Cutsinger’s Solution: The Price of Education

Question:

Is the following true or false? Explain your reasoning. 

If the quantity of higher education services supplied does not rise with the price of those services, i.e., if supply is perfectly inelastic, then subsidizing the demand for higher education services will primarily benefit universities and their employees.

Solution:

I use this question in my microeconomic principles class to get my students to think about the actual beneficiaries of a real-world policy that many of them likely believe is intended to benefit students. Whether the subsidy does benefit students, however, depends on how responsive the supply of higher education services is. In other words, the key issue is not the purpose of the subsidy, but what happens in the market when additional purchasing power is introduced.

The question asks us to assume that the supply of higher education services is perfectly inelastic—that is, colleges and universities offer a fixed number of seats or credit-hours no matter how high or low tuition is. A subsidy makes students willing and able to pay more, but because the quantity of education cannot increase, competition among students for a fixed number of spots drives tuition up rather than expanding enrollment. In this case, the price of higher education services rises by the amount of the subsidy.

Since the quantity is fixed and the price rises by the amount of the subsidy, universities capture the full benefit of the subsidy. The additional revenue accrues to universities rather than students and may show up as higher salaries and benefits for existing faculty and staff, expanded administrative spending, or other forms of institutional surplus. By contrast, students receive none of the benefit from the subsidy, since the price of higher education services rises without any increase in the amount of education provided.

Hence, the statement is true.

Of course, in reality, the supply of higher education services is not perfectly inelastic, especially in the long run. Colleges and universities can eventually expand enrollment by adding facilities or hiring additional faculty, but how quickly they do so depends on how easily key inputs can be expanded—some adjust relatively quickly, while others do not. As a result, supply is likely to be much less responsive in the short run than in the long run.

Several of the comments on the posted question raise these real-world considerations, but they do so by moving away from the assumption built into the question. The question explicitly asks us to assume that supply is perfectly inelastic. Once that assumption is taken seriously, the outcome is no longer ambiguous: when quantity is fixed, a subsidy that increases students’ willingness or ability to pay shows up as a higher price, not a larger quantity. Comments that appeal to capacity expansion, quality changes, or wage adjustments are therefore answering a different question—one in which supply is allowed to respond.

Likewise, questions about how additional revenue is distributed within universities do not affect the central result. Even if internal wages or employment do not change at all, the subsidy is still captured by universities in the form of higher tuition revenue rather than by students. And it is important to distinguish demand-side subsidies from policies that directly hold tuition below market levels. Only the former is relevant here: with a fixed number of seats, increasing students’ purchasing power simply bids up tuition.

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