by charging outrageously?”

“Now wait a mo, Peekay, that’s not quite fair.  Value for money is when the customer is satisfied that he has made the right purchase decision, or do you disagree?” 

Those words, from the audiobook version of the power of one by Bryce Courtenay narrated by Humphrey Bower could easily have been written to describe college pricing. 

All in all, private nonprofit college pricing is related to what the customer feels the product or service is worth, not what it costs to provide the service plus a margin of profit.   The charge is based on the trendiness of the product and its scarcity.  In the case of admission to selective colleges both are high. There is scarcity because the number of seats at selective colleges has remained flat despite a population increase.  Pricing is related to the overall health of the economy which has been quite generous to the affluent in the United States and abroad. This has allowed selective colleges to charge more. Less selective colleges increase their official tuition so as not to appear to be of lower quality, though they do not collect fully the extra amount charged.  Add in individual pricing in which the college seeks to extract the maximum amount of money both in the present and future from applicants and their families and we see why tuition sticker price has increased so rapidly in private nonprofit four-year institutions.

Thank you for listening to Charging U. In this episode, we discussed how demographic trends have allowed private colleges to maximize the amount of money they can charge and collect from each individual student.

In the next episode, we will look at public colleges, varying state appropriations, and how those colleges are behaving in order to improve their incoming revenue. 

If you find Charging U informative, please subscribe and please, please leave a rating and review.  I welcome any feedback.  Please email comments to larry@chargingupodcast.com   Until next time, be well and be safe.