## Sunday, November 21, 2010

### Why is paying for college a little (alot?) like buying a car? It is discrimination, I tell ya', discrimination in the first degree!

Tis the season for high school seniors to apply and get accepted to the college of their dreams.  Once accepted, then the reality of paying for it starts to set in.  I am always curious when financial aid offers start to roll in, even before students file the FAFSA form that tells students, parents and colleges what the student is expected to contribute towards tuition. No one seems to get the same offer, from the same school, with roughly the same qualifications.  My question is, does anyone REALLY know what the tuition rate is for ANY given college.  I know, they publish rates on websites and in brochures, but what do students actually end up paying?  Seems to me paying for college is like buying a car: there is a suggested price, but we all know no one pays the same price for the SAME car.  I believe colleges, like car dealers, use information to differentiate buyers (students) and extract as much money from each student as possible.
Let's use the example of Big Shot U ("BSU"--get it,  B.S. You).  BSU knows that their profit maximizing tuition rate is \$30,000 per year, Point "A",  on the graph below. Assume you and every other student knows this for sure. You have what is called "complete information" about the cost of attending BSU.
However, the demand curve ("Demand*") for BSU shows that many students (2,999) would actually pay something more than \$30,000 but less than \$60,000 per year to attend BSU. But because of "complete information" about the price of BSU, they know that they don't have to pay more than \$30,000.  Since they were willing and able to do so, then this group of 2,999 students reap what is called "Consumer Surplus". The area of Consumer Surplus is shown in blue in the graph below:

If it were only this easy.  Because the actual tuition price is not widely known, the college can attempt to capture some of this Consumer Surplus by gathering information about you and your ability to pay. Then, they can offer you a "scholarship" package to see how much surplus, if any,  they can transfer from you to themselves.  They do this through a variety of means--information on your application, demographics, your zip code, and most importantly, your FAFSA. Colleges do their best to "segregate" as many of those 2,999 students based on ability to pay and extract as much from each of them as possible.
Assume BSU calculates the first 1,000 applicants (horizontal axis is in thousands) will pay less than \$60,000 but as much as \$50,000. Of the 3,000 students they need to fill seats, they got 1,000 of them to pay much more than \$30,000.  BSU has captured some of that consumer surplus, illustrated below:
Now BSU goes to work on the next 1,000 (between 1,000 and 2,000) students and captures more surplus:

Now, to squeeze the Consumer Surplus out of the last 1,000 (between 2,000 and 3,000):
This sounds terrible, doesn't it? It is not uncommon. Businesses that are able to post vague prices can use information to segregate buyers and "price discriminate (car dealers, airlines, etc). Colleges would fall under the category of a First Degree Price Discriminator.
Why is this a smart idea?  If everyone paid \$30,000 in tuition then BSU's total revenues would be 3,000 X \$30,000 = \$90,000,000.  I will use imperfect calculations to show the change in revenues if they price discriminate---1,000 x \$50,000 = \$50,000,000, 1,000 x \$40,000 = \$40,000,000, and 1,000 x \$3,000 = 30,000,000. Total revenues in this case would be at the minimun \$120,000,000.  A \$30 million difference!!
Am I too cynical? I believe too much of the "scholarship" offers students recieve from colleges like BSU are a form of gamemanship to find out what your "reservation price" is.  I am not implying students don't deserve those scholarships but I believe the scholarships and their particular amounts serve a dual purpose.  I welcome respectful responses to back me up or tell me where I am going wrong... :)