OPINION: Why competition isn’t always the answer to high college costs

Consumers almost always win when there’s increased competition. We all learned in Econ 101 that competitive markets force companies to innovate and economize, and generate the lowest possible prices. One would think that we could apply that principle to colleges and universities.

But the market for higher education is different from the market for milk. Competition among colleges actually lowers prices for higher-income students at the expense of higher prices for lower-income students.

Why does competition help in the market for milk but not in the one for higher education? You have many choices where to buy milk. Beyond fat content and organic varieties, it is largely the same wherever you buy it. Its price is determined by supply and demand. Sellers cannot charge more than the market price because nobody would buy from them. If firms are highly profitable, new ones enter, increasing competition and lowering the price.

This is what competition can accomplish.

As I explain in my book, that is not how the market for colleges works. Not all colleges are the same. “Consumers” (students and their parents) prefer some schools over others and are willing to pay more to attend them. This provides elite schools with tremendous market power. I teach my students that the presence of market power is bad for consumers.

For example, there is a reason your cell phone bill is so high. Verizon’s and AT&T’s market power inflates prices, increasing revenue and the companies’ profits at consumers’ expense.

Competition among colleges actually lowers prices for higher-income students at the expense of higher prices for lower-income students.

But market power in higher education offers an advantage — it enables colleges to charge different students different prices. Those who can pay more are charged more. This generates greater revenue. However, most higher educational institutions (and certainly all publicly subsidized ones) are nonprofit organizations. So, rather than pad their pockets, they use these increased revenues to lower prices for lower-income students.

That is called financial aid. Students’ completion of all those complicated forms is what enables colleges to determine how much to charge to whom.

Elite private colleges, which have the greatest market power, can charge the most to students from higher-income households. That generates more revenue. Investment returns from their large endowments further enhance their bottom lines. In combination, these advantages enable them to charge students from lower-income households less than elsewhere. At least, that is what we observe.

Public institutions, however, typically have less market power and struggle to make college affordable for lower-income students.

Related: Colleges provide misleading information about their costs

The bigger issue, though, is that states cap public institutions’ sticker prices below market levels, which reduces the schools’ revenue from higher-income students, limiting the money available for financial aid and thereby squeezing students from lower-income households. Direct state funding to public institutions could fill the gap, but those funds are inadequate.

Non-elite private institutions compete directly with public institutions. That limits how much these privates can charge higher-income students. Although they frequently advertise high sticker prices, they offer “merit awards” to all or most students, reducing the actual price that higher-income students pay.

Without large endowments or direct public funding, tuition-dependent private institutions also struggle to offer sufficient financial aid to lower-income students.

Competition across institutions generates other instances when students from higher-income families benefit at the expense of those from lower-income families. Consider true merit awards, offered to highly qualified students. They typically only benefit higher-income students. Meritorious lower-income students receive merit awards too, but those funds largely displace need-based aid. Once one institution adopts this approach to help attract those students who pay more, all institutions need to do so to compete.

The practice of “poaching” accepted high-income — and thus particularly desirable — students from other institutions has a similar effect.

In both cases, if all institutions engage in these practices, none of the competing institutions will have achieved a price advantage and enrollment patterns will likely not change. Revenue will be lost, though. In game theory, this is called a “prisoner’s dilemma.”

If schools stopped competing in these ways, their increased revenue could be used to provide greater financial aid.

If we want college to be affordable for all, we need a different approach.

Related: STUDENT VOICE: Doubling the Pell Grant will make college a reality for more students like me

The solution is unlikely to come from the institutions themselves. Private institutions with limited endowments do not have enough money to cut their prices for students from lower-income families. Public institutions are constrained by state policies focused on maintaining lower sticker prices. More direct funding from the states seems unlikely.

Our best hope for closing the college affordability gap is to double the value of the Pell Grant. Doing so would entirely close the gap at public institutions between what students from lower-income families can afford to pay and what they are currently asked to pay. It would also extend the reach of Pell Grants into the middle class. It is a more targeted solution than the “free college” proposals offered by some.

Students who take Econ 101 learn that government intervention in market outcomes only makes sense in limited situations. This is one of them.

Phillip Levine is the Katharine Coman and A. Barton Hepburn Professor of Economics at Wellesley College and the author of the book “A Problem of Fit: How the Complexity of College Pricing Hurts Students — and Universities.” He is also the founder and CEO of MyinTuition, a nonprofit organization that provides colleges and universities with a simplified financial aid calculator.

This piece about college costs was produced by The Hechinger Report, a nonprofit, independent news organization focused on inequality and innovation in education. Sign up for Hechinger’s newsletter.