Are the Incentives of College Administrators Well Aligned with Social Welfare? Posner

A promising field of economics called organization economics studies the organization of activity within complex entities such as for-profit corporations, government agencies, and not-for-profit private corporations. Colleges and universities (which I’ll discuss interchangeably, calling both types of institution of higher education “university” because universities are generally larger and more influential) straddle these divides—there are public universities, private not-for-profit universities, and private for-profit universities. I’ll focus on the second—private not-for-profit universities. Public universities don’t seem much different from private not-for-profit ones, in part because in recent years many public universities have made sustained and successful efforts at raising money from alumni and foundations, lessening their dependence on state funding and as a result achieving considerable, in some cases virtually complete, autonomy. As for the for-profit universities, they presumably can be modeled as typical for-profit service corporations. That leaves the not-for-profit university, which plays a much larger role in American higher education than in higher education in other countries. Most of the wealthiest and most prestigious American universities are private. 

The differences between for-profit and not-for-profit institutions are not profound; we observe this in their coexistence in a number of fields, such as health care and education. The major difference is that for-profit institutions are financed in part by equity investment, in which the investors are compensated by ownership of any residual of revenue over cost—i.e., profit—while not-for-profit institutions are forbidden to distribute the residual to investors. They borrow, just like for-profit institutions, but the remainder of their capital consists of donations rather than of equity investment; the university’s endowment correspondents to the equity in a for-profit corporation. The residual goes in part to university administrators in the form of enhanced salary or bonuses and in part (usually in larger part) to expanding or improving the institution. 

Not-for-profits are more risk-averse than for-profits because their administrators cannot capture as much of the upside of risky investing as equity investors, and corporate executives, whose compensation is usually tied in one way or another to the corporation’s profitability, can. But competition forces even not-for-profits to take some risks, as we learned when the financial crisis that began in 2008 revealed the degree to which university endowments had been invested in high-rolling hedge and private equity funds. Competition for students and faculty forces university administrators to seek to maximize revenue and minimize cost. Competition is a pervasive socioeconomic phenomenon; it is not limited to businesses. 

The competitive pressures on universities can and often do result in a misalignment between private and social goals. From the standpoint of society as a whole, the goals of higher education are to enlarge general (as distinct from firm-specific) human capital by imparting valuable intellectual skills to young people of intelligence and ambition, and to produce research that generates mainly external benefits and so is underproduced by for-profit entities. And to a large extent, certainly, the universities work toward those goals, and with considerable success. But from the personal standpoint of a private university’s trustees and administrators, another goal is to maximize revenue (net of cost) and hence tuition income, donations, research grants, and income from consulting and patents—the grant money and income from consulting and especially patents being shared between faculty and university. The consequences of these endeavors include a high level of expenditures on student amenities (to attract rich kids), on intercollegiate sports (to stimulate alumni donations), and on faculty “stars” who can attract research grants and impress parents and alumni. Other consequences include light teaching loads for faculty stars as a form of untaxed compensation, student pandering (beyond provision of amenities) and so grade inflation, reduction in required courses, and proliferation of extracurricular activities—all being aspects of treating students as “consumers” to be pampered in partial compensation for high tuition and student debt and to encourage future donations. Still other consequences of endeavors to maximize revenue include recruitment of student athletes who may have no intellectual interests or promise, “legacy” admissions (discrimination in favor of student applicants who are children of alumni, especially wealthy alumni), and encouraging applied research (because it is patentable, as basic research is not). False advertising of job opportunities for graduates of graduate schools and professional schools (such as law) is also a not uncommon university marketing tool. 

From an overall social standpoint, therefore, there is a great deal of waste in the American university sector (as there is in most institutions), but it is not obvious to me what if anything should be done about it. I note, however, that there is a good deal of government subsidization of private universities, in the form of research grants but, more important, of below-market student loans. Government grants for basic research are defensible because, by definition, basic research generates only external benefits. Subsidizing tuition by means of below-market student loans makes less sense. If the loans, not being subsidized, were more costly, tuition would be lower; and promising students would still receive scholarships and low-cost loans, financed by the universities themselves, because universities want to have good students (along with student athletes, legacies, and “diversity” admits), to build reputation and attract good faculty. Many students who receive subsidized loans to enable them to go to college, but would not be subsidized by a university, would be better off not going to college. College is not for everyone.

 

 

 

 

 

Comments

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A bit peripheral -- but some enterprising UC doctoral student should study collusion among committee and sub-committee members of the NSF and NIH. I bet a lot of glass-ware would get broken.

[NEH]

"Incentives and Alignment with Social Welfare" or "Many students who receive subsidized loans to enable them to go to college, but would not be subsidized by a university, would be better off not going to college. College is not for everyone".

In my day it was called the "Grade Point Average" and everyone on campus lived or died by it. We had a saying, "Although, we're graduates from accredited state highschools and they have to accept us - it doesn't meant they have too keep us". As for controlling costs, you just got used to living in the "University Slums and eating oatmeal and grits on a regular basis"... ;)

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Posner writes: "From an overall social standpoint, therefore, there is a great deal of waste in the American university sector (as there is in most institutions), but it is not obvious to me what if anything should be done about it."

With all respect to Posner, the answer is obvious -- get the Federal government out of the business of subsidizing universities via student loan and grant programs. Such a reform would have at least two salutary results.

(1) Universities would have to stand on their own feet, rather than impoverishing their students, to maintain their finances.

(2) Students and their parents would never again have to fill out a damned FAFSA form.

The second point is not frivolous. When faced with a FAFSA form many years ago, I said to hell with that, and worked my way through college instead of becoming a ward of the Federal government and subsidizing the faculty lounge, while I ate oatmeal and grits. I still ate oatmeal and grits, but had the satisfaction of knowing the administrators and faculty at my college were not reaping the benefits of Federal funding that I would have to repay.

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Great analysis of the educational sector! Of course, not for profit organizations are more risk averse. Investors would not likely see incentives in investing on projects that would induce small gain for them. What these not-for-profit schools should do is raise educational standards. But then we are well aware of the fact that they cannot do that if there is not enough funds to develop infrastructures, lab equipment, libraries and of course labor (teachers and professors).

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I couldn't agree with you more. College definitely isn't for everybody which is why there is so much waste in the American university sector.

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I College Administrators were looking out for the welfare of society, then there would not be such flagrant gaming of the US News college rankings.

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They borrow, just like for-profit institutions, but the remainder of their capital consists of donations rather than of equity investment; the university’s endowment correspondents to the equity in a for-profit corporation.

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Vermont and Massachusetts - because they had nothing else to lose. It's always a dangerous thing to corner a minority into such a corner when that minority will no longer accept being so marginalized.

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