Markets in Higher Education

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Markets in Higher Education

HIGHER EDUCATION DYNAMICS VOLUME 6 Series Editor Peter Maassen, University of Oslo, Norway, and University of Twente,

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MARKETS IN HIGHER EDUCATION

HIGHER EDUCATION DYNAMICS VOLUME 6 Series Editor Peter Maassen, University of Oslo, Norway, and University of Twente, Enschede, The Netherlands Editorial Board Alberto Amaral, Universidade do Porto, Portugal Akira Arimoto, Hiroshima University, Japan Nico Cloete, CHET, Pretoria, South Africa David Dill, University of North Carolina at Chapel Hill, USA Jürgen Enders, University of Twente, Enschede, The Netherlands Patricia Gumport, Stanford University, USA Mary Henkel, Brunel University, Uxbridge, United Kingdom Glenn Jones, University of Toronto, Canada

SCOPE OF THE SERIES Higher Education Dynamics is a bookseries intending to study adaptation processes and their outcomes in higher education at all relevant levels. In addition it wants to examine the way interactions between these levels affect adaptation processes. It aims at applying general social science concepts and theories as well as testing theories in the field of higher education research. It wants to do so in a manner that is of relevance to all those professionally involved in higher education, be it as ministers, policy-makers, politicians, institutional leaders or administrators, higher education researchers, members of the academic staff of universities and colleges, or students. It will include both mature and developing systems of higher education, covering public as well as private institutions.

The titles published in this series are listed at the end of this volume.

MARKETS IN HIGHER EDUCATION Rhetoric or Reality?

Edited by

PEDRO TEIXEIRA Research Centre on Higher Education Policies – CIPES, and Universidade do Porto, Portugal

BEN JONGBLOED Centre for Higher Education Policy Studies – CHEPS, University of Twente, The Netherlands

DAVID DILL University of North Carolina at Chapel Hill, USA and

ALBERTO AMARAL Research Centre on Higher Education Policies – CIPES, and Universidade do Porto, Portugal

KLUWER ACADEMIC PUBLISHERS DORDRECHT / BOSTON / LONDON

A C.I.P. Catalogue record for this book is available from the Library of Congress.

ISBN 1-4020-2815-6 (HB) ISBN 1-4020-2835-0 (e-book)

Published by Kluwer Academic Publishers, P.O. Box 17, 3300 AA Dordrecht, The Netherlands. Sold and distributed in North, Central and South America by Kluwer Academic Publishers, 101 Philip Drive, Norwell, MA 02061, U.S.A. In all other countries, sold and distributed by Kluwer Academic Publishers, P.O. Box 322, 3300 AH Dordrecht, The Netherlands.

Printed on acid-free paper

All Rights Reserved © 2004 Kluwer Academic Publishers No part of this work may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, microfilming, recording or otherwise, without written permission from the Publisher, with the exception of any material supplied specifically for the purpose of being entered and executed on a computer system, for exclusive use by the purchaser of the work. Printed in the Netherlands.

TABLE OF CONTENTS

List of Contributors

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Preface ALBERTO AMARAL AND PETER MAASSEN

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Introduction PEDRO TEIXEIRA, BEN JONGBLOED, ALBERTO AMARAL AND DAVID DILL

1

Markets in Higher Education: Do They Promote Internal Efficiency? WILLIAM F. MASSY

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Cost-sharing and Equity in Higher Education: Implications of Income Contingent Loans D. BRUCE JOHNSTONE

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Transparency and Quality in Higher Education Markets DAVID D. DILL AND MAARJA SOO

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Regulation and Competition in Higher Education BEN JONGBLOED

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The Evaluation of Welfare Under Alternative Models of Higher Education Finance GERAINT JOHNES

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Higher Education Policy as Orthodoxy: Being One Tale of Doxological Drift, Political Intention and Changing Circumstances GUY NEAVE

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Market Coordination of Higher Education: The United States ROGER L. GEIGER

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‘Madly Off in all Directions’: Higher Education, Marketisation and Canadian Federalism GLEN A. JONES AND STACEY J. YOUNG

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Australian Higher Education: National and Global Markets SIMON MARGINSON

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The Higher Education Market in the United Kingdom GARETH WILLIAMS

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Rapid Expansion and Extensive Deregulation: The Development of Markets for Higher Education in the Netherlands CARLO SALERNO

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Is There a Higher Education Market in Portugal? PEDRO TEIXEIRA, MARIA JOÃO ROSA AND ALBERTO AMARAL

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Higher Education and Markets in France THIERRY CHEVAILLIER

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Conclusion DAVID DILL, PEDRO TEIXEIRA, BEN JONGBLOED AND ALBERTO AMARAL

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Glossary

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LIST OF CONTRIBUTORS

ALBERTO AMARAL is professor at the University of Porto and director of CIPES. He is chair of the Board of CHER, vice-chair of EUA’s steering committee on institutional evaluation, life member of IAUP, and a member of EAIR and IMHE. Recent publications include articles in Quality Assurance in Education, Higher Education Quarterly, Higher Education Policy, Higher Education in Europe and European Journal of Education. He is editor and co-editor of several books, including Governing Higher Education: National Perspectives on Institutional Governance (2002) and The Higher Education Managerial Revolution? (2003) in this series. THIERRY CHEVAILLIER is senior lecturer in economics at the University of Bourgogne (Dijon, France) and a member of IREDU, Institute for Research on the Economics of Education. His research interests are higher education finance and resource allocation in higher education. He has been involved in several international comparative studies on various aspects of higher education in Europe and is an expert to Eurydice. He is a member of the Consortium of Higher Education Researchers (CHER). DAVID D. DILL is professor of public policy and director of the Research Program on Public Policy for Academic Quality (PPAQ) at the University of North Carolina at Chapel Hill. His research interests include regulation in higher education, policy design and the ethics of public policy. He has published numerous books and articles on higher education and serves in an editorial capacity on the Journal of Higher Education, Higher Education Policy and Quality in Higher Education. He is a member of the Board of the Consortium of Higher Education Researchers (CHER), a life Fellow of the Society for Research in Higher Education (SRHE) and a member of the Association for the Study of Higher Education (ASHE) and the Association for Public Policy and Management (APPAM). ROGER L. GEIGER is distinguished professor of higher education at Pennsylvania State University and head of the Higher Education Program. His study, Knowledge and Money: Research Universities and the Paradox of the Marketplace, will be published by Stanford University Press in 2004. His volumes on American research universities in the 20th century, To Advance Knowledge and Research and Relevant Knowledge are being published in new editions by Transaction Publishers in 2004. In 2000 he published The American College in the Nineteenth Century (Vanderbilt UP) and since 1993 he has been editor of The History of Higher Education Annual. GERAINT JOHNES is professor of economics at Lancaster University Management School, UK. He is the author of numerous articles in journals such as the Economic Journal, Oxford Economic Papers and the Oxford Bulletin of Economics and Statistics, and also of four books, including The Economics of Education (Palgrave vii

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1993). He has also edited two books of readings: Recent Developments in the Economics of Education (Edward Elgar 1993) with Elchanan Cohn, and the International Handbook on the Economics of Education (Edward Elgar 2004) with Jill Johnes. He is consultant to the World Bank, OECD and the British Department for Education and Skills. D. BRUCE JOHNSTONE is university professor of higher and comparative education at the State University of New York at Buffalo, where he is director of the Center for Comparative and Global Studies in Education and the International Comparative Higher Education Finance and Accessibility Project. His teaching and research interests combine economics, finance and governance of colleges and universities in both domestic and international contexts. He has served as vicepresident for administration at the University of Pennsylvania, president of the State University College at Buffalo and chancellor of the State University of New York, the latter post from 1988 to 1994. GLEN A. JONES is associate professor of higher education and associate dean of the Ontario Institute for Studies in Education at the University of Toronto. His research focuses on higher education policy, systems and governance, including work supported by the Social Sciences and Humanities Research Council of Canada and numerous Canadian and international organisations. He is a former editor of the Canadian Journal of Higher Education, a past president of the Canadian Society for the Study of Higher Education, and in 2001 received the Society’s Research Award for his contributions to higher education scholarship in Canada. BEN JONGBLOED is a senior researcher at the Center for Higher Education Policy Studies (CHEPS), University of Twente, the Netherlands. Since joining CHEPS in 1993 his research has concentrated on the theme of higher education economics. He has written extensively on topics such as funding methodologies, student financial support, marketisation, financial management and per student costs. He currently serves on the Board of the Consortium of Higher Education Researchers (CHER). SIMON MARGINSON is a professor of education and director of the Monash Centre for Research in International Education at Monash University, Australia. The holder of an Australian Professorial Fellowship, his work is focused on the trajectories of the research university in the global environment. Current research projects include national and global education markets, the social and economic security of cross-border students, university networking and social capital, and technological innovation in higher education. His book, The Enterprise University (Cambridge UP 2000) with Mark Considine, won an American Educational Research Association publication award in 2001. WILLIAM F. MASSY is president of The Jackson Hole Higher Education Group, Inc., and an emeritus professor at Stanford University. He earned tenure as professor of business administration, then moved to Stanford’s central administration as vice provost for research and later vice president for business and finance. In 1987 he

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became a professor of higher education and founded the Stanford Institute for Higher Education Research where he worked on education quality, resource allocation, finance and mathematical modelling of universities. From 1996 to 2002, Dr Massy directed the National Center for Postsecondary Improvement’s project on educational quality and productivity. From 1991 to 2003 he served on Hong Kong’s University Grants Committee. His book, Planning Models for Colleges and Universities (Stanford UP 1981) with David Hopkins, received the Operations Research Society of America’s Frederick W. Lanchester Prize for 1981, and in 1995 he received the Society for College and University Planning’s annual career award for outstanding contributions to college and university planning. His modelling work continued with Virtual-U, a simulation game for teaching about universities as systems, supported by the Alfred P. Sloan Foundation and released in 2001. In 1996 he published Resource Allocation in Higher Education (University of Michigan Press) which introduced the idea of ‘value responsibility budgeting’. His most recent book, Honoring the Trust: Quality and Cost Containment in Higher Education (Anker Publishing Co. 2003), presents an action plan for boosting quality without increases in spending. GUY NEAVE is director of research at the International Association of Universities Paris, and professor of comparative higher education policy at the Center for Higher Education Policy Studies (CHEPS), University of Twente, the Netherlands. Foreign associate of the National Academy of Education of the United States and editor of Higher Education Policy, he taught history before moving over to education policy many moons ago. He lives on the far western edge of the Paris Basin at St Germain en Laye and is not a football supporter. MARIA JOÃO ROSA is assistant teacher at the University of Aveiro and a researcher at CIPES. She was awarded a PhD by the University of Aveiro (Portugal) in December 2003, with a thesis entitled Defining Strategic and Excellence Bases for the Development of Portuguese Higher Education. Her main research topics are quality management and quality assessment in higher education institutions and the internationalisation of the Portuguese higher education system. Recent publications include articles in journals such as Quality Progress, Total Quality Management and Higher Education Quarterly. CARLO SALERNO is a senior research associate at the Center for Higher Education Policy Studies (CHEPS) at the University of Twente in the Netherlands. His research focuses on the economics of higher education with special attention to issues surrounding university productivity and costs as well as the behaviour of institutions as non-profits. Since coming to CHEPS in 2001, he has authored or coauthored a number of monographs and papers in the areas of higher education privatisation, funding, per-student cost estimation and efficiency. MAARJA SOO is a doctoral student in public policy at the University of North Carolina at Chapel Hill. She graduated with a BA in political science and a masters degree in public administration from the University of Tartu in Estonia and she

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followed a graduate programme in political philosophy at the University of Oxford in the UK. Before her PhD studies in the US, she worked for several years in a public policy think tank in Estonia. Under the sponsorship of the Open Estonia Foundation she was one of the founders of PRAXIS, the first independent think tank in Estonia. At the UNC-Chapel Hill, she is involved in the Research Program on Public Policy for Academic Quality (PPAQ). Her research interests lie in higher education funding, in particular, in performance funding mechanisms in higher education. PEDRO TEIXEIRA is assistant professor at the Department of Economics (University of Porto) and researcher at CIPES (Portuguese National Research Centre on Higher Education Policy) and CEMPRE (Research Centre on Macroeconomics and Forecasting, University of Porto). He is also affiliated with IZA (the International Network of Labour Economists) and with PROPHE (Program of Research on Private Higher Education). He has collaborated with CIPES since its foundation in 1998 on various research projects and has published on various aspects of higher education policy, notably on markets and privatisation in higher education (with special attention to the Portuguese case) and on the history of economic thought namely on the history of human capital theory and the economics of education. GARETH WILLIAMS is emeritus professor of education administration at the Institute of Education, University of London where he was founding head of the Centre for Higher Education Studies. Most of his work has been concerned with the economics of education and education policy. In recent years he has concentrated particularly on the finance of higher education and has written many books and articles on the subject. He has previously worked for Lancaster University, the London School of Economics, Oxford University and the OECD. Books include: Financing Higher Education: New Patterns (OECD 1990); Changing Patterns of Finance in Higher Education (Open University Press 1992); The Enterprising University (Open University Press 2003). STACEY YOUNG earned her PhD in higher education from the Department of Theory and Policy Studies in Education, Ontario Institute for Studies in Education at the University of Toronto (OISE/UT). Her scholarly interests include the study of the emergence of markets in higher education, in Canada and internationally, the politics of higher education in Ontario and Canada, and higher education in the ancient world. She has worked in a variety of capacities in higher education and government, including special assistant to the president of the University of Toronto, and policy research analyst for the Ontario Ministry of Training, Colleges and Universities.

PREFACE

Hedda is a European consortium of nine centres and institutes devoted to research on higher education. At its foundation in January 2001 it was decided that Hedda, in collaboration with CIPES, its Portuguese associated centre, would promote the further development of the field of higher education studies through organising a series of annual high level seminars, named the Douro seminars. At each seminar prominent researchers present a research-based manuscript and debate the state-ofthe-art research on a specific higher education policy issue. The manuscripts and the results of the debates are published by Kluwer Academic Publishers in the book series called Higher Education Dynamics (HEDY). And paying tribute to the regularity of the seminars it was decided that the volumes originating from the Douro initiative will be collected in a ‘series in the series’ called the Douro Seminars of Higher Education Research (DOSHER). The first seminar was dedicated to Governance Structures in Higher Education Institutions. The seminar was held along the banks of the Douro River, Portugal, on 13–17 October 2001. The second seminar contemplated the Emergence of Managerialism in Higher Education Institutions and took place at the same location on 4–9 October 2002. The third seminar focused on Markets in Higher Education and was held on 2–6 October 2003. The 2004 seminar (2-6 October and once more at the same location) will be dedicated to a debate on Cost Sharing and Accessibility in Higher Education. The present volume contains the edited versions of the manuscripts presented at the third Douro seminar and examines the concept of market and its role in higher education. This is a very timely theme as the role of the market has become a recurrent issue in higher education debates. This is the case even in those systems traditionally monopolised by public provision and support of higher education. Nevertheless, this process is lacking some systematic treatment on the implications of promoting market mechanisms of regulation. And, in the field of higher education studies the impact of recent moves towards the use of market mechanisms in higher education did not receive the attention it ought to have, namely from an economic perspective. Therefore, this book aims to fill part of this gap by presenting a more systematic and comparative analysis of recent moves in Western higher education systems towards market regulation. This book brings together leading experts on the economics of higher education from seven countries to analyse the impact of market mechanisms on their higher education systems. Massification of higher education has led to increasing costs of the system, a burden that according to governments can no longer be carried only by the public purse. This has resulted in a decrease of the state contribution per student and a rise in public awareness of the need to improve the efficiency of higher education institutions so as to offset the effects of reduced funding on the quality of educational provision. Therefore, a number of governments are experimenting with xi

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the use of market-like mechanisms as instruments of public policy, aiming at maximising the social benefits of national higher education systems. However, important questions remain unanswered about this application of market-based policies to higher education. In this volume the initial theoretical chapters offer an analysis of the effects of market and government failures, and of the difficulties linked to the use of quasi-markets in which the ‘essential ingredients’ of markets are only partially introduced to promote market behaviour among public institutions. The book discusses the increasing role played by markets in the provision, coordination and organisation of higher education. In the first part some of the contributors analyse the implications and impact of introducing market mechanisms at a more theoretical and comparative level. The topics covered in this first part include the following dimensions through which market mechanisms can be expected to affect higher education systems and institutions: internal efficiency of higher education institutions, quality and informational issues in higher education markets, cost-sharing and access to higher education, privatisation and public provision of higher education, deregulation and competition in higher education. The authors present a dispassionate and ideologically neutral view of the advantages and disadvantages of the introduction of market-mechanisms in higher education and of its effects in terms of access, equity, quality of provision, student learning, research and scholarship, and so on. And they balance the performance of markets in higher education against the alternative of more, or a different kind of, governmental intervention. Empirical evidence on the increasing role of markets in higher education and their positive or negative consequences is documented through a series of country case studies of recent reforms in the higher education systems of mature economies. The national case studies explore the achievements and shortcomings of those policies attempting to enhance the role of markets in higher education. In order to promote a more fruitful comparative approach, the national case studies cover a set of common topics, though each contributor introduces some additional aspects relevant for each country. The national case studies are the following: the United States, Canada, Australia, the United Kingdom, the Netherlands, Portugal and France. In the conclusion to this volume, the common themes emerging from these national perspectives are presented and analysed, and an agenda for future research is discussed. We hope that this volume will become an indispensable reader for all those interested in higher education policies, especially those more directly concerned with the application of market-based policies to higher education. We are grateful to all who have made the third Douro seminar and book possible, namely Amélia Veiga at CIPES and Therese Marie Uppstrøm at Hedda, the perfect organisers of the Douro seminars. We are also grateful to Di Davies for her editorial work. We have appreciated the diligence of all our colleagues who have contributed to this volume with their papers, comments and editorial suggestions, and we certainly noticed their forbearance in replying to our tedious editorial demands.

PREFACE

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We want also to acknowledge the financial support from Fundação para a Ciência e Tecnologia, of the Portuguese Ministry for Science and Higher Education, making possible the organisation of this third Douro seminar. We are also grateful to the Fundação Luso-Americana that has supported the participation of William Massy and Bruce Johnstone. And last, but not least, we acknowledge once more the superb environment provided by the management of Vintage House Hotel on the banks of the Douro river. Alberto Amaral Matosinhos and Peter Maassen Oslo June 2004

PEDRO TEIXEIRA, BEN JONGBLOED, ALBERTO AMARAL AND DAVID DILL

INTRODUCTION

All across the world, higher education has become a large enterprise. The use of the word enterprise is intentional here, since not only have governments, students and private businesses invested increasing amounts of public and private resources in the sector, one can also observe a more ‘business-like’ approach in the way the higher education sector is managed (Amaral, Meek and Larsen 2003). The massification of higher education – a phenomenon describing the increasing popularity of undertaking a higher learning programme – has led to a significant share of higher education expenditures in public budgets and to problems in the steering and management of universities and colleges. In short, the political pressures for the control of public funds invested in the higher education system and the need to invent more effective and accountable models of organisation and management for the system have become prominent items on the agenda of policy makers and administrators. With the opportunity of further reductions in public spending diminishing because of the fear of deterioration of the quality of education and research, the need to reform the relationships between higher education institutions and their various clients and sponsors is apparent. What options are available to steer our still heavily subsidised universities and colleges in directions that comply with the public interest? In this context one can observe a change in the traditional role of government in many Western European countries (Neave and Van Vught 1991). The authority of government, its mode of collective decision making, its use of command and control steering approaches, the budget mechanism and the monopoly of state-run higher education institutions are increasingly being questioned. As a consequence, new and less hierarchical relationships between government and higher education providers have emerged and governments and administrators have started to experiment with more market-oriented steering and organisation models. However, these types of innovations have their own problems and the role of ‘the market’ nowadays is often debated. This is the case even in those systems that traditionally relied heavily on public provision and public support of higher education. This book aims to contribute to a more systematic analysis of the implications of introducing marketoriented mechanisms in the steering, funding and organisation of the higher education sector. The analysis is carried out primarily from an economic perspective. Moreover, the contributions presented in this book take the reader to various national systems, enabling a comparative analysis to be carried out of some 1 P. Teixeira, B. Jongbloed, D. Dill and A. Amaral (eds), Markets in Higher Education: Rhetoric or Reality, 1–12 © 2004 Kluwer Academic Publishers. Printed in the Netherlands.

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of the recent moves undertaken by various governments to inject market forces into their national higher education systems. 1. SOME FREQUENTLY USED TERMS AND CONCEPTS A discussion of the growing role of the market in higher education systems requires a definition of some of the key concepts related to market mechanisms. Instead of boring the reader with a large number of definitions, we have compiled a glossary (located at the back of the volume) that lists the definitions for some of the basic economic terms, such as, markets, types of efficiency, public goods, externalities, information asymmetry and types of competition. These terms feature prominently in the chapters contained in this volume. What most of us will remember, either from our introductory courses in economics, from reading the popular press or listening to debates on reform in the public sector, is the concept of the invisible hand, the metaphor popularised in economic thought by Adam Smith (1977), to describe what we nowadays call the market mechanism. Economists have elaborated on this metaphor, particularly with respect to the most important characteristic of the market mechanism, that is, efficiency. The utility-maximising behaviour of persons and the profit-maximising behaviour of firms will, as through an invisible hand, distribute goods in such a way that no one could be better off without making someone else worse off. A market is a powerful allocation system that produces – what economists call – a Paretoefficient allocation of goods. However, from welfare economics it is known that reality corresponds rarely to the assumptions of the idealised market model. Markets do not always produce the optimal outcome from a society’s point of view. Some markets can persistently produce too much, or too little, of goods and services, challenging the self-regulating capacity that economists usually associate with a market mechanism, that is, the capacity to adjust to situations of excessive or insufficient supply (or demand). This is a case of market failure. Classic examples of market failure are found in the case of public goods, the existence of externalities (spillovers), information asymmetry or monopoly powers. With the exception of the first (i.e. public goods), all of these examples are relevant for higher education (Johnes 1993). First, individuals making decisions on investing in higher education do not take into account the fact that their training will affect the functioning and wellbeing of others in a positive way. The same holds for firms investing in research (or R&D). Both examples point to an under-supply of higher education and research from society’s point of view. Secondly, one encounters information-related problems in the higher education sector when it comes to assessing the outcome (including the quality) of the efforts of academics and students. Imperfect information also shows up in the student loans market, where information asymmetries exist between students taking up loans and banks (or government agencies) that supply loans. Thirdly, while natural monopolies may not exist in the case of higher education, market power may be concentrated in a select number of providers, causing them to behave like a cartel and to erect barriers to entry for potential new providers.

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These examples of market failure provide the traditional economic rationale for government intervention (Wolf 1993). Government intervention takes the shape of public production, the provision of government subsidies and the issuing of laws and regulation. Government intervention may also work to introduce sufficient incentives to ensure that providers reveal the quality of their services and students express clearly their demands and capacities. Information is a vital ingredient for any market. Government ‘watchdogs’, for instance, are charged to oversee markets, enforcing regulation to prevent collusive practices or monopolies and to promote a market structure without unjustified barriers for potential new providers entering the market. Public production of higher education takes place when public organisations provide teaching and research on behalf of the government. When production partly takes place in private institutions, government (or government agencies) will often ‘buy’ education and research on behalf of society (i.e. the students, etc.). This is the case when the costs of higher education and research are partly met through government subsidies. The remainder of the costs are met by private contributions, such as tuition fees. The performance of a market – be it a free market, a heavily regulated (command) system or some mixed system – cannot be assessed solely on the basis of the efficiency criterion. Equity constitutes another important reason for government intervention; it addresses the question of whether the market produces an allocation that meets society’s requirements for justice (e.g. equality of opportunities). It must be acknowledged that the equity issue is the focus of much debate, namely, in terms of the concept of justice and its identification with equality of opportunities (see, e.g., the well-known work of John Rawls 1999). Clearly, this is a normative issue: the decision made depends on people’s values on issues of distributive justice, etc. The central problem lies in the unequal bargaining power and opportunities of individuals, often caused by an uneven distribution of income and wealth in society. When it comes to the higher education market, one of the major goals of government intervention is to provide equal opportunities to all qualified individuals who wish to participate in a higher education course. Equity is concerned with the distribution of educational outcomes, for example, whether poorer people end up with fewer qualifications and, as a result, with lower incomes (Barr 2001). In order to also protect the interests of future generations, it is in the interest of society that talents are not wasted and that people wishing to develop their talents are not restricted by factors such as parental income. Access policies not only consist of student subsidies, grants and loans, but also include regulation to prevent discrimination, as well as mechanisms to raise the aspiration levels for those who traditionally do not consider investing in higher education. Education – of all types and at all levels – is characterised by large government subsidies and many government regulations. Although no one questions a role for government, there is a real possibility that government interference impedes incentives for quality, efficiency, differentiation and innovation. Thus, while the market may fail, there is a possibility that government may fail as well (Wolf 1993). When studying the equity and efficiency effects of introducing markets and

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competition in higher education, one therefore will continually be confronting tradeoffs. Faced with this challenge, many governments and policy makers have ended up with – or ‘stumbled upon’ – quasi-markets (Le Grand and Bartlett 1993; Dill 1997) in their struggle to reach a compromise. In a quasi-market situation, decisions on demand and supply are coordinated using ‘market-like’ mechanisms in which only some of the ‘essential ingredients’ of markets (Jongbloed 2003) are introduced – often gradually. This is done in an attempt to simulate market behaviour among public institutions, as in the creation of internal markets. Government regulation and financing will still remain important coordination mechanisms, but elements of competition, user charges, individual responsibilities and freedom of choice are injected into the system. The quasi-market concept is used more widely in public policy and regulation studies compared to (micro-) economic theory. Nevertheless, we believe that it could be usefully applied to the higher education sector, since it points to the complex interaction between market elements and the strong regulatory power of government. We hope that this book illustrates the value of using this analytical category in economic analyses of higher education. Table 1 lists some of the ingredients, or basic conditions, of markets. Using the eight conditions, marketisation policies can be defined as policies that try to establish or enhance the eight ‘kinds of market operation freedom’ for providers and consumers in the higher education sector. The conditions stress the promotion of consumer sovereignty as well as producer sovereignty; in other words, autonomy, open markets and well-informed decentralised decision making are the key elements in marketisation policies. Table 1. Eight conditions for a market ‘Four freedoms’ for providers Freedom of entry Freedom to specify the product Freedom to use available resources Freedom to determine prices

‘Four freedoms’ for consumers Freedom to choose provider Freedom to choose product Adequate information on prices and quality Direct and cost-covering prices paid

Source: Jongbloed 2003: 114

The chapters contained in this book will show that, in today’s modern economies, governments have experimented with introducing several of the elements into the various sub-markets that exist in the higher education system, such as, the markets for undergraduate students, postgraduate students, international students, academic staff, research grants, scholarships, donations, etc. The introduction of quasi-markets in higher education is a combination of three main vectors. The first is the promotion of competition between higher education providers. The second is the privatisation of higher education – either by the emergence of a private higher education sector or by means of ‘privatisation’ of certain aspects of public institutions (cf. Teixeira and Amaral 2001). And the third is the promotion of economic autonomy of higher education institutions, enhancing

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their responsiveness and articulation to the supply and demand of factors and products. 2. FRIEDMAN AND THE MODERN DEBATE ON EDUCATION MARKETS The classic modern statement on the importance of markets in (higher) education rests with Milton Friedman (1962). Friedman, in his reassessment of the economic and social role of the state, recommended the use of market mechanisms in many activities for which this was unusual, especially in education. Although he acknowledged the important externalities associated with education, and the financial role that the state should take in this sector, he challenged the provision of these services by the state. Accordingly, Friedman states the classic criticisms of the public provision of education by the state. One of them is the poor efficiency of a system monopolised or quasi-monopolised by the state, based on a situation of uniformity in wages that prevents performance payments. This situation is considered to restrict the say students have over their education, while at the same time discouraging private contributions (by students or their parents). The system where government subsidies flow directly to the providers of education has – in Friedman’s view – led to less responsive institutions that are under-funded and less adapted to the demands of society. A system of vouchers, where government funding flows directly to students (and from them to the institutions), would create more competition between institutions and lead to more efficient use of resources. Such a system might be supplemented by students through fees and other private contributions. While the Friedman model primarily targeted basic education, it could easily be extended to higher education. This classic argument launched the debate on the feasibility of applying market mechanisms to the provision of higher education. The debate has devoted some attention to the specificities of higher education that are visible in both the demand and the supply side. On the supply side, one sees in general only a small role being played by private providers of higher education.1 If private higher education institutions do exist they mostly are of the not-for-profit kind. Furthermore, higher education institutions seem to pursue multiple objectives that are difficult to reconcile with the demands of market efficiency. The entry of providers to the market is highly regulated, with strict controls over the activity of private providers, in some cases even stricter than for public providers. In addition, it is argued that consumers of higher education do not freely choose the product, and instead are forced to choose from options pre-selected by the regulating authority. In the higher education market, prices rarely play the allocative, signalling and rationing roles that they are supposed to play in textbook examples (Jongbloed 2004). This is due to the low level of fees paid by students, or a complete absence of tuition fees. On the demand side, one of the important features that according to pro-market advocates causes inefficient allocations is the fact that often the purchaser of a degree programme differs from the consumer. The government is paying for (most

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of) the costs of education and the consumers – the students – are not confronted with the costs of their decision to go to college. This has led some to argue for a shift from indirect funding to funding through consumers. In other words, a system of demand-driven funding instead of supply-driven funding is part of the repertoire of market advocates. Furthermore, when it comes to the demand side, the choice of a degree programme is a peculiar one. It is a one-off choice, with very high costs to revert, and a choice that can transform the product by changing the preferences and tastes of other consumers of higher education (since one can reasonably regard higher education as a customer-input technology in which the calibre of one’s fellow students may affect the quality of one’s learning (see Rothschild and White 1995)). On the same note, higher education is a so-called experience good: consumers can determine the quality only through consumption. This fact points to imperfect information on the side of students and may contribute to distortions in decision making. 3. CONTINUING THE DEBATE Despite the fact that many of the essential ingredients of markets are not in place for higher education, market-type coordination mechanisms are becoming increasingly popular in higher education policy making (Dill 1997). Their emergence in particular can be observed in the area of funding. As we will see later in this book, voucher schemes and other more demand-driven funding mechanisms are the subject of debate and policy experimentation in some countries. Mechanisms of competitive funding for academic research have become widespread and in the future might become a reality for other parts of academic life, such as, the provision of particular types of programmes (masters or professional degrees). At the same time, the level of tuition fees has become a contentious issue in many systems of higher education. The system of free (or almost free) higher education based on public support has been criticised on the grounds of efficiency and equity. It is argued that students are the main beneficiaries of the degrees, hence they should bear a larger part of the costs of its provision. Moreover, from the late sixties onwards (see Hansen and Weisbrod 1969), there has been significant controversy on the possible regressive effects of low or non-existent tuition fees. Many countries have moved towards some direct form of contribution from students and their families, although the amount still varies significantly across countries. Cost-sharing is the term often used to describe different forms of direct charging for education services (Johnstone 1986). Direct charging is seen as a way of affecting student decisions (i.e. affecting allocation) as it makes clear to students that higher education leads to a private benefit. However, direct charging is also a way of raising revenue. This increasing financial participation of students and their families has also been associated with more complex, and in many cases more demanding, forms of student support (notably the trend of replacing grants with loans). The rising costs of higher education systems have also contributed to experiments in funding that increase competition between higher education institutions (Johnes 1993). One of the experiments was the application of auction-

INTRODUCTION

7

type mechanisms.2 There have been some proposals and small-scale attempts to develop experiments with voucher mechanisms in the US and the UK, but for various reasons the attempts were not extended to the higher education level. However, debates in the Netherlands and Australia lead one to expect that demanddriven funding will become an option that will receive increased attention in the coming years. Therefore, it is important to discuss the reasons for strong resistance and the specific type of problems vouchers pose in higher education. This debate on demand-driven versus supply-driven funding mechanisms for higher education often coalesces with the promotion of wider choice, the possibility of market-type accountability and the reduction of government interference in higher education. Those advocating a supply-driven system base their position on arguments about students being immature consumers, on the absence of sufficient and reliable information about services on offer, on enhanced policy effectiveness and coordination of the higher education system, and on better performance in terms of equity in the provision of higher education. They argue that pro-market policies might result in unfulfilled expectations of improved quality alongside serious detrimental effects, pointing out that these policies would increase polarisation in higher education, with growing inequality between institutions and between socioeconomic and ethnic groups. Several of these issues deserve detailed discussion and a serious assessment of their relevance for higher education systems. In many countries, governments have asked institutions to compete for students, research funds and funds tied to specific goals. Some countries have started funding institutions on the basis of contracts and business-like output targets, notably focusing on completion rates and the average length students take to complete degrees. This competitive environment has triggered important developments within higher education institutions, especially since alongside these developments there was in many countries a strengthening of institutional autonomy. The latter was supposed to provide the institutions with an enhanced capacity to face financial stringencies and new demands while strengthening organisational innovations. This is reflected, among other things, in the staffing and human resources policies of institutions, the outsourcing of several activities, and the setting up of subsidiary businesses and partnerships with private companies (Williams 1991). This was done in order to reduce inefficiencies, to generate additional revenues and to create innovative organisational models. Some of these initiatives have led to new institutional dynamics. The changes have impacted on management practices (Amaral, Meek and Larsen 2003), resource allocation within institutions and the internal evaluation of procedures and services. Since most of these changes occurred in a context of decreasing resources, it was necessarily a difficult process, punctuated with internal tensions. The assessment of these changes is complex, and sometimes highly controversial. Several have voiced concerns over these developments, maintaining that they have contributed to organisational fragmentation, increased administrative bureaucracy or even led to an identity crisis (Barnett 1990). Others have counterargued that there have been significant achievements in terms of cost reductions and increases in teaching and research output quality.

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It is worth debating these developments and discussing the extent to which the market has contributed to a higher education system that is stronger in terms of efficiency, equity, quality and responsiveness. 4. THE MANY PATHS TOWARDS THE MARKET – THE CONTENTS OF THIS BOOK This volume discusses the increasing role played by market mechanisms in the provision, steering and organisation of higher education. The first part of the book covers the implications and impact of introducing market mechanisms at a more theoretical and comparative level. In the second part, a series of national case studies complements the debate by exploring the achievements and shortcomings of those policies in national contexts. In order to promote a more fruitful comparative approach, the national case studies were written to cover the topics listed in table 1 (above), though each contributor introduces some additional aspects relevant to the country in question. In the initial chapters some of the main implications of market regulation in higher education are covered. In chapter 1, Bill Massy discusses one of the main arguments for the introduction of market mechanisms in higher education systems, that is, the promotion of efficiency. He focuses on the effect of market regulation in terms of the internal efficiency of higher education institutions. He explores the potential efficiency gains that can be brought about by market regulation, though, as he rightly points out, the non-profit nature of higher education institutions requires theoretical adjustments and introduces further complexity in the traditional microeconomics of the firm. In chapter 2, Bruce Johnstone, who analyses the issue of cost-sharing, corroborates this increasing pervasiveness of economic analysis in terms of higher education policy. The realisation of significant private benefits has led many, economists and others, on grounds of efficiency, to call for a diversification of the funding structure of higher education, namely, through stronger participation of students and their families. This has been particularly apparent in recent years for many European systems, traditionally largely subsidised by public sources. These systems transformed from elite systems into mass systems with sometimes more than 50% of the relevant age cohort participating in higher education. Johnstone analyses the case of student loans, which became one of the most popular mechanisms of cost-sharing, and its implications in terms of equity for higher education systems. His discussion highlights that cost-sharing is as complex as it is inevitable from a higher education policy point of view. One of the main conditions for an efficient and effective functioning of market mechanisms in the allocation of resources is the availability of sufficient and reliable information. The better this condition is fulfilled, the better the market will function. David Dill and Maarja Soo in chapter 3 explore this topic, which has attracted significant attention in micro-economic theory since the seventies. They suggest that the characteristics of higher education and its production can exacerbate this traditionally complex issue. The problem is not only due to imperfect information

INTRODUCTION

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for the consumer, but it is also due to the possibility that even the producers have imperfect information, due to academic autonomy and specialisation. These informational insufficiencies and other shortcomings of the market have been traditionally advanced as arguments in favour of a more visible role of government in regulating the sector, even when allowing for a strong presence of market mechanisms. The regulatory framework of higher education is analysed in chapter 4 by Ben Jongbloed, who discusses the changes in terms of regulation in many Western higher education systems, particularly in Europe, away from more centralised forms to more supervisory regulatory structures. He examines how government regulation can affect a potential higher education market, within the supervisory model of regulation. Using a framework borrowed from industrial organisation studies, he explores the role that governments can play in regulating the structure, conduct and performance of higher education institutions competing in a higher education market. He concludes his chapter by analysing the case of vouchers illustrating the difficulties of governments in regulating a higher education market. One of the ways governments traditionally regulated the higher education sector was through its degree of publicness. Privatisation can be implemented through the adoption of private-like behaviour by public institutions or by the emergence of private institutions in traditionally public dominated systems. This is the topic covered by Geraint Johnes in chapter 5 of this volume. Using an economic model, he defines the critical issues arising once societies allow for the coexistence of private and public sectors of higher education and for the coexistence of public and private funding sources. Johnes raises important questions associated with the definition of priorities of social spending and the distribution of public funds among different social groups. Moreover, he highlights the fact that in contemporary society higher education may find itself trapped on a level of low investment. In between the more economic theory-driven chapters and the set of case studies that forms the more empirical part of this book, chapter 6 by Guy Neave provides a much-needed historical perspective on the transformation of the university and its (sometimes forced) adoption of the market ideology. As a historian, he decides to leave aside the disciplinary debates and developments in economics that promoted an economic approach to education, and concentrates on a set of economic, political and social forces that contributed to the triumph of the economic rationale in the affairs of higher education policy and academic life. The chapter takes us back to the Soviet Union, the Cold War and the fall of the Berlin Wall. It links these events to the dialectics between economic ideas (e.g. human capital theory, manpower planning, supply-side economics) and political ideas (e.g. higher education creating competitive advantage as well as social inclusion). Neave’s account suggests that this process moved the university closer to the economic domain, transforming it into a very ‘ordinary’ institution that, compared to its past version, seems to have become much more successful at responding to external demands. However, he argues that there are alternatives to the market-driven university – other models could have been adopted. As in economics, it is all a matter of choice and responding to the incentives provided by different (social, political, etc.) arrangements.

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In the second part of the book a set of chapters develops the empirical assessment of market mechanisms for several developed economies, referring as far as possible to some of the ingredients of markets developed in this introduction (see table 1). The country studies start with chapter 7 by Roger Geiger analysing the US system, consistently identified as one where the market has a more consolidated role. In his chapter, Geiger analyses the multiple markets in American higher education and the different degrees of effectiveness of market mechanisms in each of them. Whereas in some of these markets the degree of competition seems reasonably intense, in others there seems to exist a clear segmentation of the market that prevents or hinders competition between large chunks of that market. Geiger in particular pays attention to one aspect that has characterised the US higher education landscape, that is, the rising tuition, and the role that this phenomenon seems to have played in the aforementioned segmentation of several of the higher education markets. In chapter 8, Glen Jones and Stacey Young suggest that north of the US border the situation seems to be different and probably more diverse regarding the role of markets in Canadian higher education. They survey the changing role of the federal government and the way this has interplayed with provincial policies. Notably, they analyse how the financial retrenchment of the federal government has led to more diverse models of regulation at the provincial level. This has allowed room for experimentation in terms of funding arrangements and has produced increasingly dissimilar situations across states concerning hot issues in higher education policy such as tuition fees and the public mission of higher education institutions. A system that has also experienced a substantial amount of political experimentation and reform, very much in the direction of strengthening the role of market mechanisms, is Australia. This is the country analysed by Simon Marginson in chapter 9. Based on the idea of higher education as a positional good, thus leading to a peculiar type of (positional) competition, Marginson elaborates on market segmentation in higher education, an issue also highlighted in the American case. Marginson suggests that the pervading role of market competition has been a mixed blessing for Australian higher education, leading the system to achieve some governmental goals, but also weakening some fundamental purposes in higher education, notably long-term sustainability. Another country where the policy rhetoric in favour of the market has made significant inroads is the UK, which is analysed by Gareth Williams in chapter 10. He analyses the steps towards market regulation that have been taken in a country that to a large extent was more receptive to it than most of its European counterparts, due to the tradition of strong institutional autonomy that characterised British higher education. Williams describes the 1980 transformations which had a strong ideological flavour and were stimulated largely by severe funding cuts. These cuts forced higher education institutions to search for ways of doing things much more economically and to raise income from alternative sources. These trends, especially the latter, led to a major redefinition of essential features of the British higher education system, notably the size and composition of the student body and a rebalance between major functions of higher education. In this case, as in many others, it seems likely that the promotion of market mechanisms in higher education

INTRODUCTION

11

was the product of other motivations rather than being an end in itself, despite all the rhetoric associated with it. Moving to the European continent, in chapter 11, Carlo Salerno analyses the Dutch system and the somehow rapid diffusion of market elements in a country with a strong tradition of state control and planning in higher education. Salerno explains that these market advances have been particularly strong in non-traditional sectors of higher education which are more eager to adapt and take advantage of the increasing pro-market framework. In his chapter, Salerno also stresses the complexity of issues arising even when governments have successfully promoted strong market mechanisms. For instance, higher education institutions seem to have difficulty in coping with increasing financial autonomy, possibly because this was not introduced in the most convenient way for them, but rather according to the interests of government. On the other hand, the Dutch case also illustrates the ambiguities of governments in promoting market mechanisms, as in the setting of tuition fees. The ambiguities in terms of government regulation seem also to play a prominent role in the Portuguese case, analysed in chapter 12 by Pedro Teixeira, Maria João Rosa and Alberto Amaral. The overall picture of the Portuguese system is, as in many of the other cases analysed in the volume, rather puzzling. If, in certain aspects, market elements were introduced with some significance, namely the private provision of higher education and the degree of autonomy of public institutions, in other areas there was not a corresponding development. Moreover, the authors call attention to a peculiar type of (ad hoc) government intervention which attempts to force a particular result. These interventions seem to have been prompted by the government’s frustration in not achieving certain goals, due to the strengthening of institutional autonomy and of market mechanisms that limited the government’s capacity to steer the system. The interpretation by the authors suggests that government in some cases was relying on market-type behaviour as long as it delivered a certain type of result. In the final country case, chapter 13, Thierry Chevaillier analyses the French system and the role that market elements played in a system usually regarded as strongly shaped by government regulation. Chevaillier suggests that, even in a system with a long tradition of state centralisation and control, market mechanisms have been gaining visibility. Despite the political rhetoric and the strong social resistance to markets in higher education, and what these mean in terms of privatisation and competition, there are some signs of change. Although the private sector remains small in terms of generalist institutions, there are important developments in some specialised areas with strong student demand. Moreover, there is a growing level of competition between public institutions, namely, outside the core teaching activities (such as lifelong learning) and research funding. Overall, the perspective provided by this set of chapters on the reality of markets in higher education is a complex and fascinating one, both from an analytical point of view and an empirical one. In the final chapter, the editors of this volume make an attempt to identify some common and cross-cutting themes and problems. It seems that the pace, the instruments and the effectiveness with which market elements have been introduced vary across countries. Some governments appear to be confident whereas others appear softer in their introduction of market-based

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approaches. Governments are still learning, some more effectively than others, to grasp the peculiarities of market mechanisms and their application to higher education. However, despite the variability of national experiences, we hope that this diversity adds to the quality of this book and stimulates interest in the topic of markets in higher education. NOTES 1

2

However, in a number of Latin American and Southeast Asian countries private institutions play a more important role than public ones in terms of enrolments. In Portugal, the private sector represents over 25% of total enrolment. The private sector also plays an important role in many Eastern European countries. In the UK, in the beginning of the nineties, there was a failed attempt to introduce a mechanism in which the institutions would bid for students. It was assumed that this competitive mechanism would prompt institutions to reduce inefficiencies and lower their costs. However, the experiment was soon aborted because the institutions were competing on the basis of quantities instead of prices, frustrating the goals of the experiment (Johnes 1993).

REFERENCES Amaral, A., V.L. Meek and I.M. Larsen (eds). The Higher Education Managerial Revolution? Dordrecht: Kluwer, 2003. Barnett, R. The Idea of Higher Education. SRHE: Open University Press, 1990. Barr, N. The Welfare State as Piggy Bank: Information, Risk, Uncertainty, and the Role of the State. Oxford: Oxford University Press, 2001. Dill, D. “Higher Education Markets and Public Policy.” Higher Education Policy 10.3/4 (1997): 167– 185. Friedman, M. Capitalism and Freedom. Chicago: University of Chicago Press, 1962. Hansen, W.L. and B.A. Weisbrod. “The Distribution of Costs and Direct Benefits of Public Higher Education: The Case of California.” Journal of Human Resources 4.2 (1969): 176–191. Johnes, G. The Economics of Education. London: MacMillan Press, 1993. Johnstone, D.B. Sharing Costs of Higher Education: Student Financial Assistance in the United Kingdom, the Federal Republic of Germany, France, Sweden, and the United States. New York: College Entrance Examination Board, 1986. Jongbloed, B. “Marketisation in Higher Education: Clark’s Triangle and the Essential Ingredients of Markets.” Higher Education Quarterly 57.2 (2003): 110–135. Jongbloed, B. “Tuition Fees in Europe and Australia: Theory, Trends and Policies.” In Smart, J.C. (ed.). Higher Education: Handbook of Theory and Research, vol. XIX. Dordrecht: Kluwer, in press. Le Grand, J. and W. Bartlett. Quasi-Markets and Social Policy. London: Macmillan Press, 1993. Neave, G. and F. van Vught (eds). Prometheus Bound. London. Pergamon Press, 1991. Rawls, J. A Theory of Justice. Cambridge, Mass: Harvard University Press, 1999. Rothschild, M. and L.J. White. “The Analytics of Pricing in Higher Education and Other Services in Which Customers are Inputs.” Journal of Political Economy 103.3 (1995): 573–586. Smith, A. An Inquiry into the Causes of the Wealth of Nations. Glasgow Edition of the Works and Correspondence of Adam Smith. Oxford: Clarendon Press, 1977 (1776). Teixeira, P. (ed.). Higher Education Quarterly. Special Issue on Market Mechanisms in Higher Education. 57.2 (2003). Teixeira, P. and A. Amaral. “Private Higher Education and Diversity: An Exploratory Survey.” Higher Education Quarterly 55.4 (2001): 359–395. Williams, G. “The Many Faces of Privatisation.” Higher Education Management 8 (1991): 39–56. Wolf, C. Markets or Governments: Choosing Between Imperfect Alternatives. Cambridge, MA: MIT Press, 1993.

WILLIAM F. MASSY

MARKETS IN HIGHER EDUCATION: DO THEY PROMOTE INTERNAL EFFICIENCY?

1. INTRODUCTION Do market forces spur colleges and universities to operate more efficiently? Milton Friedman thought the answer was ‘yes’: that by denying market forces, “institutional funding led to less responsive institutions, under-funded, and less adapted to the needs of parents/students” (see the Introduction, this volume). Friedman has been criticised for reasoning by analogy from profit-making enterprises and not taking account of factors specific to higher education. This chapter addresses that difficulty by analysing how non-profits in general and universities in particular respond to market forces and what can be done to mitigate market and non-market failures. I will define internal efficiency as producing the right bundle of outputs given the needs and wants of stakeholders, and then minimising production cost for the given bundle. Cost minimisation means ‘production efficiency’ in the classic sense. Producing the right outputs includes, in the words of this volume’s introduction, “responsiveness and articulation to the supply and demand of factors and products”. In higher education, however, the ‘right bundle of outputs’ also includes goods that are valued by society but not captured by individuals’ demand functions. Therefore, the consideration of internal efficiency should encompass public as well as private goods. The thesis of this chapter is that markets deliver better internal efficiency than does governmental control of universities but that, in today’s environment at least, market forces by themselves do not produce satisfactory results. To understand why, we will examine the theory of non-profit enterprises and the behaviour of universities as they relate to markets and internal efficiency. First, though, it will be helpful to review the alternatives for steering a country’s higher education system. 2. ALTERNATIVE STEERING MODELS 2.1. The Market Model Van Vught (1989: 22) describes markets as ‘basically different’ from government regulation, where ‘government tries to be in charge’. Quoting Clark (1983: 30), he says, “The market form … is a type of interaction in which, in pure form, no one is in charge and matters are disaggregated”. Higher education markets decentralise decision making on both the demand and supply side of the provider-consumer 13 P. Teixeira, B. Jongbloed, D. Dill and A. Amaral (eds), Markets in Higher Education: Rhetoric or Reality, 13–35 © 2004 Kluwer Academic Publishers. Printed in the Netherlands.

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transaction. The question is whether the resulting ‘invisible hand’ can effectively replace the so-called ‘rationalist’ steering of government regulation. Universities operate in several markets: for example, student recruitment, sponsored research, faculty and staff recruitment; and non-academic services and facilities. This chapter concentrates mainly on students, because that is where the main issues of funding and regulation arise. I will argue that, for the most part, the effect of other markets on university behaviour is substantially the same as for business firms. In the case of students, markets can be viewed as regulatory devices or as mechanisms for transferring money from consumers or taxpayers to the universities that supply the service. This chapter considers the two to be integrally connected – that the provision of funding is bound to affect incentives and thus decision making. Each participant in the marketplace responds to signals from other participants about the price, quality and availability of goods demanded and on offer. Each sends its own signals, either through its behaviour or with targeted communications. Participants aggregate and process the signals to provide the information they need for decision making. They may do so in different ways, but most if not all aggregations are weighted by market power. For example, universities often attend differentially to student segments defined by academic aptitude and ability to pay. Supply-side market power correlates with admissions selectivity, research reputation and the quality of life on campus. But while some actors wield more influence than others, the fact remains that markets decentralise decision making. Only in rare cases can one or a few entities dictate supply or demand. All entities must pay attention to market signals or suffer the consequences. Since Adam Smith, the justification for markets has been that independent decisions by individuals, each pressing personal advantage with full knowledge of the local situation, usually produce better results than the more distant decisions of central planners. According to this logic, centralised decision making incurs heavy transaction costs due to information asymmetries and other principal-agent problems. Planners also may become passive or self-interested, or allow themselves to be captured by marketplace participants to the detriment of the general welfare. For example, they may be unable or unwilling to tolerate the ‘creative destruction’ that Schumpeter (1976) described as being essential for the dynamism of a capitalist economy. Anonymous actors making decentralised buying decisions are likely to do better and, on the supply side, if the established entities in an industry fail to innovate they will be replaced by new entrants (Utterback 1996). The idea that governments should set the boundary conditions for markets is widely accepted. For example, governments define fraud and prosecute violators. They also set rules for contracting among market participants and enable private legal actions to enforce such contracts. Whether governments should regulate the details of market operation is more controversial – for example, many believe that markets should be self-regulating in the cybernetic sense (Van Vught 1989: 29) or subject to professional self-regulation by participants. But even when government absents itself from day-to-day marketplace activities, it may intervene (or ‘interfere’, as some authors put it) episodically to correct actual or threatened market failures.

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The challenge, of course, is to fix the problem while avoiding worse failures of the non-market variety. Governments also may become market actors on their own account. Funding research through grants and contracts provides a good example. The UK’s research councils and the US’s National Science Foundation operate highly competitive markets for basic research, and mission agencies issue requests for proposals to further their areas of responsibility. Sponsored instruction agreements contribute to agency and business objectives and these, too, operate in a market environment. Such arrangements do not produce market failures as long as a multiplicity of support sources prevents government agencies from exercising monopsonistic power. ‘Quasi-markets’ arise when governments fund institutions as if procuring services for their constituents (Le Grand and Bartlett 1993). Universities are not funded for their own sake, but rather as providers of specified services for identifiable groups. Students may exercise choice in deciding which institution to attend, for example, but the main element of market power is exercised by the state on their behalf. Quasi-markets substitute a well-informed buyer (the state) for underinformed ones (the students). But as Dill and Soo point out in their chapter on transparency and quality in this volume, quasi-markets are not immune to ‘government failures’ and principal-agent problems. Following Pascarella (2001), they remain dubious that “monopsonistic or quasi-market mechanisms, in which government buys or contracts for a particular level of higher education, will prove efficient in the long run because of the potential for government misdirection of the higher education system and the substantial difficulties in validly measuring educational outcomes”. 2.2. The Principal-Agent Model and Steering from a Distance What mechanisms besides markets can be used to steer higher education? By what process can governments try to apply coherent rational decision making instead of relying on the market’s invisible hand? The so-called ‘principal-agent model’ addresses this issue. Suppose a ‘principal’ with a mission and money (government, for example) engages one or more ‘agents’ (universities) to perform certain tasks – work the principal cannot easily accomplish on its own. Agents are supposed to represent their principals faithfully, but without positive incentives to do so they may divert resources to their own agendas (Sappington 1991). The agent, however, believes that ‘He who pays the piper should call the tune’. Hoenack’s (1983) formulation of the principal-agent model identifies three ways by which agents can guard against resource diversion. 1. Regulatory. The principal may restrict the agent’s freedom of action: for example, by requiring prior approval for decisions that involve resources. Tight control prevents resource diversion, but at the cost of efficiency. Transaction costs become greater as the tasks get more complex and the

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organisational distance between principal and agent lengthens. In the terms of this chapter’s title, it is foolhardy to believe that a university’s internal efficiency can be maximised from the outside. 2. Formulaic. The principal may use direct financial incentives to overpower the agent’s intrinsic objectives. Denmark’s ‘taxi-meter’ system falls under this rubric.1 Unfortunately, such formulas become less effective as the difficulty of performance measurement increases. Devising good formulas and fine-tuning them as conditions change are daunting tasks, yet the formulas must be precisely targeted to prevent unintended consequences. Formulaic control presents difficult challenges because the two parties’ basic objectives remain out of alignment. 3. Persuasive. The principal may try to align the two parties’ objectives by persuading the agent that while resource diversion might be attractive in the short run it eventually will prove dysfunctional. This strategy minimises transaction costs, but it does not always work – especially in cases, as in government control of education, where differences may run deep and there is no credible threat that the principal will switch agents. Method 1 looks like Mitnick’s (1980) ‘Regulation by directive’ and Method 2 like his ‘Regulation by incentive’. Method 1 also can be compared to Hood’s (1983) ‘Instruments of authority’, Method 2 to his ‘Instruments of treasure’, and Method 3 to his ‘Instruments of information’. However, his ‘Instruments of action’ appear closer to quasi-market operations than an element of principal-agent theory. The Netherlands’ concept of ‘steering from a distance’ eschewed Method 1 in favour of a mixed system that combined Methods 2 and 3 with market signals. According to Teichler (1989: 171), the policy did not “necessarily imply lesser effects on the part of government to determine the major goals of higher education”. Instead, policy makers believed they could steer more effectively by: x

setting at most a framework for action;

x

pursuing government goals, possibly with the help of incentives;

x

lump-sum funding;

x

resource allocation based on output measures (graduates, dissertations etc.);

x

establishment of a system of evaluation and of dialogues related to evaluation;

x

establishment of other ways of assessment, such as performance indicators;

x

setting a limited number of policy rationales which shape incentive policies, the evaluation process and possibly state intervention, in case higher education institutions fail to take steps on their own (Teichler 1989: 171).

While reporting a ‘modest optimism’ that steering from a distance would stimulate innovation and reduce the transaction costs traditionally associated with regulation, Teichler raised a number of questions. In particular, can “the mix of increased flexibility and complex mechanisms of positive and negative sanctions … have predominantly stimulating effects, or will [it] be too threatening and thus lead

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predominantly to self-protecting activities of preservation of the status quo?” (Teichler 1989: 210). Van Vught’s ex post assessment, expressed at the Douro seminar, is that steering from a distance can work if the steering is done consistently and with a ‘light touch’. The concluding section of this chapter proposes a refinement of steering from a distance – an approach I will call ‘performance-based steering’. While retaining the ‘light touch’ character of governmental involvement, performance-based steering supplements market forces with persuasion and discretionary rewards and punishments designed to nudge universities in directions judged to be in the public interest. It presumes that universities want to further the public interest but that competing forces, including the pressures associated with growing marketplace competition, may cloud or confound their thinking. Performance-based steering can protect universities’ autonomy while helping them balance public values with private market forces. 3. MARKETS AND THE THEORY OF NON-PROFIT ENTERPRISES Massification and large-scale research funding changed higher education from a small and elite enterprise, where academic autonomy could be defended as an end in itself, to a key participant in the economic mainstream for which autonomy is a means to an end. That end, of course, is to contribute to economic development and to the lives and careers of large numbers of students. This means paying attention to markets, not just traditional academic values like advancing the discipline, preserving culture and allowing elite students to ‘sit at the feet of scholars’. Massy (2003), quoting Clark Kerr (1988), points out that the tension between markets (the Agora) and traditional academic values (the Acropolis, which represents scholarship) is anything but new. Kerr says that universities have always served the market. In fact, universities began in Europe in early modern times precisely for that purpose [to serve the market] … The cherished academic view that higher education started out on the Acropolis and was desecrated by descent into the Agora led by ungodly commercial interests and scheming public officials and venal academic leaders is just not true. If anything, higher education started in the Agora, the market, at the bottom of the hill and ascended to the Acropolis at the top of the hill … Mostly it has lived in tension, at one and the same time at the bottom of the hill, at the top of the hill, and on the many pathways in between (Kerr 1988: 1).

Winston (1997) describes the tension in more earthy terms: as pitting ‘university as church’ against ‘university as car dealer’. Universities exist to produce value rather than profit, but they also must wheel and deal in the marketplace. Non-profit theory provides a framework for understanding how they balance these requirements. Estelle James and I developed the microeconomic theory of non-profit enterprises in various publications beginning some twenty-five years ago (James and Neuberger 1981; Hopkins and Massy 1981; James 1986; Massy 1996, 2003).2 Rooted in the theory of the firm, the model describes non-profit behaviour as maximising a subjectively determined value function by adjusting outputs and output

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prices, subject to market, production and financial constraints. The value function reflects the institution’s mission. Market constraints reflect the demand functions of those who purchase its outputs and the supply functions of those who provide factors of production. The production function describes how input factors are transformed into output quantity and quality. The financial function requires that total revenue minus total cost equals zero: the all-important not-for-profit condition. In contrast, for-profit enterprises maximise profits by adjusting outputs and output prices, subject to market and production constraints. Comparing the two models, one sees that the for-profit objective function is simply the left-hand side of the non-profit’s financial constraint. All other elements of the theory remain the same. This means that the classical theory of the firm carries over to non-profits in most respects.3 On the other hand, the difference of objective functions produces profound consequences. Much of the controversy about markets as steering mechanisms in higher education stems from disagreements about the similarities and differences between the two models. 3.1. The Objective Function The key difference lies in the relationship between the entities’ managers and their owners. Businesses seek to maximise shareholder value, which is achieved by maximising a stream of profits over time. It is true that businesses may concern themselves with values beyond the realisation of profits. For example, they may further their managers’ altruistic goals or self-interest at the expense of shareholder value. This presents a principal-agent problem – a breakdown rather than a generalisable characteristic of the for-profit organisational form. Some businesses value community or employee relations over short-term profits because managers believe this will improve profits over the long term, and most reinvest part of their profits to further the enterprise’s mission and thus improve future profitability. These are business judgments, made on behalf of owners, which have no generalisable implications. The privately held Ben and Jerry’s ice cream company, where the owners are said to value the environment over profitability, highlights the essential distinction between for-profit and not-for-profit entities. The owners’ decision to accept an opportunity loss in profits is voluntary and could be reversed at any time. In effect, the not-for-profit organisational form differs from the for-profit one because it tries to guarantee such choices in perpetuity. Choices like the one at Ben and Jerry’s are easiest in privately held companies. Most publicly held companies must grow shareholder value at rates equal to their competitors’ or suffer serious consequences. Shortfalls in profitability reduce the stock price, which puts pressure on managers and may eventually attract corporate raiders. Some mutual funds advertise investments in ‘socially responsible’ companies, but even here the opportunity loss in shareholder value cannot be too great. Shareholder value also remains important in most privately held companies, especially ones that loom large in the portfolios of owners who are not independently affluent and/or who may wish to sell their shares at some future date.

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The distinction between non-profit and for-profit entities is most important where a degree of public subsidy is involved. The literature identifies three reasons for favouring non-profit as opposed to for-profit enterprises when considering such subsidies (Hansmann 1986: 61 cited in Massy 2003: 31). 1. The enterprise’s output is important to society – a ‘social good’, so to speak. People need it, and no substitutes are readily available. 2. It’s difficult to evaluate quality, so buyers have to rely on the supplier to create value for money on their behalf rather than in the interest of owners who might line their pockets by shortchanging quality. 3. The output costs so much to produce that it would not be affordable if the enterprise had to recover its full costs. Broad access requires a public subsidy in this case, and nonprofits can’t siphon off subsidy payments for the benefit of shareholders. Most if not all traditional universities receive subsidies, either directly from government or via the tax system. The fact that surpluses must be reinvested within the entity rather than inuring to external private interests makes it more likely that the subsidies will be used as intended. But this benefit comes at a price. Because external stakeholders receive no stream of profits, no financial market disciplines the entities’ efficiency – whoever heard of a corporate raider in the non-profit sector? A second major difference between for-profit and non-profit entities is that the latter’s value function is not quantitative and cannot be specified unambiguously, even in subjective terms. Like utility functions in the economic theory of consumer behaviour (Samuelson 1974), non-profits’ value functions are abstract constructs rather than operational tools. Non-profits do not specify their value functions in advance, but instead proceed iteratively and ‘reveal’ their preferences by the choices they make. One cannot even claim that a university has a single value function. Reconciling stakeholders’ differing values into a coherent framework for decision making represents a key goal of institutional governance. Hence the university’s value function should be viewed as representing the outcome of a (probably messy) governance process. James and Neuberger (1981) characterise the academic department as a nonprofit labour cooperative. This is consistent with non-profit theory as outlined here. It simply reflects a particular – and self-serving – choice of value function. But this characterisation is not consistent with government’s view of universities, nor with the substantial subsidies and tax advantages granted to them. I will argue presently that the university’s value function should reflect the public interest rather than the private interests of professors. University decision making occurs in a dynamic rather than a static environment. Non-profit theory can be extended to the dynamic case, but little is gained in the present context because the dynamic non-profit model includes most features of the for-profit one (Hopkins and Massy 1981). Financial quantities are discounted over time to produce the familiar net present values. Investment decisions depend heavily on these values, but the non-profit’s value function also enters the picture.

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Discounting future mission attainment depends on ‘impatience factors’ more akin to the subjective discount rates applied by consumers than on market-determined financial discount rates. Universities are said to be very patient entities. For example, academic decisions consider the long-term development of knowledge, and endowment spending decisions may consider ‘intergenerational equity’ – the preservation of purchasing power for future generations. Finally, because reserves and borrowing mitigate the need to balance each year’s budget, the financial constraint should be viewed as balancing cost and revenue on average over time. 3.2. Behavioural Similarities Despite the difference in objective functions, the non-profit model has many of the same implications for behaviour as the for-profit one. Following Lilien, Kotler and Moorthy (1992), I will sketch them under the rubrics of product, price, promotion and place.4 Product. Non-profit enterprises set output quantity and quality using the decision rule: ‘Marginal Value + Marginal Revenue = Marginal Cost’, or MV+MR=MC for short. ‘Marginal value’ means ‘incremental contribution to mission attainment expressed in dollar-equivalent units’. Marginal revenue depends on demand functions and output prices. Marginal cost depends on production functions and input prices. A programme will be expanded when its MV+MR>MC and conversely – that is, depending on whether its contribution to value and revenue is greater than its incremental cost. In contrast, for-profit entities use the decision rule MR=MC, where mission-based value does not enter the picture. The non-profit valuemaximising solution occurs when MV+MR=MC for all outputs and the financial constraint is satisfied. Price. Like their for-profit cousins, non-profits can be price takers or price makers. Programmes without market power must accept prices as presented in the marketplace. Those with market power enjoy pricing discretion, which is exercised through the decision rule given above. Market power produces positive contribution margins. Corporate earnings boost stock prices and eventually are distributed to shareholders. Non-profits spend their earnings on cross-subsidies that boost mission attainment. Hence both entities benefit from higher prices. For universities, the incentive to raise price is enshrined in Bowen’s Law: “Universities will raise all the money they can and spend all the money they raise” (Bowen 1980). Bowen’s Law is the non-profit manifestation of Adam Smith’s self-interest concept. Absent specific reasons to the contrary, both non-profit and for-profit enterprises will raise prices as high as the market’s ‘invisible hand’ will allow. Both entities practise price discrimination. Classic microeconomic theory describes the ‘perfectly discriminating monopolist’ as one who adjusts price according to customers’ ability and willingness to pay, thereby extracting the entire consumer surplus as profit.5 Anyone who doubts the prevalence of price discrimination should look at America’s deregulated airlines. Non-profits join forprofits in striving to discriminate on price wherever possible, since bigger margins from some customers enable larger cross-subsidies elsewhere in the system. But

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their motivation may transcend profit maximisation. For example, many universities consider student diversity and access for disadvantaged students as being intrinsically important to their missions – that is, these factors enter the value function. While sticker prices may soar, financial aid in support of diversity joins the traditional profit-maximising discounts as elements of pricing strategy. It may be hard to disentangle the motivations in particular cases, but in principle the former operate through the decision rule’s MV term while the latter operate through the MR term. Finally, both entities would rather compete on the basis of product, promotion, place, or less-than-transparent price discounts than on the basis of sticker price. Sticker price is a blunt competitive instrument and price wars produce long-lasting negative effects. It should come as no surprise, then, that sticker prices tend to be sticky downward or that British universities chose to compete on quantity rather than price in response to the Funding Council’s request that they bid for incremental student numbers (see Introduction, this volume). Promotion. Non-profits will promote their products and services in the same way and with the same intensity as for-profits. Their decision rule for balancing promotion’s costs and benefits includes mission contribution as well as marginal revenue and marginal cost, but the incentive to promote and the mechanics of the process are the same as in business. Promotion furthers the public good when it informs prospective students about the institution’s programmes and educates them on how to make good choices in light of their needs and preferences. However, hard-sell appeals appear more self-serving. Some institutions may eschew promotion as a matter of principle, but most recognise its importance in an era of growing competition. Place. Traditional universities were largely campus based, but this was a consequence of their production technology rather than the non-profit model. Such universities enjoyed a degree of local monopoly power because their human resources, libraries and laboratories were specialised, lacked mobility and could not operate at a distance. Information technology is changing that. The alacrity with which universities have opened satellite operations and distance learning programmes proves that the non-profit model does not inhibit extension of place. Institutions will expand geographically whenever the MV+MR of so doing exceeds the MC. 4. THE CASE FOR MARKETS The case that markets improve internal efficiency is difficult to prove or disprove empirically. One defines efficiency as the ratio of outputs to inputs, both adjusted for quality. I shall argue presently that we lack even rudimentary information about the quality of education, the university’s main line of activity, yet quality surely varies from institution to institution and over time. Furthermore, most universities produce at least two kinds of outputs: educated students and research and scholarship. The idea that their joint production function is Millsian – that is, that the outputs must be produced in strict proportions as in the classic example of wool and

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mutton – is strongly disputed by Massy (2003) and an increasing number of other authors. Shepardian production, in which a given set of inputs can be transformed into a wide variety of outputs, is much more consistent with the evidence (Zemsky and Massy 1995). Unfortunately, the data on faculty time allocations between education and research are as bad as the data on education quality itself. The confounding of undocumented shifts of inputs between education and research with the impossibility of measuring quality makes meaningful statistical analysis impossible. The case for markets depends on three propositions: that market forces (1) spur productivity improvement; (2) improve responsiveness to supply and demand; and (3) do not compromise higher education’s role as a public as well as a private good. Non-profit theory shows that markets can fulfil all three propositions. Unfortunately, however, the conditions required for market efficacy are more stringent than those in the for-profit sector. While the case for markets is well justified by theory, we will see in the next section that it is best characterised as ‘fragile’. 4.1. Productivity Improvement Like its for-profit counterpart, the non-profit model contains built-in incentives for productivity improvement. The incentives arise because a dollar saved is a dollar freed up for cross-subsidies, other things being equal. Suppose an entity produces two outputs. One is valued by the market and the other has low market demand but is important to the institution’s mission. Let price and quality be determined by competition. Producing the high-demand output at lower cost will improve its ‘contribution margin’. (Here ‘margin’ means the difference between revenue and direct cost.) The extra contribution margin can be spent on the output less favoured by the market – thus allowing the institution to boost mission attainment, to do more of what it would like to do. Teaching and scholarship provide the classic example of cross-subsidy in higher education. Independent institutions without big endowments or sponsored research use tuition revenue to fund faculty scholarship. The more efficiently they can teach the more scholarship they can fund. Government appropriations, endowments and sponsored research complicate the picture but the proposition remains true when all such factors are held constant. For corporations, better contribution margins boost shareholder value. For universities they boost cross-subsidies. Both results provide incentives for productivity improvement. Market forces drive institutions to evaluate what they do as well as how they do it. Universities trim cross-subsidies to their least-valued programmes in times of financial stringency. Sometimes the evaluation unearths more low-priority programmes than needed to balance the budget, in which case schools may shift cross-subsidies toward higher priority programmes. Bob Zemsky and I call this ‘growth by substitution’ – which is another kind of productivity improvement. While the substitutions could have occurred anytime, markets may well provide the impetus. A similar thing occurs when corporations mount cost-cutting drives in response to margin-squeezing competition. Less-than-necessary functions that grow

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during prosperity get excised when times are tough. Shedding unprofitable lines of business represents the same phenomenon. 4.2. Responsiveness to Supply and Demand Competition also triggers responsiveness to changes in supply and demand. Shifts in the supply curves for inputs force adjustments to production processes. On the demand side, customers get value for money or go elsewhere – which forces institutions to align their offerings to the needs of the marketplace. Markets decentralise decision making by allowing customers and suppliers to assert their individual preferences. As with for-profit enterprises, competition forces universities to consider these preferences in decisions about production processes and the quantity, quality and price of outputs. Responsiveness to supply and demand enhances dynamic efficiency. Markets decentralise decision making, as noted earlier. Anonymous and decentralised market forces override all arguments against change, no matter how powerful the proponents. While not all changes are salutary, change is a necessary condition for efficiency in a dynamic environment. Recall the school experiment where iron filings are placed on a paper that sits atop a magnet. Nothing happens until one taps the paper, at which point the ‘disruption’ overpowers friction and allows the filings to align themselves with the magnetic field. The same thing happens with markets. By overpowering organisational friction, even random shifts in supply and demand can produce worthwhile adaptations. 4.3. Furthering the Public Good Universities receive public subsidies and tax benefits because, as non-profit enterprises, they are expected to further the public good. Adoption of market solutions by governments does not change this expectation. In fact, deregulation delegates to institutions the responsibility for making public-interest decisions that previously were made by oversight bodies. Deregulation unleashes market forces, reduces transaction costs and, by removing impediments to philanthropy, relieves government of some funding responsibilities. Its justification lies in the fact that traditional universities are non-profit enterprises. One can hardly imagine making such delegations to for-profit enterprises. I described earlier how the non-profit organisational form prevents public subsidy from inuring to the private benefit of owners. To be effective, however, the delegation of public-interest decision making requires more than firewalls to prevent surpluses from inuring to the private benefit of owners. Also required are an affirmative desire to interpret and serve the public good, the will to hold institutional self-interest at bay, and the financial strength to balance intrinsic values with market forces. Most university leaders would argue that these conditions, too, are fulfilled. The next section explains why I am not so sure. First, though, let me offer a brief digression on the economist’s concept of ‘externalities’.

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For-profit economic theory defines ‘externalities’ as socially desirable outcomes that are not captured by market-driven demand or cost functions and, therefore, do not enter the enterprise’s profit equation. Environmental pollution and ‘the tragedy of the commons’ are quintessential examples. The theory applies as well to nonprofits. Using a strict definition, an externality would be any public good not captured by demand or cost functions and not included in the entity’s value function, whatever that function happens to be. The strict definition suggests that stakeholder objectives not embraced by the universities should be viewed as externalities. But this turns the idea of value delegation on its head. Universities are being freed from regulation as part of a grand bargain that confirms and expands their responsibility for interpreting and serving the public good. Value delegation internalises those ‘externalities’ that reflect higher education’s particular mission. Other externalities, like pollution and the commons, should be viewed in the traditional way. 5. HOW MARKETS FALL SHORT Markets provide incentives for internal efficiency but a close look at the specifics of higher education leads one to conclude that pure market solutions do not fully serve the public interest. Market solutions improve on tight regulation, but today’s markets lack the self-correcting mechanisms needed to correct current problems. These problems fall under two rubrics. Economic issues refer to the market’s ability to constrain prices and the universities’ ability to assert their values through crosssubsidies. Value issues refer to the value systems themselves – whether universities have truly internalised the public good. 5.1. Economic Issues Prices. Market solutions assume that competition will assert downward pressure on prices or at least constrain their increase. However, structural factors and the aforementioned reluctance of universities to engage in price wars limit the market’s ability to police tuition rates. I will describe the situation in the United States and then comment briefly on Europe. In America, elite private institutions provide a strong pricing umbrella for the rest of higher education. Their prestige confers great market power which they exploit by reason of Bowen’s Law. The elites’ high sticker prices, together with gift receipts and endowment returns, enable them to spend at levels not attainable by other institutions. For example, when Bob Zemsky and I analysed the forty-eight most elite US private colleges and universities we found the high spenders’ unit costs to be almost sixty per cent greater than those of institutions on the efficient frontier (Massy 2003: 72; Zemsky et al. 1999). This exercise of market power sets two standards: high sticker prices and aggressive spending targets for other institutions to shoot at. Less elite institutions, both public and private, emulate the elites’ spending levels to the extent they can. The market allows them to raise tuition as long as they stay

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under the pricing umbrella. Instead of constraining price increases, the whole market responds to the elites’ upward leadership. Moreover, the difficulty of gauging education quality tends to equate quality with spending in a classic price-quality association. This provides a further incentive for raising tuition. State funding trade-offs have further contributed to the upward pressure on prices. Public university tuitions have been limited by regulation. Zemsky (forthcoming) points out, however, that when fiscal times get tough, governors and legislators find they can constrain appropriations to higher education if they allow or even encourage institutions to boost tuition. The universities are quick to respond, and once tuition-oriented strategies become embedded they acquire a life of their own. Most schools have plenty of headroom. For example, in 2000–01 public institutions’ enrolment-weighted average tuition rate was $3510 compared to $25,000 in the private sector (Duderstadt and Womack 2003: 78). And, as part of a vicious circle, the rise of average public-sector tuition gives the elite private institutions more room to exercise their market power. The absence of a two-tiered system makes the situation different in Europe. However, governments still may encourage tuition increases to compensate for lower appropriations. As in America, universities have every motivation to boost tuition and it appears that students usually accept such increases if the change is not too dramatic. Discretionary Spending. Some believe the best way to make colleges and universities more efficient is to put them on a severe revenue diet. Financial stringency forces cost cutting, they say, and the deeper the cuts the more efficient institutions will be. The political rhetoric in some US states seems to embrace this philosophy – for example, in Missouri where the universities are expecting a twenty per cent appropriations cut this year. Many observers believe the rise of competition, including competition from for-profit entities like the University of Phoenix, will accomplish the same thing. There is truth to these assertions, but can there be too much of a good thing? Can too much competition, perhaps combined with cuts in governmental appropriations, undermine even the most efficient universities’ ability to serve the public good? To discharge their value delegations, universities must have enough financial strength to balance mission with market. While competition spurs institutions toward production efficiencies, too much drives mission out of their decision making. To see why, we need to examine the non-profit decision rule more closely. Consider a mission-critical programme, say literature, that a school would like to expand but cannot because of weak demand.6 Incremental value (MV) is positive by hypothesis but expansion would require more resources (MC) than would be recouped in revenue (MR). Transposing the non-profit decision rule shows that value is maximised when MV=MC–MR. It implies that literature’s contribution margin is negative, which means the university is subsidising it through discretionary spending.7 Discretionary spending can be funded from two sources: fixed revenue, as from endowments or government appropriations, and other programmes’ positive contribution margins.8 Give a school enough fixed revenue and every programme can be subsidised – in which case all its MVs can be positive. Resources will feel

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constrained because positive MVs cry out for programme expansion, but no programme need cross-subsidise any other. Erase the school’s fixed revenue, however, and discretionary spending can only be accomplished through crosssubsidies. This requires at least some programmes to operate with positive contribution margins. Such programmes must have negative MVs, which means they are larger or priced more aggressively than would be desired if the institution had lots of money.9 The ability to earn these positive margins depends on market power. There can be no cross-subsidies in a perfectly competitive market.10 Internal subsidisation is what distinguishes non-profit from for-profit enterprises. Non-profits recycle surpluses to boost mission attainment, whereas for-profits eventually distribute the money to shareholders. Most universities rely on positive margins from popular programmes to boost discretionary spending capacity, which in turn allows them to express their values through internal subsidies. What happens if a non-profit has no capacity for discretionary spending? Again we turn to the model – this time to its MV term. I defined MV earlier as ‘marginal value expressed in dollar-equivalent units’. One gets dollar equivalence by dividing ‘subjective marginal value’ by the institution’s ‘marginal value of money’ (MVM).11 MVM is the extra value attainable from an extra dollar of spending. It usually shrinks as spending grows and universities run out of high-value activities in which to invest. Conversely, MVM may approach infinity as an institution fights for survival. MV goes to zero as MVM goes to infinity, in which case the decision rule changes from MV+MR=MC to MR=MC. Institutional values vanish from the left side of the equation, so market forces rule. Non-profits in serious financial difficulty tend to behave like for-profits! The proposition can be understood without resort to mathematics. Universities buck the market by injecting their own values into decision making. This means support of things the market does not care about, which requires discretionary spending. Institutions without spending discretion cannot assert their values. They must respond to supply and demand and only supply and demand. For example, the aforementioned literature programme might well be downsized if the university suffered a major financial setback. For-profit universities do not emphasise literature programmes because of the subject’s weak demand, just as they do not support much faculty scholarship. Literature provides an example of the so-called ‘endangered species’ argument against over-zealous reliance on markets. But one can identify other ways in which universities balance values with market forces to promote the public good. Needbased financial aid provides a particularly good example. This is being covered by others in this volume, but I should note that competition has forced many US institutions to reduce or eliminate need-based aid – just as predicted by non-profit theory. Competition from for-profit universities cherry-picks high-margin programmes – precisely the ones traditional universities rely on to generate the resources needed for discretionary spending. The president of a mid-level private university once told me what happened when the University of Phoenix moved in down the street: enrolments in her MBA programme dropped by fifty per cent in two years. I do not mean to criticise the University of Phoenix or similar for-profits. They produce real

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value for money. But we should recognise the consequences of such competition, and also competition from traditional universities that seek to expand their territory or cope with financial stringency by competing away the margins of others. 5.2. Value Issues Universities will discharge their delegated responsibilities when and only when their value functions truly reflect the public good. A university’s mission statement reflects its values. It should call out these values with sufficient specificity to provide practical guidance. Then university leaders should rally their institutions to defend and fulfil the mission in the face of internal self-interest and external market forces. To quote my colleague Bob Zemsky, “Universities should be mission centered as well as market smart”. University leaders try to fulfil this responsibility but they confront daunting obstacles. Derek Bok’s recent book on the commercialisation of higher education (Bok 2003) describes how, despite good intentions, institutional values can be undermined: for example, in distance education, applied research and – that hardy American perennial – big-time athletics. Bok asks whether today’s universities are in fact discharging their delegated value responsibilities. I will add four additional problem areas: the tendency to value inputs as well as outputs, perceived property rights within institutions, mission drift, and lack of attention to information about education quality. Valuation of Inputs. Bob Zemsky tells a story that vividly illustrates how value gets ascribed to inputs. He was Penn’s chief planning officer when, during a conversation about efficiency, the dean of the Wharton Business School asked why arts and science departments were not cutting costs by substituting staff and technology for high-cost faculty wherever possible. “If they aren’t maximising the margins available for cross-subsidies”, he asked in effect, “What are they maximising?” “Monks”, Bob replied without hesitation. “That is, faculty numbers. Like the monasteries wanted as many monks as possible – as colleagues and for the good of the order.” This does not violate non-profit theory. It just says that professors, the university’s most important factor of production, are being valued for their own sake as well as for what they produce. Perhaps there was a time when professors could legitimately be valued like monks – for example, when the university sector was small and heir to scholarship that had been kept alive by the monasteries. But massification and large-scale sponsored research have changed all that. Professors hardly represent an endangered species. In today’s world, efforts to promote academic jobs look more like labour actions than genuine interpretations of the public good. To the extent such efforts are self-serving they have negative consequences for internal efficiency.12 The consequences were less apparent before information technology began offering opportunities for changing the educational production function. Barriers to the substitution of lower-cost for higher-cost inputs are moot as long as the technical means for substitution remain limited. But that is changing. For example, the new generation of ‘learning modules’ now coming over the horizon embeds content,

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interactivity and student assessment in the same software. The design of such modules will be capital intensive and require professorial content experts – but not in large numbers. Local faculty will deploy the modules and help students interpret the material, but their efforts can be leveraged by staff and by the software itself. Professors will not become obsolete, but their role will change. Whether professors are valued intrinsically will determine the degree to which universities substitute technology and staff for faculty – and thus their internal efficiency as compared to for-profit educational providers. Property Rights. In addition to being intrinsically valued, successful academics accrue what educational economist Henry Levin calls ‘property rights’.13 They feel vested in their programmes and fiercely resist efforts to downsize them. Another story will illustrate what I mean. Suppose the dean delivers the following message to a senior professor: “I’ve got good news and bad news. The good news is that your programme’s quality has been reviewed and passed with flying colours. The bad news is that I’m eliminating it in order to fund a promising new initiative”. Imagine the strenuous appeals to colleagues, the provost, the president and friendly board members. Such behaviour reflects more than ego. Because academics are so highly specialised, losing one’s programme can blight a career. Such cuts get appealed in the corporate world, but the appeals usually challenge facts or analyses. In universities, they often focus on equity – on violations of ‘property rights’ built up by a period of successful service. Property rights represent a serious barrier to growth by substitution. Market forces can make it harder for universities to fund initiatives with new money, but they do not necessarily solve the property rights problem. To solve that problem, institutional leaders must provide due process and deal compassionately with faculty whose programmes are downsized or eliminated. Most important, they must convince their constituents to put mission first. Failure to do so prevents the university from adapting to new conditions. This diminishes its internal efficiency and ability to serve the public good. Mission Drift. Today’s market forces reinforce the natural tendency of academics to steer their institutions toward research. Most professors come from PhD programmes that stress research much more than teaching – if, indeed, teaching enters the programme at all. It is natural for professors to want to succeed at research, for this generates personal satisfaction and rich rewards in the marketplace. Salaries of research stars tend to be higher than those of great teachers, and so are mobility and the chances for promotion. Good research leads to sponsored projects, which further boost salary through summer stipends and provide funds for graduate students, equipment and travel. For institutions, research-centred prestige boosts fundraising and student demand, and sponsored projects may confer direct financial benefits. No wonder that missions are drifting toward research at surprisingly many universities, even those whose external stakeholders focus mainly on undergraduate education.14 The so-called ‘academic ratchet’ produces a “steady, irreversible shift of faculty allegiance away from the goals of a given institution, toward those of an academic specialty” (Zemsky and Massy 1990: 22). The result may at first improve educational quality. But because there are only so many hours in a day, increases in

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research per faculty member eventually come at the expense of time devoted to educational tasks. The ratchet also generates pressure for smaller classes, lower teaching loads and more courses in the professor’s specialty – which reduce the student-faculty ratio. Such shifts appear optimal to universities whose mission is drifting toward research, but they reduce internal efficiency as seen by stakeholders who do not value research to a similar degree. Missions are drifting in other ways as well: for example, Bob Zemsky and I have cited the shift from traditional academic programmes like the humanities and soft social sciences toward market-oriented programmes like executive education and technology transfer (Zemsky and Massy 1995). Such shifts stem from institutional values as well as opportunistic responses to market demand. They follow from the ‘New Golden Rule’: ‘Those with the gold set the rules’. Successful academic entrepreneurs wield disproportionate influence in the councils of their universities, and this eventually rubs off on the definition of mission. Such shifts may or may not be consistent with the value delegations of external stakeholders. Market Information. Given the grand bargain between governments and universities, one would expect institutions to provide comprehensive, accurate and timely information to prospective students. Such information is essential for the efficient operation of markets and for higher education as a public good. One would think universities would be quick to give students the tools they need to choose effectively among schools and programmes. One can imagine a world where universities shoulder this responsibility as an essential part of their mission. In such a world, institutions would learn as much as possible about how their offerings cater to or fail to meet the needs of various student groups, and then use all available promotion vehicles to get the information out. Scholarly standards of evidence would apply to such communications, and robust public debate would be welcomed as a means of spurring improvement. The interests of prospective students would be more important than competitive advantage. Puffery and ‘hard-sell’ appeals would be avoided. Such behaviour characterised some elite colleges and universities in the kinder and gentler days before the floodgates of competition opened. But generally not today, at least in the United States. To assert that the market lacks essential information may seem strange given the proliferation of college choice publications and league tables, but consider the content of these vehicles. Data on institutional size, academic and extracurricular programmes offered, faculty reputation and student selectivity abound. Graduation rates are beginning to be reported, and some US publications have added student satisfaction and impressions about the institution. For example, the Princeton Review’s “Best 351 Colleges” lists the top academic and top party schools as seen by students. What is missing, though, is systematic data on what actually happens to students between matriculation and graduation. What kinds of knowledge and skills have they acquired and how ready are they to apply their learning? How have their attitudes been moulded by the institution and their fellow students? What do students do after graduation and why? Such data would seem essential for reasoned pre-college choice. Doing without it is like buying a ticket on an airline that promises to transport you in style with people you would love to meet, but is vague

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about the destination. Psychologists may say the journey is its own reward, but one should expect more from a once-in-a-lifetime investment in higher education. Defenders of the status quo point to two widely used surrogates for education quality: research performance and admissions selectivity. The surrogates boil down to institutional prestige. Unfortunately, they are too crude to serve prospective students or to guide faculty in their efforts to improve education quality. Ask a professor how research boosts quality, and you will probably get vague assertions like ‘research allows us to get better faculty’ coupled with anecdotal examples of how a few undergraduates got involved in research and went on to gradate school in the discipline.15 Selectivity is a self-fulfilling prophecy: good students go to selective schools, interact with other good students, and lever the resulting propinquity and their college’s prestige to get ahead in life. In this case the students get what they pay for, but they would get much more if better information improved their ability to choose among the many selective schools and spurred the schools themselves to improve learning.16 Hoxby (1997) argues that peer effects justify selectivity’s self-fulfilling prophecy. To quote Geiger in this volume, “Due to their role in educating one another (peer effects), high-ability students have an incentive to cluster together. Better students contribute to higher quality, which in turn attracts better students”. The argument makes sense from the students’ point of view, but one should not use it to justify institutional indifference to the quality of educational provision. Such a position depends on the highly dubious proposition that peer effects are all that matter, that faculty performance cannot differentiate among institutions. Institutions could do more to assess their students’ learning, but most seem happy with the status quo. The elite institutions have committed themselves to research and selectivity as market appeals, and they are pleased that their prestige keeps them on top of the heap. It is telling that no elite private institutions and only a handful of the elite publics have adopted the National Survey of Student Engagement or the Collegiate Results Survey (Zemsky forthcoming).17 The market provides little incentive for them to assess and report on the quality of their students’ learning and this objective is absent from their mission statements. Indeed, the incentive may be negative because it is the dearth of good market information that perpetuates the myth that research invariably begets education quality. Many lesselite institutions seek to follow the elite ones, so improving market information is not important for them either. A few institutions are beginning to develop and publicise data on student learning, but the phenomenon has yet to reach critical mass. Worse, no ‘invisible hand’ drives markets toward better informational efficiency. 6. PERFORMANCE-BASED STEERING My conclusion in this chapter is that markets provide important incentives for internal efficiency, but that market failures prevent the full measure of efficiency rightly desired by government stakeholders. Non-profit theory shows that markets generate the same basic efficiency incentives for universities as in the for-profit

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sector. The alternative to markets is government control which, to paraphrase Friedman, produces less responsive institutions that are less adapted to the needs of parents and students. Yet the markets for higher education as currently constituted fail in certain crucial respects. Universities tend to value faculty for their own sake, which inhibits technology-based productivity improvement. They honour the perceived ‘property rights’ of faculty, which inhibits growth by substitution. They do not resist mission drift, which encourages faculty to substitute research for educational tasks to the detriment of students. They under-invest in the provision of information about education quality, which forces the market to rely on surrogates that serve the interests of providers far more than those of consumers. Markets cannot discipline price without meaningful information about quality. In the US, elite institutions exploit peer effects and price-quality associations to boost their own spending and provide a pricing umbrella for other universities and, indeed, for state governments that wish to shift funding priorities away from higher education. Worst of all, information shortfalls prevent the market’s invisible hand from driving incentives for quality improvement. We are caught in a vicious circle that produces an arms race in spending without regard to educational value added. This encourages mission drift, which actually inhibits education quality improvement. Yet non-profit theory confirms the universities’ contention that punitive funding cuts or price controls are dangerously blunt instruments for breaking the circle. What is to be done? How can governments correct the shortfalls of today’s markets without exposing universities to the non-market failures associated with regulation or overpowering them with oversimplified formulaic objectives? Hoenack’s (1983) formulation of the principal-agent problem, discussed earlier, identified only three approaches. The first two – regulation and strictly formulaic funding – are problematic in higher education. That leaves the third approach, persuasion. But persuasion cannot work without something on the line. If one likens persuasion to ‘jawboning’, to use a term familiar in the US, the jawbone must have teeth. I believe ‘performance-based steering’ is the answer. The idea is very simple: allocate a small amount of funding based on the subjective evaluation of key elements of performance – and make the evaluations public. Experience shows that a few percentage points of annual appropriation can refocus universities on important public goals (see Massy 2003), without undermining their responsiveness to markets. The goals might include demonstrated technology-based productivity improvement, growth by substitution and adherence to mission. Most importantly, they might include investment in the provision of information about education quality. Constructive dialogue on these issues would help align the university’s objectives with the public good, and the ensuing financial allocations and attendant publicity would underscore the seriousness of the exercise. Performance-based steering nudges universities in directions judged to be in the public interest, but it does not overpower them. It strengthens Hoenack’s ‘persuasive’ alternative while retaining the ‘light touch’ character of Van Vught’s conception of ‘steering from a distance’. I have discussed the approach elsewhere under the rubric of performance-based funding (Massy 2003), but the approach

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should not be confused with the many formulaic approaches that have been proposed or implemented in higher education. The keys to performance-based funding are as follows. x

x

x

x

The amount of money at stake should be large enough to get institutional leaders’ attention, yet small enough to allow them to engage in constructive dialogue without fighting the scheme at every opportunity. The objectives should be few in number, understandable and compelling in terms of the public interest. (The examples given above meet these criteria.) Institutional leaders should be allowed to present qualitative as well as quantitative evidence but the standards of evidence should be high. Unsupported rhetoric and assertion should be penalised so that institutions have an incentive to get the facts – which is a prerequisite for effective action. The exercise should be even-handed and transparent. At the same time, the evaluators should not be required to prove that their judgments are correct – it is enough to show that they flow reasonably from the facts.

Performance-based steering presumes that, as non-profit enterprises that enjoy substantial government subsidies and tax advantages, universities want to further the public interest. It also recognises that competing forces, including the pressures associated with growing marketplace competition, may cloud or confound their thinking. Resource dependency theory (Pfeffer and Salancik 1978) confirms that money is an important motivator for all kinds of organisations – including nonprofits. Performance-based steering leverages small increments of funding to nudge universities in the right direction without disempowering them. It provides for a more effective delegation of responsibility from government to universities than is possible with regulation, formulaic incentives or persuasion alone. NOTES 1 2 3

4 5

6

Described on the Web at http://eng.uvm.dk/publications/factsheets/taximeter.htm. A comprehensive mathematical treatment, including all the results discussed in this chapter, can be found in chapter 3 of Hopkins and Massy (1981). The most accessible non-technical discussion can be found in chapters 2 and 3 of Massy (2003). One can argue that for-profit enterprises include social responsibility in their objective functions or consider it as a constraint on profit maximisation. The fact remains, though, that the profit motive is dominant for most companies, especially public ones that are subject to corporate raiding. My discussion of the differences between non-profit and for-profit enterprises is based on this formulation. Most university programmes are better classified as ‘services’ than ‘products’. However, the distinction need not concern us here. Consumer surplus is the area under the demand curve. The perfectly discriminating monopolist possesses market power and is able to compartmentalise demand so that customers charged lower prices cannot resell to those charged higher prices. Price discrimination produces higher profits than a one-price-for-all strategy. The argument also applies to faculty scholarship as in the two-product entity considered earlier. However, the marketplace for faculty as a factor of production tends to bundle teaching and

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7

8 9

10

11

12 13 14

15 16 17

33

scholarship so that it is hard to hire and retain PhDs who will do the former without the latter. This does not change the example’s principles, but it does make it more complicated. This requires that the demand and cost functions meet certain regularity conditions. For linear functions, marginal revenue equals average variable revenue (i.e. price) and similarly for marginal cost. Hence MR–MC equals contribution margin. The regularity conditions do not require linearity, however. ‘Fixed revenue’ is analogous to ‘fixed cost’ in that it does not vary with changes in output. (Both quantities may vary over time, however.) Endowments always produce fixed revenue by this definition. I will address the relation of government appropriations to fixed revenue later. A negative MV does not imply that the programme is not valued overall. For example, a university might consider business education to be an important part of its mission (positive overall value) but expand enrolment beyond ideal size (negative marginal value) in order to bulk up the programme’s contribution margin. A more precise statement is, “There can be no permanent cross-subsidies in a purely competitive market where costs are homogeneous”. As in industry, temporary cross-subsidises can arise as competitors enter the marketplace or fend off others’ inroads, and permanent cost advantages can lead to permanent cross-subsidies. ‘Subjective marginal value’ is the partial derivative of the value function. MMV is the Lagrangian multiplier for the financial constraint, which is determined as part of the value maximisation. Dividing the former by the latter produces the ‘incremental contribution to mission attainment expressed in dollar-equivalent units’ referred to in section 3.2. Universities are substituting non-tenure-line for tenure-line faculty, which shows that the intrinsic valuation of faculty can take a back seat to economic necessity. Such substitution has not been easy, however. Henry R. Levin, Columbia Teachers College and formerly Stanford University, pers. comm., early 1990s. National Center for Postsecondary Improvement (NCPI) interviewers observed the drift toward research in all types of institutions studied – including comprehensive universities and even liberal arts colleges. Indeed, certain faculty at one prestigious liberal arts college (not in the study) refer to their institution as a ‘research college’. My team at the NCPI (Stanford University) did ask this question of a sample of almost 400 faculty at 19 institutions of varying types. We got the kinds of answers suggested in the text (see Massy 2003, chapter 4). This brief treatment of a very complex subject is intended to be indicative rather than fully convincing (see Massy 2003 for a more extensive treatment). As described by Zemsky (forthcoming): The NSSE or National Survey of Student Engagement has been administered over the last four years to a sample of seniors at 730 baccalaureate institutions. The instrument focuses on the extent to which the respondents’ college experiences reflected agreed upon best practices leading to a quality undergraduate education. The CRS or Collegiate Results Survey, now a licensed product of Petersons, the publishers of some of the nation’s best college guides, was initially adopted by 80 institutions in the spring of 1999. In all more than 40,000 college graduates six years beyond their receipt of a baccalaureate degree, reported on their current activities, the skills they required in the workplace, their principal activities outside of work, by responding to 10 specially crafted scenarios their degree of confidence in performing a host of tasks their college educations might have prepared them for. Neither the CRS nor the NSSE was able to convince a private medallion university to participate; none of the Ivies joined; not Duke nor Stanford nor the University of Chicago, nor any other universities belonging to the Consortium for Financing Higher Education (COFHE). A handful of public medallions – the University of Michigan, the University of Illinois, and the University of North Carolina Chapel Hill – used either the CRS or NSSE, but in general public medallions also declined to participate. Among the eight campuses of the University of California offering undergraduate programmes, for example, only UC Santa Cruz has participated in the NSSE and none participated in the CRS.

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REFERENCES Bok, Derek. Universities in the Marketplace: The Commercialization of Higher Education. Princeton, NJ: Princeton University Press, 2003. Bowen, Howard. The Cost of Higher Education: How Much do Universities and Colleges Spend per Student and How Much Should They Spend? San Francisco: Jossey-Bass, 1980. Clark, Burton R. The Higher Education System: Academic Organization in Cross-National Perspective. Berkeley: University of California Press, 1983. Duderstadt, James J. and Farris W. Womack. Beyond the Crossroads: The Future of the Public University in America. Baltimore: The Johns Hopkins University Press, 2003. Hansmann, Henry. “The Role of Nonprofit Enterprise.” In Rose-Ackerman, Susan (ed.). The Economics of Nonprofit Institutions. New York: Oxford University Press, 1986, 57–84. Hoenack, Stephen A. Economic Behavior Within Organizations. New York: Cambridge University Press, 1983. Hood, Christopher C. The Tools of Government. London: MacMillan, 1983. Hopkins, David S.P. and William F. Massy. Planning Models for Colleges and Universities. Stanford, CA: Stanford University Press, 1981. Hoxby, Carolyn M. “How the Changing Market Structure of US Higher Education Explains College Tuition”, National Bureau of Economic Research, Working Paper 6323, December, 1997. James, Estelle. “How Nonprofits Grow: A Model.” In Rose-Ackerman, Susan (ed.). The Economics of Nonprofit Institutions. New York: Oxford University Press, 1986, 185–195. James, Estelle and Egon Neuberger. “The University Department as a Nonprofit Labor Cooperative.” Public Choice 36 (1981): 585–612. Kerr, Clark. “A General Perspective on Higher Education and Service to the Labor Market.” Unpublished paper excerpted in Policy Perspectives (September), “Distillations.” 1988. Le Grand, J. and W. Bartlett. Quasi-Markets and Social Policy. London: Macmillan Press, 1993. Lilien, Gary L., Philip Kotler and K. Sridhar Moorthy. Marketing Models. Englewood Cliffs, NJ: Prentice Hall, 1992. Massy, William F. (ed.). Resource Allocation in Higher Education. Ann Arbor: University of Michigan Press, 1996. Massy, William F. Honoring the Trust: Quality and Cost Containment in Higher Education. Bolton, MA: Anker Publishing Company, Inc, 2003. Mitnick, Barry M. The Political Economy of Regulation; Creating, Designing and Removing Regulatory Reforms. New York: Columbia University Press, 1980. Pascarella, E.T. “Identifying Excellence in Undergraduate Education: Are We Even Close?” Change 33.3 (2001): 19–23. Pfeffer, Jeffrey and Gerald R. Salancik. The External Control of Organizations: A Resource Dependence Perspective. San Francisco: Harper and Row, 1978. Samuelson, Paul. Foundations of Economic Analysis. New York: Atheneum, 1974. Sappington, D.E.M. “Incentives in Principal-Agent Relationship.” Journal of Economic Perspectives 5.2 (1991): 45–66. Schumpeter, Joseph A. Capitalism, Socialism, and Democracy. London: Taylor & Francis Books Ltd, 1976 (1942). Teichler, Ulrich. “Government and Curriculum Innovation in the Netherlands.” In Van Vught, Frans (ed.). Governmental Strategies and Innovation in Higher Education. London: Jessica Kingsley Publishers, 1989, 168–211. Utterback, James M. Mastering the Dynamics of Innovation. Boston: The Harvard Business School Press, 1996. Van Vught, Frans. “Strategies and Instruments of Government.” In Van Vught, Frans (ed.). Governmental Strategies and Innovation in Higher Education. London: Jessica Kingsley Publishers, 1989, 21–46. Winston, G.C. “Why Can’t a College be More Like a Firm?” Discussion Paper 42, Williams Project on the Economics of Higher Education, May, 1997, http://www.williams.edu/wpehe/DPs/DP-42.pdf. Zemsky, Robert. “The Dog That Doesn’t Bark: Why Markets Neither Limit Prices nor Promote Educational Quality.” In Burke, Joseph C. (ed.). The Many Faces of Accountability: Holding Higher Education Responsible for Performance (working title), Jossey-Bass, forthcoming.

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Zemsky, Robert and William F. Massy. “Cost Containment: Committing to a New Economic Reality.” Change 22.6 (1990): 16–22. Zemsky, Robert and William F. Massy. “Expanding Perimeters, Melting Cores, and Sticky Functions: Toward an Understanding of Our Current Predicaments.” Change 27.6 (1995): 40–49. Zemsky Robert, William F. Massy, Daniel Shapiro, Susan Shaman, Gregors Dubrow and Jennifer Giancola. “Market, Price, and Margin: Determining the Cost of an Undergraduate Education.” Philadelphia: The Institute for Research on Higher Education, University of Pennsylvania, unpublished manuscript, 1999.

D. BRUCE JOHNSTONE

COST-SHARING AND EQUITY IN HIGHER EDUCATION: IMPLICATIONS OF INCOME CONTINGENT LOANS

1. INTRODUCTION This chapter explores the fitful saga of cost-sharing in European higher education, and some implications of the current (2003) interest in income contingent loans for recovering a portion of the costs either of student living or tuition fees or both. Europe is the last bastion (some might say the last refuge) in the world of fully (or almost fully) tax-supported higher education, extending in many countries beyond free higher education to at least some governmental, or taxpayer, responsibility for expanding higher educational participation and equity with need-based grants covering some of the costs of student living. However, there is a long tradition in Scandinavia of the student bearing all or most of the financial responsibility for food, lodging and other costs of student living – generally through partially subsidised student loans (in Sweden, loans of the income contingent variety). This long tradition of student contributions in Scandinavia, plus the increasing expenses of student living costs everywhere in Europe, coupled with low and frequently diminishing (in the UK virtually disappearing) cost-of-living grants from the government, have kept the question of student contributions – and thus of student loans – at least on the table in many European countries. The advent of tuition fees – implying a greater share of the actual costs of instruction borne by parents as well as by students, and which can be seen on a modest scale in the Netherlands, Portugal and most recently Austria, and on a more substantial scale in the UK – extends cost-sharing to a far more economically significant as well as a more ideologically controversial arena (at least in Europe). The spread of cost-sharing in Europe, then, implying parental and/or student shares of both the costs of instruction and the costs of student living, although still lagging behind most other countries of the world, has profound implications for the spread of market forces to higher education generally as well as for the realisation of the virtually universal objective of preserving and expanding equity. And in this saga, student loans – which make possible a student share of this cost burden – will almost certainly grow in importance to European higher education policies. This chapter will look first at the implications of cost-sharing, or the shift of higher educational costs from exclusive or near-exclusive financial reliance on government, or the taxpayer, to being shared with parents and/or students.1 We will consider especially the implications of cost-sharing to several different notions of 37 P. Teixeira, B. Jongbloed, D. Dill and A. Amaral (eds), Markets in Higher Education: Rhetoric or Reality, 37–59 © 2004 Kluwer Academic Publishers. Printed in the Netherlands.

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higher educational equity. We will then consider the implications of income contingent loans as a means of implementing a measure of cost-sharing. We will look especially at the implications of such loans to the two principal (and at least partially conflicting) purposes of any student loan programme: (1) to effect a real cost recovery as evidenced by a shift of some of the higher educational cost burden from taxpayers to students; and (2) to expand participation (thus advancing equity) to some who would likely have been excluded in the absence of this cost-sharing – and of the particular income contingent form of student loans. This chapter addresses the overall Douro Conference theme of higher education and market forces in the policy context of the important and virtually universal goal of higher educational equity, and in the programmatic context of the increasing popularity of income contingent loans (sometimes mistakenly termed ‘graduate taxes’) as currently employed in Sweden, UK, South Africa, Australia, New Zealand and, to a much more limited extent, the US.2 We will look especially at the current (2003) fascination with the Australian Higher Education Contribution Scheme (HECS) which embeds the incorporation of a tuition fee3 within a system that allows the fee to be either paid ‘up front’, as a direct tuition fee (presumably mainly by parents), or deferred and assumed by the student via an income contingent loan. This is the system that was adopted in 2001–02 in Scotland as an alternative to the (then) UK ‘up-front’ tuition fee and that is currently (2003) ‘on the table’ for adoption in the rest of the UK according to the government’s 2003 White Paper. 2. COST-SHARING IN HIGHER EDUCATION The concept of cost-sharing as developed by Johnstone (1986, 2002, 2003a) begins with a presumption that the underlying costs of higher education are borne by some combination of four parties: government or taxpayer (via direct or indirect taxation or even by inflation);4 parents (via savings, borrowing or current income); students (via savings, current earnings or borrowing); or philanthropists (via endowments or current contributions). Cost-sharing as a governmental policy generally refers to a shift of at least some of these costs from a substantial reliance on governments or taxpayers to a greater reliance on parents and students. Cost-sharing is especially thought of as the introduction of, or especially sharp increase in, tuition fees to cover part of the costs of instruction. In Europe, the UK is an example of a country which has recently introduced tuition fees, in 1997. Austria in 2001 became the first German-speaking country to introduce tuition fees for all students (although the fees remain nominal). The US is an example of a country that has already shifted a significant portion of higher education costs to parents and students via tuition fees – ranging in the public higher education sector in the early 2000s from ‘lows’ in the neighbourhood of $1500 to ‘highs’ in the range of $4000 to $6000 (and much higher for out-of-state students and for advanced professional students) and in the private sector from ‘lows’ in the neighbourhood of $10,000 to ‘highs’ in excess of $25,000. The US public higher education sector in particular has continued the shift via especially sharp increases in public sector tuition fees that have far outpaced not only the cost of living, but also the rise in the underlying costs of higher education,

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thus compensating (but only partly) for the very considerable cuts in state funding (Johnstone 1999 and 2004). Cost-sharing can also take the form of user charges to cover more of the costs of lodging, food and other expenses of student living that may have hitherto been borne substantially by governments (taxpayers) or institutions. In fact, much of Europe has traditionally assumed living expenses to be the responsibility of other-than-thetaxpayer, although there are differences in whether these expenses are assumed to be the responsibility of parents – as in Germany, France and most of Southern Europe – or of the students themselves, via universally available loans, as in Scandinavia. Less noticeable shifts in the prevailing patterns of cost-sharing – almost always in the direction of shifting the burden from the taxpayer to the parent and/or student – include the introduction of small, non-instructional fees (with the advantage of not having to be called tuition fees), the freezing or diminution of student support grants (especially in an inflationary economy), the channelling (sometimes with some governmental resources) of more students into a tuition-dependent private sector, or, in the few countries that have introduced significant loan programmes, an improvement in recovery rates (i.e. a lessening of needed public subsidies) via an increase in the rate of interest or an improvement in collections. A form of tuition fee that is especially popular in former Communist or Marxist countries – where there is likely to be especially intense ideological opposition to the very concept of cost-sharing, but where there is also likely to be a desperate need for the revenue that can rather easily be generated by tuition fees – is the so-called dual-track tuition fee, in which students who are not academically accepted into the small and selective pool of fully state-supported positions may still be admitted for a fee. Such a system maintains a kind of fiction of free higher education even in Russia, for example, where the revenues from tuition are approaching 50 per cent of all university revenue in spite of an official policy of free higher education (Bain 2001).5 The rationale for cost-sharing has been the subject of a large and well-accepted (even if politically and ideologically contested) body of economic and public finance theory. Much of this rationale focuses on the presumed greater efficiency brought about when there is a charge, or a price, that reflects (even with a substantial taxpayer subsidy) at least some of the real costs and the trade-offs involved. Thus, higher education that is free to the student/family ‘consumer’ can, by virtue of this degree of subsidisation, either be over-consumed (i.e. too much partaken of, or too much partaken of by students with insufficient capacity to benefit, and/or at too great a cost) or consumed with insufficient academic effort, presumably because there is no cost incurred by either the student or their family and therefore nothing foregone by the participation. Some tuition fee is thus assumed to induce both a harder working student and one who is more perceptive and demanding of the institution. And the institutions, at least in theory, have an incentive to hold down their tuition fees in order to attract and retain the student (or the parent), thus presumably becoming more efficient (or at least less wasteful), and also to provide what the student is likely to want – which is also likely to be what the potential employers want.

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In fact, the most compelling case for cost-sharing in the transitional countries of the former Soviet Union and Eastern and Central Europe, the developing world, and even in the advanced industrial countries of Europe and the rest of the OECD countries, may rely less on the economist’s presumptions of theoretically superior efficiency and equity (as valid as these presumptions may be) and more on the much simpler to grasp – and much less controversial – sheer need for alternative (i.e. nongovernmental) revenue. This need, in turn, emerges from the long and compelling queue of competing public needs (even in Europe) as well as the political pressure for tax relief. The increasing pressure on public revenues in Europe and the other highly industrialised nations is exacerbated by the effects of globalisation, which increase the predilection, as well as the ability, of taxable individuals and enterprises to escape to lower tax venues. And by most calculations, a substantial portion of this non-governmental revenue is going to have to come from parents and students in the form of tuition fees. Cost-sharing thus takes on many different forms. But in whatever form or forms, cost-sharing is generally increasing throughout the world, including the advanced industrialised world, at the start of the 21st century. For example: x

x

The US, where the costs of higher education – high and rapidly rising over time to begin with – have been rising even faster in that share borne by parents and students. Tuition fees at public universities rose by some 84 per cent in the 1990s as the share borne by governments or taxpayers diminished (NCES 2002, table 312). Public sector tuitions and fees vary widely – mainly by state and type of institution rather than by degree programme – but range for undergraduates from a low of around $2000 to a high of $5000 and more, and at least double that amount for students from another state. Total expenses to students range from a low of about $5000 for students at community colleges living with their parents, to a high of $35,000 to $40,000 a year living in residence or independently at a prestigious private college or university (Johnstone 1999, 2001b). The US, however, has extensive programmes at both the state and federal levels of government and from the colleges and universities themselves, of ‘need-based’ or ‘means-tested’ grants and minimally subsidised loans, such that all students – at least of traditional college-age, and albeit with loans and part-time employment – can afford at least the public college or university. Coincidently, the most able students, regardless of the income of their family and albeit with extensive loans, can be assured of sufficient financial assistance to attend the most expensive institution. The UK, which in 1997 became the first European country to impose more than a nominal tuition fee – although it is still low by US public college and university standards. The tuition fee in England and Wales is £1500 (2003) and can be covered by need-based grants and loans, to be repaid as a portion of student earnings, or ‘income contingently’. The government, in the form of a White Paper that is ‘on the table’, in 2003 (Department for Education and Skills 2003), is proposing to replace this ‘up-front’ tuition fee with a tuition fee that would be deferred for all

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x

x

x

x x

x

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students and repaid after graduation at a rate of interest equivalent to the increase in the general cost of living (i.e. a zero real rate of interest). This would make England and Wales much closer to the cost-sharing arrangement in Scotland, which was allowed in 2001 to replace its ‘upfront’ tuition fee (paid for by parents, albeit means tested) with a mandatory income contingent loan (paid for by students), called a ‘contribution’ to the Scottish University Endowment Fund (Department for Education and Skills 2003; Richards 2002). Australia, where the HECS was inaugurated in 1989 as a way of combining a tuition fee with a scheme that allowed most students to defer this tuition and repay as an income contingent loan at a rate of interest that would mirror the prevailing Australian rate of inflation. The tuition in 2001 was about $2600 (US) for undergraduate arts and sciences and could, in lieu of the income contingent loan, be paid ‘up front’ at a discount (Chapman 2002; Chapman and Ryan 2002). Sweden, where there is no tuition fee but students receive study assistance to cover living expenses and repay via income contingent loans. Germany, where there is also no tuition fee but where a means-tested student assistance grant is partly repayable as a conventional, very highly subsidised, loan. Austria, which ‘broke ranks’ with the rest of German-speaking Europe and began charging a tuition fee in 2001. Russia, where the universities are legally free, but where the dual tuition programme allows up to one-half of all Russian university revenue to come via tuition fees. China, which abandoned its dual tuition scheme in 1997 to charge all students a tuition fee that is high by the per capita income of the country, but that has provided a great deal of revenue for China’s rapidly expanding system of higher education.6

3. OPPOSITION TO COST-SHARING AND THE ISSUE OF HIGHER EDUCATIONAL EQUITY Cost-sharing – particularly the imposition of, or sharp increase in, tuition fees – is contested on many grounds. Much of the opposition to tuition fees, aside from that which is simply self-serving (i.e. the understandable opposition to paying for something that was at one time paid for by someone else), is based on the allegation that tuition fees are inequitable as they inhibit or discourage children of the poor (and the rural and those of ethnic or linguistic minority status or girls) from attending higher education. The relationship between cost-sharing (or tuition fees) and equity is a complex and contested one, to which we now turn. Equity in higher education has very different meanings and connotations. A core meaning is that higher education should be equitably accessible, that is, accessible to all with the interest and the academic ability to benefit. By this narrow construction

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of higher educational equity, interest and academic ability, or academic preparedness, are acceptable correlates to higher educational participation, whereas attributes such as socio-economic class, occupation, race, religion, language, one’s gender, or ethnicity of one’s parents are generally thought to be unacceptable correlates to participation. By this construction, cost-sharing can be made more or less equitable to the degree that need-based grants and/or generally available student loans are provided to those students from low income families to make up for the revenues not forthcoming from the parents. The problem with this construction of educational equity is that there is in all industrialised countries a substantial and persisting correlation between these socalled acceptable and unacceptable correlates: that is, children born into poverty or into an ethnic or linguistic minority group are statistically less likely to exhibit the interest and academic preparation for higher education and thus will be statistically less likely to participate – in spite of those children from the remote countryside or from very poor parents who surmount these odds and succeed in their academic high schools (see Farrell 1999). Most of this insufficient preparation or ambivalent interest has little to do with the presence or absence of tuition or other elements of cost-sharing, or of the availability of financial aid in the form of need-based grants and generally available student loans. However, to the degree that young people of low income, or ethnic or linguistic minority, or rural or otherwise isolated backgrounds may be more ambivalent about the opportunity costs of higher education (i.e. about foregoing the income from directly entering the workforce) or about the sacrifices and/or risks entailed by incurring indebtedness, even need-based grants and generally available student loans might not be enough to maintain equitable participation under a policy of shifting cost burdens onto students. The assurance of genuine equity in a country moving in policy directions of greater recognition of market forces and/or more cost-sharing, then, almost certainly requires a special sensitivity to, and possibly additional financial compensation for, the fundamentally greater ambivalence, the greater perceived opportunity costs and the arguably greater debt aversion of those from low income, rural, or ethnic/ linguistic minority backgrounds or, in some cultures, of females. Some critics of cost-sharing are fundamentally opposed to cost-sharing on the mainly ideological ground that higher education, like elementary education and other basic needs, simply ought to be free – that is, paid for by all citizens/ taxpayers. Some attempt to buttress this argument by asserting that the overwhelming preponderance of benefits are social – an assertion, however, that is not well supported by econometric evidence. Other critics take a more pragmatic and political view, asserting that cost-sharing accompanied by need-based grants and generally available loans might be theoretically compatible with equity, particularly if the grants are generous enough to compensate for the likely debt aversion and greater felt opportunity costs of the poor or of girls or of rural or ethnic minorities. To these critics, however, the problem is that sufficient need-based grants are simply never a high enough political priority, and that when revenue shortfalls occur or other pressing public priorities emerge, politicians are too apt to accept the high-tuition but fail to deliver the promised high-aid.7

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An altogether different construction of higher educational equity is fairness, based on the notion that those who benefit should bear at least some of the costs. Under this construction, free tuition is inequitable because the children of the wealthy in all countries disproportionately benefit, while all taxpayers/citizens (whether contributing via direct taxes, indirect taxes or the confiscation of purchasing power through deficit spending-induced inflation) bear the costs. This is the classic liberal economic critique of free tuition. From this construction of equity as fairness, free higher education is most inequitable – and therefore cost-sharing is most likely to actually further the cause of greater higher educational equity – to the degree that: (1) higher educational participation is minimal, including only the most interested and best prepared; (2) the children of the wealthy and powerful disproportionately benefit from this rationing of free higher education via their greater access to good schools, academic role models and other forms of cultural capital; and (3) the taxes used to support ‘free’ higher education are proportional or even regressive. Also by this construction, then, ‘free’ higher education that is supported by relatively progressive taxes and is more or less universally partaken of, with little if any correlation between higher educational participation and the unacceptable correlates of socio-economic class, gender and ethnicity, would be essentially equitable – or at least not inequitable. One of the major policy issues in higher education is whether the powerful trends toward greater cost-sharing and other forms of higher educational privatisation and market orientation that we are observing around the turn of the 21st century are compatible with our deeply held values of equity and social justice. The answer that most academic leaders, interested politicians and policy analysts would give is that these trends can be compatible – but only with policies and resources that provide, among other things: x

x

x

x

need-based, or means-tested, financial assistance in generous enough amounts not only to compensate for the missing parental contributions of the children of low income parents, but also to at least partially compensate for the greater ambivalence and felt opportunity costs of those children and young adults who are likely to be missing some of the culturally based academic ambition and vision of their more socioeconomically fortunate age peers; similarly, student loans to cover some of the costs both of instruction (i.e. tuition fees) and of student living – in sufficient amounts and with sufficiently manageable repayment schemes to encourage children and young adults to invest in their own further education; public information (public relations, as it were) aimed at the children of the poor and the rural and at ethnic and/or linguistic minorities and girls – in short, at all who may have been historically under-represented in higher education – to urge not only the importance but also the feasibility (especially the financial feasibility) of tertiary education; admission policies that screen appropriately for academic talent and interest, with sensitivity to the virtually universal cultural biases of most measures of academic preparedness and commitment;

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continued attention to the most problematic origins of socio-economic educational screening, which are in the middle and secondary school years and which require the greatest political attention and public resources.

With such policy attention and public resources devoted to the furtherance of higher educational equity, the superior efficiency, responsiveness and fairness associated with cost-sharing and privatisation (and with the additional public revenues made at least theoretically available by this greater efficiency) the seemingly inevitable trend toward a greater orientation to markets in higher education can be not only compatible with, but may actually enhance, our social and political attention to equity and to other public values in the academy. Expressed another way, if the trends are as ineluctable as they appear to be, and if there will almost certainly be fewer public revenues to continue free higher education plus generous need-based grants for the costs of lodging and food, then some further movement in the direction of greater cost-sharing in the mature industrialised countries seems virtually inevitable. And if this is so, then the combination of costsharing with the optimal amount and form of financial assistance – including opportunities for student borrowing – has the ability to increase the total revenues to higher education and to better focus the available public revenues in support of higher educational equity. 4. STUDENT LOANS Student loans, or any other sort of what are sometimes called deferred payment plans – including all forms of income contingent and so-called graduate tax schemes as well as more conventional, or mortgage-type, forms of lending – are integral to any policy that features a share of higher educational costs to be borne by students. Student loans purport to achieve two distinct and basically contradictory aims. In the first place, such schemes are usually part of a policy of cost-sharing, as described above. Second, loan schemes are ways of enhancing participation or accessibility, and thus equity, by increasing the total revenue stream and thus expanding higher education’s capacity (and thus its accessibility), and by making it possible for would-be students without parental or other sources of support nonetheless to invest in their own higher education. Student loans may take one of two basic forms, with many variations of each and with ‘hybrid’ versions of the two also possible.8 Conventional Loans. A conventional, or mortgage-type, loan carries three contractual elements: (1) a rate of interest expressed as an annual percentage of the amount borrowed or still to be repaid (which may be fixed or may vary according to some index such as the government’s borrowing rate or the calculated annual rate of inflation); (2) a repayment period or the amount of time the borrower has to repay the loan; and (3) a repayment mode such as whether the payments are to be in equal monthly instalments, or instalments that begin small and increase over time, or some

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other arrangement that yields a stream of payments sufficient to amortise the loan at the contractual rate of interest. Income Contingent Loans. An income contingent (or ‘contingent repayment’) loan carries a contractual obligation to repay some percentage of future earnings (sometimes per $1000 borrowed) generally until the loan is repaid at the contractual rate of interest (whether subsidised, unsubsidised, or premium – that is, designed to generate a surplus) or until the borrower has repaid for a maximum number of years. The borrower who has repaid the maximum number of years without paying off their loan at the contractual rate of interest is released from further obligations and thus granted a subsidy, or an effective grant. This subsidy is given not on the basis of the current low income of the borrower’s family at the time of the original loan, but on the basis of the borrower’s own low income over an effective earning lifetime – that is, on the basis of their higher education never really ‘paying off’ monetarily. Elements that are stipulated in the income contingent loan contract are (1) the annual repayment burden, or the percentage of income or earnings that must go to loan repayment (which may be fixed for all income levels, or progressive, increasing at higher incomes); (2) the stipulation of precisely what is to be counted as income and over what span of time (e.g. last year’s actual taxable, or the current year’s estimated gross); and (3) the provision for release from further repayments (which would be either repayment in full at a contractual rate of interest or, in the event of low income and the consequent inability to repay in full within a reasonable period of time, repayment for a maximum repayment period or until a maximum age). The elements of an income contingent loan that vary according to income or earnings, then, are (1) the actual monthly or yearly repayments; (2) the repayment period; and (3) the ultimate (i.e. after the final payment is made) cost of the loan expressed as an overall effective interest rate on the original amount borrowed. (This is in contrast to a conventional loan, which stipulates the rate of interest, repayment period and repayment mode – and thus the required monthly or annual payments – but in which the burden of repayments varies according to income or earnings.) Graduate Taxes. A variant on the income contingent loan is the graduate tax, whereby the student (sometimes only the graduated student), in return for government subsidisation of higher education in the form of low or no tuition (and possibly of an additional student maintenance grant), becomes obligated to an income surtax, generally for the rest of their earning lifetime. A true graduate tax is just that: an income surtax on university graduates, without the keeping of individual borrower accounts or ‘balances owed’. However, because the purpose of a graduate tax – like any governmentally sponsored student loan plan – is to shift a portion of the costs of higher education from the government or taxpayers to students, but to be paid only after the student has finished (presumably graduated) and is earning an income (supposedly higher because of the higher educational experience), the financial success of the graduate tax, like the success of any other student loan, must be measured by the discounted present value of this stream of future income surtax payments. Thus, the mathematics and the practical effect on participating students of the graduate tax and the income contingent loan – assuming similar terms – are practically indistinguishable. (It should be noted that there has never been, through 2003, a true operational graduate tax according to the definition just given; most

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references to graduate taxes are to income contingent loans that do, in fact, maintain ‘balances owed’.) Student Loans, Cost-Sharing and Equity. The degree to which a student loan programme, whether conventional, income contingent or a hybrid version between these two models, serves the goal of cost-sharing – that is, supplementing taxpayer revenue with student and/or parental revenue – depends on the net cost recovery of the programme. This may be viewed as the discounted present value of the reasonably anticipated repayment stream, net of defaults and servicing/collection costs. This value, in turn, depends on three elements: (1) the degree of ‘built in’, or ‘best case’, subsidisation, which is a function of the cost of money, the interest rate charged to borrowers who repay in full, the repayment periods and the number of low-earning borrowers who, in the income contingent plans, will eventually be released from further repayment obligations with balances outstanding; (2) anticipated defaults (mainly, although not exclusively, within the conventional repayment plans); and (3) the costs of servicing and collections. On the other hand, the degree to which a student loan programme serves the goal of higher educational equity – that is, reducing the link between higher educational participation and the aforementioned unacceptable correlates of socio-economic class, gender, ethnicity and the like – depends on the degree to which the loan programme makes possible participation that would be unlikely in the absence of this student borrowing. And insofar as virtually all generally available student loan programmes require some public subsidisation – and thus must be viewed as tradeoffs for other equivalently costly ways to expand participation and equity – the taxpayer costs of the student loan programme, including all publicly funded subsidies, administrative costs and guarantees against default, must be compared alongside alternative public expenditures to the same end, such as free or highly subsidised tuition fees for all, or additional need-based grants. In this comparison – because only a loan programme makes possible a substantial contribution from the students themselves – a student loan programme that is minimally subsidised, efficiently administered, and experiences modest defaults (all of which are possible in advanced countries) has the theoretical ability to release some public revenues from the support of all instructional expenses to be used in various targeted ways to advance participation and equity. 5. INCOME CONTINGENT VERSUS CONVENTIONAL REPAYMENT OBLIGATIONS: MISUNDERSTANDING, MISREPRESENTATION AND UNINTENDED CONSEQUENCES As an optional mode of repaying a student loan, the income contingent repayment form has some theoretical as well as practical advantages and has attracted (for quite different reasons) the attention of economists, politicians and students alike. In fact, knowledgeable proponents of income contingent loans, such as Australia’s Bruce Chapman (Chapman 2002; Chapman and Ryan 2002) and the UK’s Nicholas Barr (2001), proclaim income contingent loans to be ipso facto superior to all other forms of student lending. However, income contingent loans are also thoroughly

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confounded with misunderstandings, misrepresentations and unintended consequences. As an example of a misunderstanding, much of the popular attractiveness of income contingent loans is not the property of income contingency, per se, but of the extent and type of the built-in governmental subsidisation of a particular loan plan or of the use of the government’s machinery of income tax withholding and pension contributions – either of which could be extended just as well to conventional, or mortgage-type loans. In addition, there are certain disadvantages in the income contingent loan form that seem insufficiently recognised by their proponents. (These genuine disadvantages, incidentally, are generally not the alleged disadvantages cited by student groups and others simply opposed to any form of tuition fees and/or student loans.) There is also, whether intended or not – particularly in the political advocacy of income contingent loans – what would appear to be misrepresentation, as in the employment of income contingency to effectively obfuscate the true nature of tuition fees, the implications of student indebtedness and how particular plans shift the higher educational cost burdens among taxpayers, parents and students. This misrepresentation (if it is indeed that) may be politically expedient. But it may also simply postpone more difficult but necessary actions on the part of government and/or encourage students to borrow more than they would otherwise intend. Finally, as in so many public policies forged in ideological conflict and political compromise, there may be unintended consequences – or at least consequences that were almost certainly unintended by some of those responsible for the policy and its details. In the case of the Australian HECS, its ‘look alike’ adoptions in Scotland and Wales, and its serious entertainment by the UK government for the rest of the UK, a consequence that appears to be unintended (at least to some) is a shift in the higher educational cost burden not from parents and students to governments and taxpayers, but from parents (who can and do pay) to students in the form of additional indebtedness. In short, while the income contingent repayment form does have attractive features, it is well to keep in mind several qualifications, or caveats, to the common presumption of the superiority of the income contingent loan form (for elaboration on these points, see Johnstone 2000, 2001a). In the first place, an income contingent loan is still a loan and is not per se any ‘cheaper’ for most students than a conventional loan merely because the repayment obligation is expressed as a percentage of income or earnings. The cheapness or expensiveness of a loan – not to be confused with the manageability of its repayments – is measured by its ‘true’ simple annual interest rate (or the discounted present value of the repayment stream). In any income contingent loan, most borrowers will still repay their loans ‘in full’ at whatever interest rate is built into the provisions of the loan, depending on how generous the government (or any other lender) aims to be. Both the Australian and UK plans aim to collect from most borrowers a zero real interest rate – that is, a rate of interest that mirrors the prevailing rate of inflation. South Africa aims to collect a 2 per cent real rate of interest, that is, 2 percentage points above the prevailing rate of inflation. The US income contingent loan, on the other hand, aims to collect through those loans to be repaid income contingently the same rate that is charged on other repayment modes which in 2002 was 8.25 per cent. If there is a

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special advantage to the borrower in the degree of subsidisation, it is not from the income contingent nature of the repayment obligation. Some proportion of low earners, of course, fare better in an income contingent plan. But the degree of low earnings subsidisation is a function of the percent of income or earnings to be repaid and the number of years that a low earning borrower will be ‘held in repayment’ attempting to repay ‘in full’. Thus, the degree of low earner subsidisation is separate from the degree of subsidisation accorded to all borrowers – and each is a function of the particular features built into the particular plan. An income contingent loan scheme can provide especially generous subsidisation to the lifetime low earner by means of a low percent-of-income repayment rate and a short maximum repayment period. Or, an income contingent scheme can require almost all borrowers to repay their loans at the same interest rate, requiring low earners to repay for extremely long repayment periods and reserving real repayment forgiveness only for the truly destitute.9 Second, some of the attractiveness attributed to income contingency – specifically, the presumed convenience to the borrower and the presumed greater certainty of repayment (and thus of lower defaults) to the lender, or the government – comes primarily from the government’s willingness to enlist the policies and procedures of income tax and pension or insurance withholding to the cause of collecting student indebtedness. But this machinery, including the power to mandate employers to collect such sums at the point of wage and salary payments, as well as the government’s power to verify compliance and punish transgressors, could in theory be applied as well to the collection of conventional loans, or, for that matter, to the collection of any payment owed by citizens, the effective collection of which is deemed to be of overriding public importance (e.g. local taxes, child support, alimony, traffic fines, philanthropic contributions or tort judgments).10 Third, an income contingent loan presents major complications not found with conventional mortgage-type loans. Most of these arise from the need to stipulate precisely, and to be able then to verify, the income that is effectively to be ‘taxed’ in order to arrive at the proper repayment amount. Multiple sources of income, highly variable income, income that tends to not get reported at all, and income that can be easily shifted between a borrower and a non-borrower member of the family all constitute great problems for the viability of an income contingent loan scheme. OECD countries, with extensive reporting and monitoring of virtually all income and with a culture of voluntary income tax compliance, may be able to overcome these problems, as Sweden and Australia seem to have done. For other countries, where sources of income or earnings are frequently multiple, highly variable and generally unreported, the problem of establishing the repayment obligation will be an enormous one and will invite misrepresentation of income and almost certain repayment shortfalls. (This is quite clearly the case in virtually all developing and transitional countries; but may also be the case in many European countries where income tax evasion has been carried out to a high art.) (See Johnstone 2001a, 2003b.) Finally, following upon the observations above, it is not as clear as it is often proclaimed that an income contingent loan will be superior on the criterion of effective cost recovery. Student loan plans, whether conventional or income

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contingent, will recover insufficient repayments to the degree that the plan: (1) carries too great an interest subsidy (i.e. is initially designed to recover far below the true opportunity cost of money); (2) incurs excessive defaults or consistent underpayments; or (3) is excessively costly to service. It follows, then, that successful plans – at least on the criterion of effective cost recovery – will be minimally subsidised and will experience minimal defaults, underpayments and administrative costs. The appropriate question for our analysis, then, is whether an income contingent or a conventional form is apt to be better on the criterion of actual cost recovery assuming that either plan would carry the same degree of builtin taxpayer subsidy and that either would have the same access to whatever governmental machinery existed for the collection of tax withholding and pension contributions at the point of wage and salary payment. The question posed in this way can only be answered in theory, as the purportedly successful income contingent loan programmes such as those in Australia, New Zealand, Sweden and South Africa have never been compared ‘side by side’ to a conventional loan programme operating in the same culture and with the same access to governmental subsidies and to the government’s tax and pension withholding machinery. In theory, however, the two repayment forms are likely to experience different kinds of losses. A conventional repayment plan incurs losses from defaults or from losses in cash flow due to late payments – either of which may be attributable to wilful non-payment or to errors in servicing and collection. Both default and arrearage can be expected to increase with financial hardship – as in periods of unemployment – although sensitive provisions for deferment or refinancing can lessen such losses in conventional loan schemes. Losses from income contingent loans, on the other hand, will mirror the losses from income tax collections generally in the particular country: that is, from non- or under-reporting of income, either earned or unearned, and from overstatement of the expenses purportedly incurred to bring in this income (or of any other kinds of otherwise allowable deductions from an individual’s gross earnings). The problem with income contingent repayment obligations is their essential non-detectability. There is no signal, or trigger, similar to the missing of a scheduled payment on a conventional loan for the underpayment on an income contingent loan due to an under-reporting of income. In short, a conventional loan programme employing a combination of monthly repayments as well as employer deductions where appropriate, with vigorous enforcement, and with clear repayment expectations at the time of initial borrowing as well as at the time of departure from the university, may stand to recover as much or even more than an income contingent plan. 6. INCOME CONTINGENT LOANS AND THE NEED FOR PRIVATE LOAN CAPITAL Insofar as the impetus behind student loans is the need to shift a portion of the costs of higher education from governments to students, the loans need ultimately to tap private savings rather than rely simply on governmental tax revenue. Large-scale savings in industrialised countries are found mainly in banks or investment funds, in

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corporate and insurance company reserves, funded pension plans and the like as well as in personal savings accounts. These private savings are tapped either by having banks make and hold the loans, or by having the university or the government make the loans, but then to sell the loan notes in ‘bundles’ to the banks or other primary holders of savings. The student loan notes themselves are too risky for private savers without some assurance of ultimate repayment – for example, collateral from the parents or a guarantee from the government – but with this assurance, the student loan notes can find buyers in the private savings market. Herein lies another problem with loans of the income contingent variety. Unlike most conventional loans that may be defaulted upon but can then be collected from a guarantor or co-signatory (or collateral seized and sold), an income contingent loan, although fairly well insulated from defaults per se, can be recovering little or no repayments due to the low but misreported current income of the borrower and still not be detectable as a default, per se. The holders of the income contingent loan notes, then, would be unable to collect from any guarantor or co-signatory; indeed, guarantors and co-signatories are generally not associated with income contingent loan schemes. Depending on the nature of the prevailing employment, the health of the economy, the technical ability of government to monitor all incomes and the culture of compliance with income tax reporting and payment, the risk of underpayment on an income contingent loan may be as common – but considerably more difficult to ‘catch’ or ‘stem’ – as defaults and arrears on conventional loan repayments. Thus, loans of the income contingent variety are less likely than conventional guaranteed loans to find any private buyers and therefore to continue their dependence on government/taxpayer for loan capital.11 7. AN UNINTENDED CONSEQUENCE: INCOME CONTINGENCY AND THE SHIFT OF PARENTAL TO STUDENT COST BURDEN One of the consequences of the form of income contingency that has been adopted in Scotland and is advanced in the 2003 UK White Paper (Department for Education and Skills 2003) is the transfer of cost burden from parents to students. This is because income contingency in these cases has been advanced not as a way simply for the students to repay an indebtedness already deemed by policy to belong appropriately to the student, but as a means of shifting that cost burden currently borne by many parents, in the form of the relatively small, means-tested tuition fee, to an additional burden borne by students (i.e. in addition to what students are already bearing, frequently through student debt, via their assumption of living expenses). For this reason, it is important at this point in our analysis to explore the distinction between the parent share and the student share of costs of higher education, and their respective roles in any considered policy shift from the government, or taxpayer, to either or both the parent and student. Cost-sharing is frequently advanced as though the student share and the parent (or family) share were theoretically and practically indistinguishable. This can be true in some instances. Policy assumptions can be made that parents with certain profiles of income, assets, purported special hardships and other dependent children

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still in school can afford to contribute so much to the costs of their children’s higher education and that students ought to be able to earn so much during their years at the university and then be able to bear so much higher educational indebtedness to be repaid after graduation. In practice, however, some students may wish to be financially independent even though their parents could and would contribute; or some parents may decide not to contribute up to the expected amount. In either case, the children will need to earn more and/or assume more indebtedness in order to replace the now-missing expected parental contribution. Or, students may assume higher educational indebtedness according to plan, but it may be the parents who in fact make the repayments, further complicating whether the non-governmental share is being assumed by the student or the parent. However, the theoretical rationales underlying the expectation of a parental (or perhaps an extended family) share and a student share are quite different. A parental contribution is based on the principle that the student is still, at least through their first degree (assuming no significant time lapse between the completion of secondary and the beginning of tertiary education), a financially dependent child and that parents have an obligation to contribute financially to the expenses associated with their children’s higher education, at least to the limit of their financial ability. (Additionally, it is assumed that the parents derive considerable satisfaction from the higher education of their children, and receive more satisfaction – and even some derived status – from being able to place their children in the ‘best’ university they can afford and that their children are able to get into.) In countries that have tuition fees, this parental obligation, or expected parental contribution, generally extends both to the underlying costs of instruction (i.e. tuition fees) as well as to food, lodging and other expenses of student living. Where there is an extensive, tuition-dependent private sector and where the public sector also charges more-than-nominal tuition fees, the expected parental contributions can be very high indeed.12 To the extent that the parents are financially able, these contributions are expected to be borne at least through the baccalauréat, and the family may be expected even to draw on savings or other assets and in some instances to borrow from future income. In order to uphold the principle of higher educational opportunity, or widespread accessibility – a principle officially embraced by virtually all countries – the notion of an officially expected parental contribution requires some measure of parental means or need so that financial assistance or some kind of offset to tuition fees can be granted. This requires some way to assess and be able to verify the parents’ professed means, or need. In most of the OECD countries, especially those that rely heavily on income taxes and have thus constructed elaborate systems of determining and verifying income from all sources (both earned from wages, salaries, commissions and the like, and unearned from dividends, interest and rents), parental means can be reasonably inferred from whatever income has been determined to be appropriately taxable.13 The expectation of a parental contribution towards the expenses of higher education raises a number of other complications and questions: for example, the degree of sacrifice to be expected, whether to consider assets such as the family home in the calculation of ability to contribute, whether to expect the parents to

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have made any effort to have saved for their children’s higher education, or whether reasonably to expect some additional parental indebtedness. Officially expected parental contributions become complicated in instances of parental separation or divorce or disputed custodianship of the children. Also, there is a question about where to draw the line between financial responsibilities for the first degree, and for subsequent advanced degrees. But the most complicating factor of all may be the very appropriateness of the expected parental contribution itself: that is, the assumption underlying an officially expected parental contribution that the student is still, at least while enrolled full time through a first degree, a financially dependent child. The validity or applicability of this assumption, that is, whether the university student is properly viewed as a financially dependent child or an independent adult, is largely cultural, but is also a function of the extent of higher educational participation in the particular country as well as the ability and willingness of that government to tax, both extensively and progressively. US parents, for example, expect to pay at least through the baccalauréat (to the extent they are financially able) and are even expected to draw on savings or assets, and in some instances to borrow from future income. South and East Asian parents seem to expect to contribute and to sacrifice financially to support their children. German parents are obligated by law, up to their officially calculated means, to contribute to their children’s costs of food and lodging (there are still no tuition fees), and they can be taken to court for the failure to do so. British parents, according to Barr (from studies in the early 1980s and reportedly corroborated in the early 1990s), frequently do not meet the full officially expected parental contribution, leaving students both “… in poverty” and “… in a dependent position” and leading Barr to conclude that a proper UK system should eliminate ‘up-front’ fees and the notion of an expected parental contribution altogether (Barr 2001: 205). In contrast, Scandinavian culture views the student as an independent adult, and there is no official parental contribution either toward the costs of instruction (there are no tuition fees) or toward the costs of student living, which are deemed to be the responsibility of the students themselves (although many observers believe that many Scandinavian parents in fact do contribute). But the Scandinavian countries are also blessed with high per capita incomes and very successful and progressive tax systems. Scandinavian parents understandably believe themselves to have already paid for their children’s university education – and the families that are most likely to send children on to higher education have almost certainly paid substantially more taxes than those who are not. In addition, Scandinavian countries have effective and ubiquitous student loan schemes that impose considerable costsharing on students in the form of student financial responsibility for virtually all of the costs of student living. Thus, a combination of wealth, relatively flat demographics (providing for high but relatively stable participation rates), a very progressive and technically successful tax system, and extensive and generally available student loans allow the Scandinavian countries to forego an officially expected parental contribution towards either the costs of instruction or the costs of student living.

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The theory behind the appropriateness of a student contribution, on the other hand, is based almost entirely on the assumption of substantial personal and private benefits from higher education. These presumed benefits may be manifested in higher lifetime earnings, greater status and influence, more ‘life options’ or simply the personal satisfaction that comes (to most people) from being better educated. This theoretical appropriateness of a student contribution is buttressed by the fact that higher education in almost all countries (including developing and transitional countries) tends to be partaken of disproportionately by an intellectual and social elite further supporting the principle that students should contribute something toward the costs of their higher education. It is this principle – quite apart from the principles that supported the parental contribution – that calls for student loan programmes so that students can defer this contribution until they are financially able to do so. However, the increasing interest in the UK and elsewhere in adopting an Australian-type scheme in lieu of a tuition fee will have the effect of shifting what has been a financially successful (if controversial) parental contribution to an additional student contribution toward the costs of higher education. 8. INCOME CONTINGENT LOANS AND EQUITY The other major aim of student loan programmes – to some degree working against the goal of shifting the expense burden from the taxpayer to the student – is to maintain and even enhance equity or access to higher educational opportunities. Taken by itself – that is, without any additional cost-sharing, or further shift of cost burden to parents and/or students – the ability to borrow, at a reasonable rate and possibly with little or no collateral, provides a way for some students, particularly those from poor families or those who by any system or tradition have outgrown their financial dependence on their parents and who thus may have no other resources, to be able still to invest in their own higher education. In addition, student loans (as a component of cost-sharing, designed to provide additional revenues to higher education) provide a way to expand revenues, therefore to expand capacity and the participation of those for whom the access barrier is as likely to be insufficient higher educational capacity as it is to be insufficient personal or parental resources. It is true that students would prefer no tuition fees to even some tuition fees and would prefer grants to loans. It may also be the case that there are some populations (perhaps rural, or ethnic or linguistic minorities) who are more debt-averse and reluctant to borrow, and who would, in the short run, abandon altogether higher educational aspirations for themselves or for their children if borrowing is the price of getting a higher education. On the other hand, the claim of widespread debt aversion may also be a self-serving assertion by students who will not lose their presumed entitlements without a struggle. In the end, since the consequences of insufficient higher educational revenue and therefore of insufficient higher educational capacity tend inevitably to fall disproportionately on the poor, who have no private or ‘out-of-country’ alternatives, it is more likely in fact to be the poor

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who most need the loans, both for higher educational capacity to be increased and for a way to make an investment in their own future. The question that is relevant to this enquiry, then, is whether a particular form of student lending – specifically a conventional loan with a known cost (i.e. a simple annual interest rate) and a fixed repayment schedule or an income contingent loan with a fixed percent of income owed, but an indeterminate cost and repayment period – provides more access. Posed another way, this question asks whether one or another form of student indebtedness makes students more (or less) willing to go into debt in order to attend a college or university that they would have been unable to attend in the absence of that opportunity to borrow. Some subtly different forms of nearly the same question include: Which form of student loan repayment obligation would the student prefer at the onset of the need to borrow (when, as in the US, an income contingent repayment mode might be available as an option)? Which form would the student prefer when actually making the repayments? Under which form of repayment obligation would the student be better off after full repayment? These loan preference questions are exceedingly difficult to answer even in theory, and quite impossible to answer experimentally or through actual observation, as there have been so few occasions where there have been two different but fiscally comparable plans in operation long enough to see which one seems to make a difference in accessibility. In fact, the US Direct Loan Program provides the only generally available student loan programme in the world where borrowers have a choice between an income contingent, a conventional mortgage-type, and a fixedbut-graduated repayment mode – each with precisely the same present value of anticipated repayments. In this contest, the income contingent option has not been the favoured choice (General Accounting Office 2001). In fairness to the proponents of income contingency, the US income contingent option is also extremely complicated, notoriously ungenerous to low-earning borrowers, and lacks the convenience of being ‘piggybacked’ onto the US income tax and social security withholding systems at the point of wage and salary payment, and so fails on all counts to provide the kind of loan that the proponents of income contingency have always advocated. The US income contingent option has been purposely constructed to maximise the recovery of repayments, minimise the need for governmental subsidisation (at least beyond that called for by the conventional student loan plans) and not provide any further burden to employers or jeopardise the very high US voluntary income tax compliance. On the other hand, another reason for the relative lack of interest in the US income contingent repayment option may be that the US conventional student loan schemes currently (as of 2003) provide such easy and almost automatic deferment in the event of a return to school as well as relief and refinancing in the event of unemployment or other occasions of genuine financial hardship that the flexibility and manageability once thought to be the special property of income contingency seem now to have been built into US conventional loan programmes (US Department of Education 2003).

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9. INCOME CONTINGENT LOANS AND POLITICAL EXPEDIENCY At the same time, even if income contingent loans are neither ipso facto less costly or burdensome, nor even necessarily more manageable, they may still be more politically saleable than loans of a conventional variety – and, thus, more likely to allow the introduction of cost-sharing into a country where there is extraordinary resistance to the very concept of either students or parents bearing a significant portion of the costs of higher education. This is a purely political – almost a public relations – case for income contingency. The Australian HECS, for example, has been undeniably successful in expanding the revenue to higher education. It can also be said that it has done so in a way that obscures the fact that it is the introduction of tuition fees – far more than the introduction of any particular means of handling the resulting student loan obligation – that accounts for the increased flow of revenue to Australian public higher education. The increased revenue still comes in the first instance entirely from the government. But the government is presumably more generous to the Australian universities because of the two forms of enhanced revenue offsets within HECS: (1) the increased non-governmental revenue from the parents who pay tuition up front to lessen their children’s HECS obligations; and (2) the increased governmental borrowing capacity that is at least in theory covered by the government’s new assets in the form of the signed HECS future ‘surtax’ obligations. In the case of Scotland, most students and most of the political left were apparently made happy by the conversion of what was a relatively modest, meanstested and largely parent-borne tuition fee to an entirely student-borne income contingent loan – for some reason preferring the additional burden on students (cleverly termed a ‘contribution to the Scottish University Endowment Fund’) to Britain’s politically unpopular tuition fee. And the 2003 UK White Paper, The Future of Higher Education, is promising the same thing for England, that is, the conversion of what has been an avowed and continuingly controversial (however modest and means-tested) tuition fee to a mandatory student-borne income contingent loan – on top of loans that the students are already bearing for their living costs. Some academics and policy analysts may be made uncomfortable by what might be viewed as misrepresentation – represented, for example, by calling a mandatory contribution from students and/or parents to cover a portion of instructional costs anything but what it is: a tuition fee. Furthermore, students who are made to believe that their income contingent obligations are fundamentally unlike real debts may borrow more than they need to, or even mean to. Similarly, politicians may erroneously believe (or be encouraged to pretend that they believe) that they have solved a serious higher education revenue problem when of course they have not – to the fiscal jeopardy of the public universities and possibly as well to the students. On the other hand, if the ideological and political opposition to tuition fees and other elements of cost-sharing is so extreme – and the need for other-thangovernmental revenues is so great – then perhaps the introduction of tuition fees and student loans under the cover of an income contingent contribution is worth the price of just a little misrepresentation.

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In summary, income contingent loans modelled on the Australian HECS would seem to work well when: x

x

x

x

a government, by downplaying (or not mentioning at all) the politically treacherous concept of tuition fees, is able to get an element of costsharing that it would likely be politically unable to get were it to advocate openly even a modest tuition fee; a government, in stressing mainly the income contingent loan obligation of the student in lieu of a tuition fee, is willing to forego the potential of more up-front tuition and to minimise the role of parents (even affluent ones) as an important partner in sharing the costs of higher education; a government does not really need even the students’ deferred revenue now, but is able to tax and/or borrow sufficiently to keep the public universities academically strong and accessible, and is willing and able as well to be the true lender for the student loan scheme; the majority of student borrowers (or students who become obligated to future income contingent payments) will have during most years of their working lives a single employer at a time, who will pay them a periodic and relatively regular salary, and who will also be sufficiently large, sophisticated and legally compliant that they can be counted upon to take out of the borrower’s paycheck the correct amount owed for student loan repayment, year in and year out.

Conversely, HECS-type income contingent loans are less applicable when: x

x

x

x

the need is for non-governmental revenue now, making the parental contribution to tuition (even with a great deal of discounting) the primary source of needed revenue supplementation; the scarcity of governmental revenue precludes government from being the sole lender (which places a premium on student loans that have some – albeit discounted – value on the private capital market); many of the graduates (borrowers) are likely to hold multiple short-term jobs and to be employed in the informal economic sector where records are most unreliable – or to emigrate; there is no tradition of voluntary, reliable self-reporting of incomes, and the state systems for monitoring and verifying incomes for the purpose of income tax withholding and/or pension or social security contributions are non-existent or unreliable. 10. SUMMARY

Cost-sharing, or the shift of increasing portions of the costs of higher education from governments and taxpayers to parents and students, early in the 21st century, is pervasive and expanding even as it remains controversial. Within this policy shift, student loans, also controversial, seem destined to play an increasingly important

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role. And among the very many forms of student loans, the form employed by Australia in its HECS, together with other variations of so-called income contingent loans, are receiving increasing attention from politicians and policy makers. The Australian scheme appears to have been successful, and there are many reasons to favour elements of student loan programmes that incorporate features associated with income contingency generally. At the same time, income contingent loans, especially as identified with the Australian HECS, seem also immersed in misunderstanding, misrepresentation and unintended consequences. Student loans are important, both to the financial viability of higher educational institutions, to the accessibility of these institutions to students without regard to the income or other background characteristics of their families. But student loans are also more complicated than often portrayed. Countries contemplating the adoption of loans, or of larger financial schemes that incorporate the deferment of a student contribution, should study carefully both the theoretical underpinnings of cost-sharing and the actual operations of alternative programmes of tuition fees and student loans. NOTES 1

2 3

4

5

6 7

8 9

This chapter is considering cost-sharing and the phenomena of privatisation and marketisation within the public, or at least the publicly financed, higher education sector, which in all of Europe remains the overwhelmingly dominant sector in spite of the rapidly emerging privately owned, tuitiondependent institutions in post-Communist Eastern and Central Europe, Russia and the other European countries of the former Soviet Union. Income contingent loans are also being urged by their proponents in some of the formerly Communist countries in Eastern and Central Europe as well as in many developing countries. In the UK and elsewhere (except US), the word tuition means instruction: thus the price one must pay for instruction needs to be called a tuition fee. In the US, the word tuition has come to mean only the fee, and so the term tuition fee would seem redundant. However, this chapter will follow the UK usage and generally refer to the tuition fee. It is important to bear in mind that the ‘taxpayer’ can also be the average citizen consumer or even worker whose real take-home pay is diminished by the government in indirect forms of taxation, such as payroll taxes or even business taxes, which leave less revenue to be distributed to workers, or even (the most regressive form of taxes) to deficit finance-induced inflation that only indirectly, but still assuredly, removes the purchasing power from the ordinary citizen or worker. Dual-track tuition is also seen in several countries of East Africa (also with Marxist legacies) where, for example, Makerere University in Uganda, arguably one of the most successful in Sub-Saharan Africa, admits as many as 80 per cent of its students on a tuition fee-paying basis in spite of the official governmental policy of free higher education (see Johnstone 2003b). For cost-sharing information of some 35 countries, see the International Comparative Higher Education Finance and Accessibility Project web site at http://www.gse.buffalo.edu/org/IntHigherEdFinance/ (November 2003). This critique is especially compelling in low income countries where student loans have simply not worked, for all kinds of reasons (see Colclough 1991 for an effective presentation of such a view). See Johnstone (2000, 2002) for a rebuttal, pointing out that most of the student loan programme failures in Sub-Saharan Africa, for example, are essentially faults in programme design and should have been anticipated, and that the right combinations of programme design and efficient execution, with the exception of South Africa, have simply not occurred. The section on conventional loans draws extensively on Johnstone (2000) while the section on income contingent loans draws on Johnstone (1972). This is quite clearly the case in the US optional income contingent repayment mode, which has not been popular with students in part because of its extreme complexity, but in part also because only

58

10

11

12

13

D. BRUCE JOHNSTONE the very destitute stand to gain any ultimate forgiveness, with all others paying until their loans are fully repaid at the same rate of interest as on other conventional student loans. An obvious corollary to this presumed advantage, of course, is that a government that lacks the power and/or established means of collecting taxes and pension contributions from all or nearly all of its citizens can hardly be expected to be able to collect much of any payments on income contingent loan or graduate tax obligations. Even in Australia, which touts its HECS as a success and a model for much of the world, the loans depend entirely on government revenue, and the income contingent loan notes in the hands of the government (i.e. the promises to pay what can be viewed as income tax surcharges) have virtually no market value (even though these HECS promises could in theory sustain a higher level of governmental indebtedness). This theoretical position, however, has not been supported by the International Monetary Fund. US parents, for example, can expect to pay $10,000 or more for their child to attend a public college or university and $25,000 or more for an expensive private college, in both cases including tuition fees as well as student living expenses – and also in both cases in addition to the $5000 to $10,000 share that may be expected to be borne by the student through loans and part-time employment. In countries with neither highly developed systems nor a culture of tax compliance – and this includes most if not all developing and transitional countries – the determination of parental or family means and thus of the financial assistance required for a student to access higher education is extremely difficult and subject to both error and misrepresentation. In such cases, approximations to, or proxies for, means such as parental occupation, or the educational level of one or both parents, or verifiable ownership of an automobile or of a home with plumbing, may have to be employed (see McMahon 1988; Tekleselassie and Johnstone forthcoming; and Wolanin 2002).

REFERENCES Bain, O. “Cost of Higher Education to Students and Parents in Russia: Tuition Policy Issues.” Peabody Journal of Education 76.3/4 (2001): 57–80. Barr, N. The Welfare State as Piggy Bank: Information, Risk, Uncertainty, and the Role of the State. Oxford: Oxford University Press, 2001. Chapman, B. A Submission on Financing Issues to the Department of Education, Science, and Training Inquiry into Higher Education Reform. Submission 317, Higher Education Review. Canberra: DEST, July, 2002. Chapman, B. and C. Ryan. “Income Contingent Financing of Student Charges for Higher Education: Assessing the Australian Innovation.” In Woodhall, M. (ed.). Paying for Learning: The Debate on Student Fees, Grants and Loans in International Perspective. Special International Issue of The Welsh Journal of Education 11.1 (2002): 64–81. Colclough, C. “Who Should Learn to Pay: An Assessment of Neo-Liberal Approaches to Education Policy.” In Colclough, C. and J. Manor (eds). States or Markets? Neo-Liberalism and the Development Policy Debate. Oxford: Clarendon Press, 1991, 197–213. Department for Education and Skills. The Future of Higher Education (White Paper). London: Her Majesty’s Stationery Office (HMSO), Cm 5735, 2003. Farrell, J. “Changing Conceptions of Equality in Education.” In Arnove, R. and C. Torres (eds). Comparative Education: The Dialectic of the Global and the Local. Lanham: Rowman and Littlefield, 1999, 149–177. General Accounting Office. “Details on Income Contingent Repayment in FDLP.” Alternative Market Mechanisms for the Student Loan Programs. Appendix IV. Washington, DC: US General Accounting Office, 2001, 82–92. Johnstone, B. New Patterns of Student Lending: Income Contingent Loans. New York: Teacher’s College Press, 1972. Johnstone, B. Sharing the Costs of Higher Education: Student Financial Assistance in the United Kingdom, the Federal Republic of Germany, France, Sweden, and the United States. New York: College Entrance Examination Board, 1986. Johnstone, B. “Financing Higher Education: Who Should Pay?” In Altbach, P., R. Berdahl and P. Gumport (eds). American Higher Education in the Twentieth Century: Social, Political, and Economic Challenges. Baltimore: Johns Hopkins University Press, 1999, 347–369.

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Johnstone, B. “Student Loans in International Comparative Perspective: Promises and Failures, Myths and Partial Truths.” International Comparative Higher Education Finance and Accessibility Project. Buffalo: University at Buffalo Center for Comparative and Global Studies in Education, 2000, http://www.gse.buffalo.edu/org/IntHigherEdFinance/. Johnstone, B. “The Economics and Politics of Income Contingent Repayment Plans.” International Comparative Higher Education Finance and Accessibility Project. Buffalo: University at Buffalo Center for Comparative and Global Studies in Education, 2001a, http://www.gse.buffalo.edu/org/IntHigherEdFinance/. Johnstone, B. “Higher Education and Those ‘Out-of-Control Costs’.” In Altbach, P., P. Gumport and B. Johnstone (eds). In Defense of American Higher Education. Baltimore: The Johns Hopkins University Press, 2001b, 144–180. Johnstone, B. “Challenges of Financial Austerity: Imperatives and Limitations of Revenue Diversification in Higher Education.” In Woodhall, M. (ed.). Paying for Learning: The Debate on Student Fees, Grants and Loans in International Perspective. Special International Issue of The Welsh Journal of Education 11.1 (2002): 18–36. Johnstone, B. “Cost-Sharing in Higher Education: Tuition, Financial Assistance, and Accessibility.” Czech Sociological Review 39.3 (2003a): 351–374. Johnstone, B. “Income Contingent Loans and Graduate Taxes: Can They Work in Developing and Transitional Countries?” International Comparative Higher Education Finance and Accessibility Project. Buffalo: University at Buffalo Center for Comparative and Global Studies in Education, 2003b, http://www.gse.buffalo.edu/org/IntHigherEdFinance/. Johnstone, B. “The Economics and Politics of Cost Sharing in Higher Education.” Economics of Education Review 20.4 (2004): 403–410. McMahon, W. “Potential Resource Recovery in Higher Education in the Developing Countries and the Parents’ Expected Contribution.” Economics of Education Review 7.1 (1988): 135–152. NCES (National Center for Education Statistics). Digest of Education Statistics 2002. Washington, DC: US Department of Education, 2002. Richards, K. “Reforming Higher Education Student Finance in the UK: The Impact of Recent Changes and Proposals for the Future.” In Woodhall, M. (ed.). Paying for Learning: The Debate on Student Fees, Grants and Loans in International Perspective. Special International Issue of The Welsh Journal of Education 11.1 (2002): 48–63. Tekleselassie, Abebayehu A. and D. Bruce Johnstone. “Means Testing: The Dilemma of Subsidy Targeting in African Higher Education.” Journal of Higher Education in Africa forthcoming. US Department of Education. Repayment Book: William D. Ford Federal Direct Loan Program. Washington, DC: Department of Education, 2003, http://www.ed.gov/DirectLoan/pubs/repabook/index.html. Wolanin, Thomas. “Means Testing in Developing Countries.” International Higher Education 28.4 (2002): 9–11.

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TRANSPARENCY AND QUALITY IN HIGHER EDUCATION MARKETS

Since applicants are generally hard-put to know just how much they are really learning, let alone how much they can expect to learn at a school they have never seen, they do not make enlightened choices. They rarely possess either the time or the information to explore all the promising options available to them and usually have only a limited basis for comparing the options they do consider. Under these conditions, competition does not necessarily cause good instruction to drive out bad. Instead, students often flock to courses with superficial appeal or to institutions with established reputations even though the education they receive is only mediocre … Competition does not inspire universities or their faculties to do as much as they might to improve their instruction in the way that it forces computer companies to work at improving their products (Bok 2003: 161–162).

1. INTRODUCTION Perfect competition and efficient markets presuppose that market transactions are ‘transparent’, that is, that producers and consumers possess ‘perfect information’ about products or services.1 This perfect information includes information on price as well as information about relevant characteristics of the product or service such as quality.2 In the case of pure commodities and/or ‘search goods’ that are frequently purchased, information about price alone may provide sufficient knowledge to the consumer to assure that markets are Pareto efficient. However, in the case of less frequently purchased and/or ‘experience goods’, whose relevant characteristics can only be effectively assessed by consumption, it is possible that reliance on price information alone may lead to market failure. This economic logic is therefore used to justify various regulatory policies designed to protect consumers such as licencing and the provision of information on the quality of goods and services (Smith 2000). Higher education is not only perceived to be an experience good (McPherson and Winston 1993) and a rare purchase, but also a major influence on student ‘life chances’.3 Therefore a strong argument can be made for adequate consumer information in higher education (Cave 1994). Better information is important not only for consumer protection purposes, but also for producer effectiveness. Information on the quality of a product provides an incentive for producers to invest in quality improvements and thereby better compete in the market. Within the field of economics, information problems that contribute to market failure are often described as ‘information asymmetries’. This implies that producers of a good or service may have knowledge about their product that is unknown or unavailable to consumers and this asymmetry of knowledge creates an uncertainty in 61 P. Teixeira, B. Jongbloed, D. Dill and A. Amaral (eds), Markets in Higher Education: Rhetoric or Reality, 61–85 © 2004 Kluwer Academic Publishers. Printed in the Netherlands.

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transactions that may not produce a Pareto optimum (Akerlof 1970). In the instance of higher education, this uncertainty can be understood in several ways.4 In the first instance, information asymmetry in higher education can be understood as an example of the ‘principal-agent’ problem. Higher education in all countries is provided by or heavily subsidised by the state due to its presumed social benefits. Because students can be considered ‘immature consumers’, the state may stand in for the consumer and act on the students’ behalf to ‘purchase’ higher education. In developing its implicit contracts with universities, the state may confront difficulties in determining the relative quality of academic work and therefore may be enticed to pay more for research and/or academic programmes than is Pareto efficient. In the second instance, information asymmetry in higher education can be understood as a ‘consumer protection’ problem. Universities may produce or publish information about their academic programmes that is misleading or not in the interests of prospective students and/or the public. Lacking valid knowledge about the relative quality of educational programmes, students may be forced to spend additional time and money searching for relevant academic quality information. Or they may be enticed to purchase an expensive campus-based university education, ignoring a less expensive, but similarly effective, distance learning educational programme (of course, the opposite could also occur). Thus in both of these examples there may be an information asymmetry that leads to inefficiency in the market for higher education. As a result, the social costs of a higher education system may not produce the optimal social benefits. But, in the particular case of higher education, there may be a third type of information problem that is not caused by an asymmetry of information so much as by imperfect information (Stiglitz 2000). Both principals and student consumers may have imperfect information about the true quality of academic programmes – that is, the value added they provide to the student and ultimately to society – but, because of the distinctive properties of universities, the producers may have imperfect quality information as well. Because of traditions of academic autonomy and specialisation, professors may also lack sufficient information to judge the quality of academic programmes and may as a consequence fail to improve them. From the standpoint of the overall efficiency of the market in higher education, it may not matter whether there is a problem of asymmetrical or imperfect information. But, from the standpoint of designing effective policy interventions, whether inefficiency is caused by academic opportunism or by a dilemma of collective action could be quite important. This chapter reviews relevant research on the transparency of higher education markets. The relationship between academic quality information and perfect competition in higher education markets will be explored first then the known problems of misinformed principals and under-informed consumers, as well as the less familiar problem of ignorant professors, will be discussed. The discussion will focus on the university sector, because the combined production of teaching and research poses particular issues of transparency and quality in higher education markets. In addition, the observed ‘research drift’ in many systems of higher education, in which former teaching-oriented institutions seek to compete with

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traditional universities for academic reputation and research funds, suggests that the informational problems associated with universities may become more common in other sectors as well. 2. PERFECT COMPETITION AND INFORMATION ON ACADEMIC QUALITY Efficient market competition presumes that consumers have perfect information about price and essential characteristics of a service such as its quality. As noted, for perfect competition to occur in the case of ‘experience goods’, such as academic programmes, readily available consumer information about quality is even more crucial. For example, there is some evidence that imperfect information on academic quality in the US market for higher education is encouraging an ‘academic arms race’ in which institutions seek to build their academic reputations through expensive investments in research and high ability students rather than through improvements in teaching and student learning (Ehrenberg 2002). To better comprehend this potential market failure, the social benefits of academic quality need to be clarified and their potential influence on the efficiency of higher education markets needs to be understood. We assume that the performance of universities in educating students is to be judged by their contribution to human capital (Becker 1964). During their university education, students develop knowledge, skills and abilities that over their lifetime provide private benefits to themselves as well as social benefits or social capital to the larger society. This human capital perspective provides the logic for public subsidies for higher education and is also explicitly reflected in current national policies on academic quality which seek to improve the academic standards of higher education institutions (Brennan and Shah 2000). Consistent with human capital theory, these policies increasingly focus on information about student learning outcomes – the educational ‘value-added’ of an academic programme or degree (Dill 2000).5 However, there is an alternative perspective on the performance of higher education institutions, the signalling or screening perspective (Spence 1973). This perspective suggests that academic programmes do not actually add to human capital, but simply ‘screen’ students on pre-existing abilities and offer confirmatory signals of these capabilities to the labour market.6 ‘Signalling’ also provides economic value to the society by saving employers the costs of identifying and recruiting new employees, but it is unlikely that these social benefits alone could justify the current substantial public subsidies for higher education throughout the world. Therefore, in order for market competition in higher education to be Pareto efficient, we assume that the increasing social costs of academic programmes are purchasing equivalent social benefits as reflected in gains in student knowledge, skills and abilities.7 For market competition to produce this outcome, consumers of higher education will need information on both the ‘price’ of an academic programme and its educational value-added. In the absence of such quality information, market competition may encourage inefficient behaviour. Two

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prominent examples of how imperfect information may lead to market failure are the problems of ‘cross-subsidisation’ and ‘cream skimming’. An important source of normative regulation in academic institutions is the department or faculty, whose structure provides a primary means of social control (Braxton 1990). But university departments or faculties operate as non-profit labour cooperatives engaged in the production of multiple products (James 1986). In other words, faculty members essentially control the means of production. As Clotfelter (1996: 179) has observed: The university’s central and most distinctive activities – teaching, research, and public service – are carried out largely by its most distinctive sector of employees: the faculty. As a consequence, the decisions about how to allocate faculty effort are basic to the functioning of colleges and universities, and to their cost. ... most day-to-day decisions concerning these activities are entirely in the hands of departments and faculty members themselves.

Faculty members in universities tend to value research over teaching, because of its intrinsic interest, because of its clear contribution to unit reputation (which is a major proxy for academic quality) and because in competitive research and labour markets time spent on research can lead to increased grant revenue and future earnings for the individual faculty member (James 1986). Given these incentives and the absence of valid measures of the value added by academic programmes, faculty members will choose to ‘satisfice’ teaching quality (Massy 2003). That is, they will limit their time investment in teaching first degree students in order to maximise their time investment in research and graduate teaching. In effect, faculty members act individually (and are supported in these actions by academic policies that they collectively determine at the departmental level) to shift to research, activity time paid for by the government and tuition paying students principally for teaching.8 This represents a market failure in the sense that tax payers and consumers pay a higher ‘price’ for a university education of a given quality than they would if perfect competition caused faculty members and their institutions to continually improve the educational value added of academic programmes.9 Research on faculty activity in the US (Clotfelter 1996; Fairweather 1996; Getz and Siegfried 1991; James 1986) over the last several decades has revealed that the proportion of time faculty members reported spending on teaching had fallen and the proportion of time they reported spending on research had risen in all types of fouryear institutions. As Clotfelter (1996: 204) discovered in a detailed analysis of changes over time at representative departments at Chicago, Duke and Harvard Universities: If the [three] institutions examined here are any indication, the period between 1977 and 1992 was one of gradual, but quite perceptive, change. Virtually without exception, average classroom teaching loads, measured in courses taught per year, decreased in the sample departments. Although these calculated loads by no means cover all aspects of teaching, they are suggestive of a significant movement away from teaching and toward research.

An important objection to this cross-subsidisation thesis in US higher education is that it fails the ‘stand-alone cost test’ (Rothschild and White 1993). In this test, one assumes that first degree education as a product could be supplied by an

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undergraduate-oriented college in competition with traditional universities. One then asks whether, as a separate firm, on a stand-alone basis, the undergraduate college would not have a competitive price advantage over the traditional university. If it does not, then research cannot be cross-subsidising teaching in the university sector. Rothschild and White (1993) apply this test in the US by noting that undergraduate education programmes produced as a joint product with graduate teaching and research by research universities such as Harvard and the University of California, Berkeley compete easily and well for top students with ‘single-product’ selective liberal arts colleges such as Swarthmore and Pomona. Thus the evidence of the higher education market in the US suggests that the cross-subsidisation of research by teaching in the university sector does not take place. Rothschild and White’s (1993) argument, however, makes a critical assumption and appears to be inconsistent with recent empirical evidence. Applying the stand-alone test to a good such as higher education implies that US consumers currently have sufficient information to discriminate between selective liberal arts colleges and research universities on academic quality, since price alone is unlikely to be a sufficient indicator for such a complex service. As already noted, in the absence of valid measures of the educational value added by academic programmes, ‘academic reputation’ has become an influential proxy for academic quality among student consumers. Academic reputation itself is strongly related to measures of admissions selectivity and faculty research. Therefore, in order to compete with research universities for the best students, selective liberal arts colleges have been forced to invest more of their discretionary tuition revenues in faculty time for research. Fairweather’s (1996) national survey data revealed that the proportion of time spent teaching had fallen and the proportion of time spent on research had risen over the last ten years not only in research universities but also in selective liberal arts colleges. He also discovered that the promotion and tenure policies of liberal arts colleges were increasingly emulating those of research universities, placing less emphasis on teaching and more on faculty publication. More recent studies of the underlying cost structures of colleges and universities have provided further empirical support for the cross-subsidisation hypothesis in both elite undergraduate colleges as well as research universities (Clotfelter 1996; Ehrenberg 2002; Massy 2003). A second contributor to inefficiency in the academic market may be the increasing emphasis on the test scores of entering students as a measure of academic quality. For example, average entering student test scores are given significant weight in current league tables of academic quality published throughout the world (Dill and Soo 2003). This focus on the quality of entering students has received some legitimacy from the recent work of educational economists. In a seminal economic modelling exercise, Rothschild and White (1995) argue that talented student peers may act as educational inputs in the production of human capital. That is, the concentration of the most able students in certain colleges and universities is socially beneficial because of the positive peer effects they have on each others’ learning. As evidence in support of this thesis, Rothschild and White (1995) note the lifetime earnings advantage that accrues to graduates of the most selective US universities.10 Subsequently ‘peer effects’ have become an accepted component of

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higher education production functions among many educational economists (Bratti 2002; Hoxby 2002). For example, in an analysis of the US higher education market Hoxby (2002) argues that, despite evidence of continual tuition increases in both the public and private sector that exceed growth in average family income and inflation, market competition in the US has created an efficient system of first degree education. She bases this conclusion on evidence that US colleges and universities overall have increased their educational quality as measured by their expenditures on educational inputs, which include their expenditures to recruit more talented student peers. She thereby treats the marginal costs of recruiting high ability students as ‘implicit wages’ in payment for their input to improved academic quality. Hoxby concludes that the US baccalaureate market is now in equilibrium and that the net benefit to society of the new competitive market in US higher education is positive. She therefore argues that letting the market work is the most effective public policy. There are serous questions however about the assumed relationship between peer effects, as measured by entering student average test scores, and human capital formation. Empirical research in support of this relationship is based largely on econometric studies of the relationship between average entering student test scores and graduate lifetime earnings as well as a small number of studies of the effects of peer quality (again as measured by entering test scores of freshman roommates) on grade point averages in US colleges.11 However, the extensive research on student learning indicates an inconsistent and trivial relationship between admissions selectivity based upon average entering student test scores and measures of the knowledge, skills and abilities learned by students during their education (Pascarella and Terenzini 1991). In fact, the most recent review of the peer effects research also casts significant doubt on the supposed relationship between peer effects, as measured by average test scores of entering students, and students’ earnings capabilities.12 First, the research confirms that the impact of institutional selectivity on earnings is nonlinear. Only the most selective institutions may have an impact on earnings. Second, the relationship depends on the students’ major field of study, which is often not controlled in relevant studies. That is, less selective, public institutions in the US often offer academic majors with less potential earnings capacity than selective schools. Finally, and most importantly, when studies control for the types of students who apply to more selective institutions – utilising measures of individual ambition – the earnings advantage of more selective schools disappears. As Dale and Kreuger (1998: 30) conclude in their carefully controlled study of the relationship between college selectivity and earnings: After we adjust for selection, our findings cast some doubt on the view that peer group quality, as measured by the average SAT score of the students who attend a college, is an important determinant of student subsequent life outcomes. The average SAT score of students who attend college – though commonly used as a proxy for peer groups and school quality in previous studies – may be too coarse a measure to accurately reflect a student’s actual peer group or college quality once school selection is taken into account … It is also possible that peer group effects are trivial for college students.

Let us be clear about our argument here. We are not denying that university students can be affected by the behaviour of their peers, but we seriously question

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whether manipulating average entering student test scores alone will influence the educational value added by universities. Logically, the effect of peers on the quality of education is moderated by the organisation of education and the nature of instruction. For example, many selective US colleges and universities attempt to create a rich ‘on-campus’ opportunity for student interaction through special living and eating arrangements, small seminars, honours colleges and other special educational opportunities. Similarly, student learning in the UK may benefit from the peer effects promoted by Oxbridge-type colleges. The benefits of peer contacts may be minimal or non-existent however in the large and/or non-residential universities that educate the majority of US college students as well as the majority of students in many other countries.13 As in the case of cross-subsidisation, there is reason to fear that a misplaced focus by universities on improving average entering student test scores, or ‘student selectivity’, could contribute to inefficiency in higher education markets. In a recent national study of US higher education Brewer, Gates and Goldman (2002) discovered that many institutions are making extensive investments designed to increase the selectivity of their admissions process by linking tuition discounts with academic merit and student ability, attempting to lower student acceptance/yield rates, and investing in expensive student consumption benefits such as dormitories, eating facilities or fibre optic computer networks that will help attract high ability students.14 The researchers suggest that this attempt to build prestige by ‘cream skimming’ the student market is pursued as a substitute for investments in improving the quality of educational delivery and may therefore lessen the overall educational benefits of higher education for students and ultimately for society. The problems of cross-subsidisation and cream skimming are likely to be exacerbated by the dynamic nature of global reform in higher education. The worldwide adoption of market-based policies for higher education such as common degree frameworks, competitive allocation of research funding, competitive salary schedules, merit-based promotion and tenure policies, and the international competition for research faculty and high ability students could foster an international ‘arms race’ among universities in which global academic reputation will play an increasingly central role. Historically, incentives for faculty members to conduct research in many national systems were constrained by state salary schedules, the inclusion of research support in university base budgets, promotion and tenure policies with limited links to research performance, nationally oriented research cultures and differentiated higher education sectors. These policies are now rapidly disappearing. Many countries that have expanded access to higher education over the last decade in order to provide greater economic opportunity for their citizens are now expressing concern about an observed ‘research drift’ in their higher education systems (Dill 1998). The recent UK White Paper on higher education explicitly noted the danger of cross-subsidisation and called for new efforts to assure the quality of teaching and student learning in the more competitive research environment (DfES 2003). Finally, universities in a number of countries, which have historically had an open admissions policy, are now experimenting with selective admissions in order to recruit the most able students from their own country and abroad (Jongbloed 2003).

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In sum, an analysis of existing behaviour in higher education suggests that the nature of information on academic quality will be highly influential on the efficiency of future academic markets. We will now turn to a review of the research on the role played by existing quality information among buyers and consumers of higher education. 3. MISINFORMED PRINCIPALS The last decade has produced a ‘paradigm shift’ in governmental thinking about higher education from the state meeting the institutions’ needs to the college or university meeting the state’s needs. Many states are now experimenting with performance-based funding and various forms of contracting in an attempt to improve the efficiency of their higher education systems (Jongbloed and Vossensteyn 2001). These contractual relations represent a form of quasi-market in which the state ceases being a direct provider of higher education, but instead becomes a purchaser of services from independent providers who compete with each other in an internal market (Le Grand and Bartlett 1993). Quasi-markets differ from real markets in several respects, the most noteworthy being that while student consumers may express their preferences by their choice of educational programmes, their choices are not purchases. Instead, purchasing is centralised in a monopsonistic government agency acting on the behalf of the consumers. Government purchasers therefore confront the classical principal-agent concern: “how the principal [government] can best motivate the agent [university] to perform as the principal would prefer, taking into account the difficulties in monitoring the agent’s activities” (Sappington 1991:45).15 In order to address this problem, states have attempted to define relevant performance indicators for higher education including measures of academic quality. Governmental steering by performance indicators rests on two main premises: (a) agencies have, or should have, a specified goal or a set of goals; and (b) the goals can be quantified so that success or failure relative to the goals can be measured (Heckman, Heinrich and Smith 1997). Both of the premises are problematic in higher education. Universities not only pursue multiple goals, competing objectives and contentious trade-offs, but the primary goal of higher education – developing student knowledge, skills and abilities – is extremely difficult to measure with validity. As a consequence, a variety of proxy measures for academic quality has been adopted. The most common performance indicators of academic quality include cost per student, student non-completion rates, time to degree, graduate employment and student satisfaction (Cave et al. 1997; Jongbloed and Vossensteyn 2001). Even if there is a belief that these indicators are effective proxies for desired educational processes and outcomes, there is still the question of how well they measure a university’s performance. Johnes and Taylor (1989) discovered that inter-university variation in students’ non-completion rate in the UK is highly influenced by the qualifications of entering students and the subject mix. Yorke (2001) shows that the most important variables affecting student dropout are maturity of entry and social

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class, which together explain more than 80% of the variation. Graduate employment is similarly heavily influenced by subject mix as well as the labour market situation in the relevant region (Cave et al. 1997). Average cost per student, per graduate or per credit has also been used as an indicator of academic quality. A high cost per student, however, may indicate either the availability of resources for educational processes or an inefficient use of resources (Cave et al. 1997). Moreover, a significant part of a university’s costs is often beyond its control. The implementation of performance funding in Finland revealed that universities in different geographical areas face different prices and are not therefore economically comparable (Höltta and Rekilä 2003). Over two-thirds of the variation of university unit costs in the UK was explained by different disciplinary mixes between institutions (Johnes 1990). Inter-institutional comparisons of costs may thus be helpful in assessing quality only if institutions experience the same ‘production technologies’ and prices (Cave et al. 1997). Student satisfaction is an increasingly important indicator of the quality of teaching performance and can also be considered as an outcome measure of the education process (Ramsden 1991). Astin states that “it is difficult to argue that any other outcome category – cognitive or affective – should be given greater priority than student satisfaction” (Astin 1991: 62). There nonetheless are important issues about the validity of student satisfaction measures as they may vary for reasons other than academic quality and are subject to manipulation. For example, student satisfaction differs between required and non-required classes (Haladyna and Hess 1994) and is related to professors’ grading practices (Nimmer and Stone 1991). Ehrenberg (2002) reports examples of US business schools inflating independently administered alumni satisfaction measures by informing the graduates prior to the survey that higher scores would enhance the economic value of their degrees. Finally, use of student satisfaction as a performance measure may deter professors from experimenting with new teaching methods (Emery, Kramer and Tian 2003). The main challenge of performance indicators is how to measure the contribution that universities make for students’ intellectual and personal development. Burke and Serban (1998) point out that among the number of US states that use some form of performance funding, only two included an indicator related to student learning. Because of the weak measures of learning outcomes, government’s ability to provide valid incentives for performance is limited and may have dysfunctional effects. Poorly designed performance measurement may lead to risk-avoiding behaviour among institutional administrators and academic personnel and cause them to under-invest in academic quality improvement over time (Jongbloed and Vossensteyn 2001). For example, using graduation rate as an indicator of a university’s performance may encourage institutions to lower academic standards or make them more reluctant to accept higher-risk students, which conflicts with the public goal of increased access (Cave et al. 1997). Recent US research has revealed some of the dysfunctional impacts of poorly designed performance indicators. The state of Ohio attempted to improve academic quality by monitoring the time faculty members spent teaching (Colbeck 2002). Universities responded by changing the way they reported faculty time use to the state. In one university, administrators simply lengthened the time assigned to each

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class by 10%. The frequently cited Tennessee Performance Funding Initiative (Fairweather and Beach 2002), which offered supplements of up to 5.45% over university operating budgets for institutions that demonstrated improvements in student learning and increased programme quality, has not increased faculty efforts to improve academic quality. The performance measures used focused on indicators such as graduate job placements, pass rates or scores on professional licensure tests, rather than changes in teaching and student learning at the department level. Improvement funds were also awarded to the central university rather than to academic departments demonstrating quality enhancements and these supplemental funds were often expended on activities not directly related to undergraduate instruction. University administrators also attempted to shield faculty members from the burdens of complying with the programme; as a result most of the faculty members supposedly affected by the performance indicators were unaware of their very existence. Finally, in addition to the mentioned measurement problems associated with government performance indicators of academic quality there is the additional problem of the structure of quasi-markets. Because these markets are monopsonistic, rather than truly competitive with many suppliers and consumers, there is the possible danger of ‘government failure’ (Wolf 1993). When government is the single ‘buyer’, those responsible for defining and monitoring appropriate measures of academic quality may choose to pursue private organisational goals or particular personal biases rather than the public interest. Or the government agency may be ‘captured’ in the sense that those being monitored gain control or significant influence over the monitoring agency and alter the performance indicators to favour their own interests over those of the broader public (Baldwin and Cave 1999). As a consequence, the expected innovation and efficiency benefits from market competition may not materialise. For these reasons it is important to explore in greater depth the informational problems associated with truly competitive higher education markets, particularly student choice of academic programmes and insufficient incentives for faculty cooperation to improve academic quality. 4. UNDER-INFORMED CONSUMERS In contrast to the principal-agent problem of government as a monopsonistic purchaser is the asymmetric information problem in a higher education market of many suppliers and consumers. Here we encounter the question of whether potential students and their families have sufficient information about academic quality to make an economically rational decision about which university to attend. Economists have been generally chary about surveying students to learn how they form expectations about college choice.16 However, as a guide to the possible information imperfections in the consumer market of higher education, it is possible to ask a more limited question of students. That is, what types of information on academic quality do students use to choose the programme or university in which they enrol and do existing measures permit students to successfully differentiate between institutions on the quality of learning? This question has been pursued in a

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number of studies in both the US and UK. Because of the different structures of the higher education systems of these two countries, we separately review this research, although there is much overlap in the relevant studies. From an economic perspective, the potential university student may be conceived as a rational investor in human capital who is evaluating the costs and benefits of attending a particular university.17 In assessing these relative costs and benefits, students utilise a variety of information. In the case of the UK, a national survey (Connor et al. 1999) indicates that the most important factors influencing the choices of applicants to full-time university education are the course or subject and academic quality – particularly teaching reputation, entry requirements, employment prospects for graduates, location, available academic and support facilities, social life and costs of study. Information on the academic course or subject has consistently proven the most influential on student choice in the UK (Carrico et al. 1997; Connor et al. 1999; Moogan, Baron and Harris 1999). This obviously reflects the structure of higher education outside North America, where first degree students apply to and enrol in a particular subject or field. In assessing academic quality, university reputation was a factor often mentioned (Connor et al. 1999; Moogan, Baron and Harris 1999), but applicants generally placed little importance on research quality and instead sought information on teaching reputation.18 This clear distinction between teaching and research quality may be more common to UK consumers because of differential government-required programme assessments of research and teaching quality. In terms of the value-added by university education, the most relevant information sought by applicants was graduate employment prospects. The applicants also reported that the most used and most useful sources of information in declining order of importance were university prospectuses, visits to universities, and a handbook on university programmes published by the University and College Admissions Service. Following these documents, applicants listed various ‘advisors’ as most useful: personal contact with a schools’ career advisor, current university students, university staff and various staff members at their school. About half of the applicants had read the commercially published league tables of universities and about 40% also used the ratings of teaching quality and research upon which these rankings are based. Students reported some vagueness on what these published quality assessments actually revealed and relied more upon parents, other students and employers to gauge academic reputation. Higher ability and higher social class applicants as well as ethnic minorities used league tables and quality assessments more than other applicants, but overall quality rankings were viewed as of below average influence and were not listed among the most useful sources of information by the survey respondents. At the time of the survey, ITbased sources of information were used by less than 30% of the applicants. While the surveyed applicants reported that they were not overwhelmed by the large amount of information available, they did desire information about particular academic programmes and universities that was more focused and less one-sided. Although there is a great deal of government defined and published data about UK universities, applicants still had concerns about the quality and accuracy of information provided by some institutions.

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Based upon the survey, the researchers (Connor et al. 1999) also made recommendations for improving consumer information for university choice. With relevance to academic quality, they called for regular, independently validated information about courses and institutions so as to discourage reliance on less reliable and anecdotal sources. More information was desired on the work and other experiences of those graduating from different types of programmes. Although ITbased information had been little used by the applicants in this sample, the researchers also called for the use of more interactive formats of information that would permit consumers to personalise their search for information. The extensive research on college choice in the US suggests that the institutional factors important for US students and parents in choosing among colleges are primarily the academic programme (major area of study), tuition costs, financial aid availability, general academic reputation/general quality of institution, location (distance from home), college size and social atmosphere (Hossler, Braxton and Coopersmith 1989; Manski and Wise 1983; Paulsen 1990; Zemsky and Oedel 1983).19 In an annual survey of entering students, ‘a good academic reputation’ is the reason given most frequently by freshmen in selective colleges for having chosen the institution in which they enrolled (Litten 1991). However, perceptions of the academic reputation of an institution have been found to be most highly related to institutional admissions selectivity, as measured by average student test scores (Grunig 1997; Paulsen 1990), and to indicators of research activity as well as doctoral programme rankings (Astin 1985; Grunig 1997). Therefore, it is debatable as already noted whether information on ‘academic reputation’ in the US will promote student choice that is efficient for society. In contrast, Litten and Hall (1989) examined how a sample of high ability students and their parents defined quality in colleges. They identified the following among the leading indicators: high admissions rates of graduates who apply to top graduate and professional schools, students who were high achievers before college (i.e. institutional selectivity), surveys showing graduates were satisfied with the college, high starting salaries for graduates in the fields that interest them, and faculty who spend as much time teaching as doing research. In a subsequent set of focus-group interviews with high school students in Indiana and Massachusetts, Hossler and Litten (1993) discovered that over 25% identified the following as extremely or very important characteristics for choosing a college: advantages in getting a job, advantages gained in admission to advanced degree programmes, learning/intellectual development students achieve, students’ psychological development (value formation), students’ social development and income of graduates. These latter characteristics and indicators include a number of process and outcome measures that come closer to addressing the ‘value-added’ concept of academic quality. Research on the sources of information considered by US applicants suggests some of the limitations of published information. The most frequently used sources were in fact college catalogues, campus visits, school guidance counsellors, students already enrolled in college and college admissions officers (Paulsen 1990). Commercial college rankings or league tables are used primarily by students of high achievement and social class (McDonough, Antonio and Perez 1998). There is

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evidence that the information provided in different college guidebooks about the same institution is often inconsistent and even contradictory (Hossler and Litten 1993). Most of the available guidebooks also failed to provide information of particular interest to college applicants, such as student outcomes and student educational experiences. In addition, the visibility of US college rankings based upon prestige or reputation also appears to be encouraging institutions to ‘game’ the market in order to better position themselves on the proxy measures of academic quality currently employed (Ehrenberg 2002). Universities have attempted to manipulate information on average entering student test scores by dropping out the lowest scores, not reporting the scores of international students or by making the tests optional for admission. In the latter case, only students with high test scores are likely to report them and applicants with lower test scores will now more likely apply. Thus the relevant colleges should be able both to increase their average test scores and increase their admissions selectivity. A number of colleges and universities have also adopted early admissions plans for students who will make a commitment to a particular institution. Because almost all early applicants eventually enrol, such programmes lower the fraction of total freshman applicants that need to be admitted and also increases the institution’s ‘yield’ rate, both of which improve the college’s selectivity. Hossler and Litten (1993) reviewed the overall provision of information on academic institutions in the US. They noted that virtually all of the published data on colleges and universities, whether collected by government or by the publishers of guidebooks and commercial rankings, are supplied by the institutions themselves and that no independent source of verification exists: When colleges compete for students via the information they provide and the public must rely primarily upon this information, we find it intolerable that some form of audited and certified information, as precise and objective as our financial audits, is not available (p. 78).

They suggest the development of standardised data gathering instruments, including questionnaires completed by current college students and alumni that would permit an objective comparison of institutions. Most needed was information on student educational experiences and outcomes. Among the types of information recommended were student satisfaction, as measured by senior and alumni surveys, the percentage of graduates who enrol in advanced degree programmes and information on the occupations and incomes of programme graduates.20 They recommend that the data be subjected to third party verification. For example, information on university applications, admissions and enrolment could be reviewed as part of financial audits and the information in college prospectuses on programme offerings could be verified as part of accreditation reviews. The collected research on college choice in the UK and US offers some support for the view that consumers associate academic quality with the knowledge, skills and values to be gained through a university education. In both countries, however, despite the growing number of guidebooks, league tables and other publications designed for the higher education market, there still appears to be inadequate comparative information on the academic quality indicators of interest to students.

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Quality information tends to focus on the uni-dimensional concept of academic reputation or prestige, which is highly influenced by factors other than the quality of undergraduate instruction. Insufficient information is available on student outcomes and the quality of students’ educational experiences in different programmes and institutions. There is also evidence, particularly in the US, that imperfect information on academic quality together with competitive higher education markets create incentives for institutions to misrepresent the information students need to make rational college choices. Improved consumer information on academic quality offers some potential for increasing the efficiency of higher education markets, but there is some question as to whether this information will be provided without government intervention. 5. IGNORANT PROFESSORS In the preceding sections, the empirical evidence on efforts to improve academic quality by providing relevant information to the buyers and consumers of higher education has been reviewed. In this section, a more speculative cause of market failure in higher education – ignorant professors – will be discussed. It will be suggested that the current institutional framework of academic work provides insufficient incentives for academic quality improvement within universities. Consequently, information provision to consumers and buyers may need to be supplemented by incentives for the development of institutional-based information and quality assurance mechanisms that, with regard to their basic educational processes, help to make universities more effective learning organisations (Dill 1999a). Those advocating information provision as a remedy to uncompetitive markets assume that over time the demands of better informed consumers will increase the incentives for producers to decrease the costs of higher education and generate greater innovation and quality. But given the nature of student consumers, the difficulties of effectively measuring student learning outcomes, the constantly changing nature of academic knowledge and the deeply ingrained traditions of academic freedom and specialisation in higher education, there is reason to question whether demands from better informed consumers alone will be sufficient to motivate quality improvement. In a classic analysis of universities, Cohen and March (1986) argued that they were prototypal ‘organised anarchies’. That is, they did not know what they were doing! An important contributor to organised anarchy in Cohen and March’s (1986) formulation was poorly understood technology. Professors possessed a weak understanding of the core production process whereby incoming students are transformed into educated graduates and therefore improvements in teaching, student learning and academic productivity were fitful and uncertain. More recent research by Massy (2003) suggests the continuing confusion about and lack of interest in academic productivity among the US professoriate. This ignorance is reflected in the continually increasing costs of US higher education, which regularly exceed the rate of inflation and growth in medium family income.

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The nature of the core processes of academic production differs between teaching and research. While more difficult, it is still possible in many fields for a single investigator to make a substantial discovery or contribution to research or scholarship. However, in the case of student learning, the quality of a student’s academic experience is best conceptualised in an interdependent manner that is greater than the sum of the activities of individual teachers in separate classrooms (Ewell 1988). The research on teaching and learning in higher education reveals that while what students learn is related to the quality of the individual teaching they receive, it is also closely associated with what may be termed the academic coherence of the curriculum (Dill 1999b). That is, student content learning and cognitive development are affected by the nature and sequence of their curricular experiences as well as by the extent to which the faculty are collectively involved with the substance of teaching and the student’s education experience (Pascarella and Terenzini 1991). Therefore, more systematic efforts to improve the quality of learning outcomes will likely require cooperative action by faculty members to ‘restructure’ the curriculum, to redesign course sequences and requirements, and to better coordinate their individual efforts at instruction in order to achieve greater academic coherence. The primary unit for improvement in teaching and student learning in US universities is the academic department. Departmental meetings, committee work focusing on teaching and curriculum, and other face-to-face informal interactions among colleagues facilitate both the detection of ineffective education as well as the communication of norms and behaviours supportive of quality teaching and student learning (Braxton and Bayer 1999). Field research at the departmental level in US universities (Massy, Wilger and Colbeck 1994), however, has uncovered a pattern of ‘hollowed collegiality’ in which departments nominally appear to act collectively, but avoid those specific collaborative activities that might lead to real quality improvements in academic programmes. For example, faculty members readily reported informal meetings to share research findings, collective procedures for determining faculty promotion and tenure, and consensus decision making on what particular courses should be offered each term and who should teach them. But: Despite these trappings of collegiality, respondents told us they seldom led to the more substantial discussions necessary to improve undergraduate education, or to the sense of collective responsibility needed to make departmental efforts more effective. These vestiges of collegiality serve faculty convenience but dodge fundamental questions of task. This is especially the case, and is regrettable, with respect to student learning: collegiality remains thwarted with regard to faculty engagement with issues of curricular structure, pedagogical alternatives, and student assessment (Massy, Wilger and Colbeck 1994: 19).

The researchers suggested that academic beliefs about individual autonomy and academic specialisation that have led to atomisation and isolation among faculty members were a major contributor to this observed pattern of fragmented communication. Faculty members not only do much of their teaching alone, but, because disciplinary sub-fields are defined quite narrowly, many faculty members find it almost impossible to discuss their teaching with one another.

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The prevailing norm of academic individualism may therefore impede the systematic monitoring or measuring of student achievement that is crucial to the improvement of academic quality. Without public information about the valueadded by an academic programme there are insufficient incentives for individual faculty members to enter into the coordinated activity necessary to produce academic programmes with the academic coherence and structure research suggests are associated with student learning. The improvement of academic quality thereby represents a classic dilemma of collective action.21 Why does cooperative activity among faculty members to improve the quality of academic programmes not now spontaneously occur? Game theory would suggest that individual faculty members already work within a context that should encourage cooperative activity in the design and improvement of academic curricula. These conditions are: 1) that individuals have repeated dealings with one another; 2) that individuals possess information on the other players; and 3) that individuals deal with a small number of other people (North 1990). Under these conditions cooperative behaviour for joint gain should theoretically occur. But game theorists have also identified an additional condition necessary to sustain cooperative behaviour, that is, the ability to calculate collective costs and benefits. Thus, if a measure of the value-added to students by an academic programme is not available, then individual faculty members will base their decision, with respect to the amount of time to commit to cooperative activity in teaching and curricula improvement, on the individual costs and benefits to themselves. The benefit of cooperating with other faculty members in the design and implementation of higher quality academic programmes will therefore receive little or no value. By the same logic, faculty members also have few incentives to invest time and effort in developing or maintaining measures of the value-added by academic programmes; as a consequence, the decline or rise of academic standards in subject fields remains largely invisible to academic eyes.22 Academic administrators often contribute to this problem by adopting what Massy (2003) has termed an ‘invisible hand’ approach toward academic quality improvement. That is, they actively encourage the recruitment of the best students and faculty members and feel that they have thereby met their responsibility for improving academic standards. Countries such as the UK, Hong Kong and Sweden that have systematically reviewed the mechanisms for maintaining academic standards in different academic subject fields, however, have discovered substantial variance in the means employed for assuring academic quality across units within the same university (Dill 2000). When these variations were revealed to deans or university administrators with authority over the relevant programmes, the administrators often indicated that they were ignorant of these differences. This lack of knowledge and, in many instances, lack of concern with observed variations in academic quality assurance processes within universities suggest that traditional beliefs about academic freedom and autonomy have encouraged administrators to abdicate their responsibility for assuring academic standards. As Rosovksy and Ameer (1998: 150) argue, “academic freedom does not absolve colleagues or administrators from assuming responsibility for what are essentially matters of procedure, management, good order – and above all else – legitimate student needs”.

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In sum, there is some evidence that inattention to academic quality improvement within universities is caused not only by under-informed consumers, but also by ignorant professors. Policies designed to provide better information to consumers and buyers may increase market competition for effective teaching and student learning. But it is likely that actual improvements in academic standards may also require policies that provide stronger incentives for cooperative faculty behaviour on the development of effective quality assurance processes within universities. 6. CONCLUSIONS As higher education markets develop within countries and expand around the globe, the extent to which market competition will prove efficient for society will depend upon whether the new framework provides sufficient academic quality or value for money. It is possible that increased competition alone will create greater incentives for institutions of higher education to constantly improve student learning. Some evidence from the US (Brewer, Gates and Goldman 2002), for example, suggests that while traditional institutions of higher education may compromise student learning in an effort to gain academic prestige, profit-making institutions have a greater incentive to compete on educational value added, since they cannot make money by contesting on reputational indicators such as student selectivity and academic research. On balance, however, based upon our review of the evidence on the information on academic quality currently available to buyers and consumers, we believe there a is a genuine potential for market competition in higher education to promote an inefficient ‘academic arms race’ that will contribute to a market failure. This suggests the need for some type of government intervention. We remain dubious as noted above that monopsonistic or quasi-market mechanisms, in which government buys or contracts for a particular level of higher education, will prove efficient in the long run because of the potential for government misdirection of the higher education system and the substantial difficulties in validly measuring educational outcomes (Pascarella 2001). It is possible that introducing institutionally determined differential fee structures may promote sufficient consumer pressure for quality improvement that government contracting along with appropriate consumer information could then be effective in addressing potential failures in the academic market. However, our own view is that a more effective policy would combine better consumer information with enforced professional self-regulation as a means of quality improvement. As governments increasingly use market forces to coordinate and steer their university systems, they will need to define the essential quality information to be maintained and reported by universities and make public subsidies conditional on the accuracy of the data.23 Public policy can thereby improve the reliability of information for student consumers, whether provided by the commercial sector or the not-for-profit sector. In terms of the type of data to be provided, information on subject fields and academic programmes is of particular value to student consumers, even in North America where the structure of academic programmes includes a strong emphasis on general education prior to the choice of a major field of study.24

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The types of programme information publicly required of all institutions should include, at a minimum, entry standards for programmes, programme completion rates, the proportion of programme graduates entering employment/professional training/higher degrees, the average starting salaries of graduates and the satisfaction of graduates with their academic programmes. While such information on academic programmes is still not available in much of the world, it is obtainable for universities in Australia. The Australian government has required all publicly subsidised universities to conduct Course Experience and Graduate Surveys that make this type of information publicly available. In addition, the new National Survey of Student Engagement (NSSE) (Kuh 2003) in the US can provide information on how effectively colleges are contributing to educational value added though a number of process indicators that have been shown to be valid predictors of student learning. The public provision of NSSE data is now required for statesupported colleges and universities in a number of the US states. Academics strongly object to the concept of regulation, especially as it relates to academic quality. But academic standards cannot be maintained or improved without some type of external control, a fact made clear when we routinely describe professional processes such as external examining and voluntary accreditation as self-regulation. The issue is not whether regulation is needed, but who is responsible for developing and implementing it. We believe that improved consumer information as outlined above along with ‘enforced self-regulation’ (Baldwin and Cave 1999) offers the greatest potential for addressing the causes of potential market failure in higher education we have outlined. Examples of such enforced selfregulation could include existing academic processes such as external examining, or newly developed processes such as subject assessments or academic audits as they have evolved in the UK, Europe and Asia. These processes, required by government but designed and implemented by the academic community, can provide public evidence that academics are meeting their obligation to assure academic standards (Cave, Dodsworth and Thompson 1995). Unlike the regulatory initiatives on student assessment in the US, there is some evidence that these external reviews of quality assurance processes and academic standards have helped address the collective action dilemma of academic quality within universities. They have helped promote greater communication among faculty members on the improvement of teaching and student learning, by challenging academics to provide the evidence of student learning upon which they are basing academic and resource allocation decisions and by strengthening the internal collegial processes by which academic standards are assured (Dill 2000; Henkel 2000). Given the complexity and dynamism of academic knowledge, we believe professional self-regulation is still likely the most effective safeguard for assuring academic standards in competitive academic markets. But, given the rapidly increasing social costs of higher education and its growing influence on the life chances of our citizens, we seriously question whether reliance primarily on ‘trust’ in the academic profession (Trow 1996) is a feasible option for assuring the efficiency of the system. In our view there needs to be more valid and reliable consumer information on academic quality available as well as public evidence that universities take self-regulation of academic standards seriously and that existing

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professional processes designed to assure academic quality in fact promote student learning. NOTES 1 2

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The basic theoretical concepts of information economics to follow are derived primarily from Carlton and Perloff (2000) and Friedman (2002). The major concern with imperfect information in higher education relates to academic quality, but recent US research suggests that there may also be some potentially important issues related to the transparency of ‘price’. Kane (1999) surveys the longstanding issues associated with cost and access in US higher education and suggests that informational issues may be a primary cause of poor college-going rates among low income groups (for more recent empirical support, see Avery and Hoxby 2003; Kane 2002). Kane (1999) argues that college access policies featuring backwardlooking, means-tested financial aid benefits make the price of higher education less transparent. Students and their families cannot effectively determine the cost of higher education until after they have applied for university and learned about their eligibility for financial aid. He points out that, in contrast, the Australian means-tested Higher Education Contribution Scheme (HECS) is forwardlooking, based upon the student’s future income. Arguably, this approach increases the transparency of the costs and benefits of higher education in two ways. First, it makes clearer prior to applying to university the student’s eligibility for financial assistance (i.e. there is no eligibility criterion for HECS) as well as the associated costs. Secondly, it focuses students’ attention on their future earnings stream, which should be an important component of their decision to attend university. Because the adoption of tuition fees and the expansion of means-tested financial aid have accompanied policies designed to enhance access to higher education around the world (Jongbloed in press), increasing the transparency of university ‘price’ may help secure the expected benefits of higher education markets. It could be argued that the products of higher education are ‘post-experience’ goods like psychotherapy (Weimer and Vining 1999), whose quality can be accurately assessed only after consumption is completed, if then. Post-experience goods may therefore warrant even more rigorous efforts at consumer protection. We are not convinced that higher education meets this stricter standard. In the analyses to follow, the focus is on the informational issues associated with the market for educational programmes. Similar issues can be raised with the market for research. For example, informational problems have emerged as part of the evaluation of research quality in the UK (i.e. the Research Assessment Exercise – RAE) with critics arguing essentially that funding based upon imperfect information on research quality is inefficient for the larger society. Astin (1985) most clearly articulates this perspective on academic quality in his ‘talent development model’. Astin argues that the major purpose of a university is to develop the talents of its students to their maximum potential. This development is achieved by facilitating changes in students’ intellectual capacities and skills, values, attitudes, interests, habits and mental health. Institutions that provide the largest amount of developmental benefits to students therefore possess the highest academic quality. A recent study (Bratti 2002) of the degree performance of life sciences students in the UK suggests the type and score of A-level exams taken by university entrants have a high and significant effect on the class of degree awarded. Consequently, Bratti argues, if the quality of student intake is not controlled, the supposed ‘value-added’ by academic programmes with a high academic reputation is significantly mis-specified. Astin (1985) conducted similar research in the US indicating that when entering students’ abilities are controlled, ‘academic reputation’ is often a poor predictor of educational value added in higher education. Hanushek and Kimko (2000) provide intriguing evidence for the relationship between academic quality as defined here and economic development. They compare the extent to which changes in educational quality (as measured by standardised scores for mathematical and scientific literacy) and in the quantity of schooling (as measured by the number of years of schooling) have contributed to economic growth differences averaged over thirty years across 139 countries. They find that increases in workforce quality have a profound influence on economic growth, much more than increases in the quantity of schooling.

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DAVID D. DILL AND MAARJA SOO Within US colleges and universities, expenditures for instruction are traditionally listed in an accounting category termed ‘instruction and departmental research’ which means that expenditures for instruction also include the time professors spend on research that is not externally funded. If faculty members choose to invest more of their time on research and less on instruction, this could lower the quality and/or drive up the cost of instruction. An obvious response to the cross-subsidisation thesis, as well as to our argument below that academic prestige and quality rankings are highly influenced by research reputation, is that teaching and research, particularly in the university sector, are joint products. That is, faculty time spent on research can improve the quality of academic content taught to students at the first degree level (Clark 1997). For evidence on the other side see Astin (1996). The available empirical evidence on the relationship between faculty research productivity and quality of instruction at the first degree level indicates the association is at best modestly positive, but so small as to suggest the two are unrelated (Terenzini and Pascarella 1994). For a related review in the UK, see Coate, Barnett and Williams (2001). Whatever else may be said about this relationship, it appears too tenuous to provide support for the observable research drift now occurring in higher education systems throughout the world and the growing investment of scarce resources and faculty time in research activity. If these increasing social costs are to be justified, they must be by the social benefits of the research itself, not by its supposed contribution to first-level degree instruction. Rothschild and White (1995) do note that, because of limitations in their modelling exercise, the differences in the incomes of graduates of more and less selective colleges and universities may in fact be attributable to other factors than peer effects. For a comprehensive review of this economic research see Winston and Zimmerman (2003). This discussion is based on the analysis in a draft chapter on ‘Career and Economic Impacts of College’ kindly provided to me by Ernest Pascarella from the manuscript of a planned revised edition of Pascarella and Terenzini (1991). That talented peers are not a sufficient condition for effective student learning is also suggested by the current controversy in US higher education over grade inflation in the most selective universities (Rosovksy and Hartley 2002). Grade inflation, or more precisely grade compression in which all students receive high grades, may lower student motivation for significant academic effort, thus negating or undermining the supposed learning benefits to be gained from contact with able peers. Note that students may be willing to pay higher tuition and fees to attend universities that provide greater immediate satisfaction in terms of student living conditions and social life. But unless these satisfactions experienced during the process of education contribute to the students’ future productivity, their capacity for learning or other benefits to the society, they are essentially consumption benefits that add to the cost of higher education and do nothing to enhance human capital (Cohn and Geske 1990). See also the discussion of principal-agent relationships by Massy in this volume. For a particularly insightful exchange on this issue, see the paper by Manski (1993) which includes a comment by E.A. Hanushek. As Hoxby (in press) emphasises, massification of higher education has altered the nature of the discussion. From a human capital standpoint the critical choice is no longer whether to attend university, but which university (and/or programme) to attend. Interestingly, minority university applicants in the UK gave much greater weight to teaching and research reputation as well as graduate employment prospects than did applicants as a whole. Reflecting the unique US collegiate culture there is also the belief that intercollegiate athletic success has a positive effect on the volume of institutional applications. Toma and Cross (1998) discovered that winning a national championship in football or basketball subsequently translated into increased applications for major universities, but they did not control for applicant quality. Zimbalist (1999) also finds evidence for a modest relationship between athletic success and applications, but finds no evidence that athletic success increases a university’s average student test scores or its yield on admissions. Note that the only country where this type of information is currently readily available to student consumers is Australia where government policy requires universities to conduct surveys of current students and graduates, that is, the Course Experience Questionnaire and the Gradate Survey. The lack of university-based information on the value-added by higher education has been identified by US state policy makers as an important problem. By 1990, over two-thirds of the states had passed regulations encouraging public institutions of higher education to implement various forms of

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‘student assessment’ programmes designed to place greater institutional attention on the improvement of student learning (Ewell 1997). Ultimately, all five regional accrediting bodies also adopted an assessment criterion as one of their criteria for reviewing institutions of higher education. However, this effort appears to have had a limited impact on faculty behaviour. A national survey provides little evidence of a sustained commitment by institutions or academic programmes to using student assessment information to improve student learning (National Center for Postsecondary Education 1999). Less than a quarter of the surveyed institutions reported that faculty members involved in institutional governance even supported student assessment activities and few institutions actively linked information on student assessment with improvement of the faculty’s instructional approaches. 22 The UK and a number of other countries have a tradition of subject exams and external examiners that potentially provide the needed information and incentives for quality improvement at the subject level. However, the most comprehensive study of the UK examination system (Warren Piper 1994) suggests that faculty cooperation in quality improvement and the maintenance of academic standards is being adversely affected by the increasing specialisation of academic work as reflected in the development of modular forms of instruction and multidisciplinary programmes. 23 See, for example, the work of the Performance Indicators Steering Group in the UK, which defined information to be provided on the nature and performance of the higher education sector (Bowden 2000). 24 Programme or subject level quality information is of increasing importance to students. Entry qualifications can vary across subject fields in the same university, even in the US where entry to the subject field often occurs after enrolment in the college or university. Furthermore, the quality of the student learning experience, graduation rates, student satisfaction, employment prospects, and even lifetime earnings are apt to vary significantly by subject field within the same university. Therefore, quality rankings based upon average data for the university as a whole not only misrepresent the experience for particular subject fields, but fail to provide the academic quality information most desired by student consumers. Finally, the public provision of quality information by programme will reveal differences among them that may create incentives for institutional administrators and faculties to make improvements.

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BEN JONGBLOED

REGULATION AND COMPETITION IN HIGHER EDUCATION

1. INTRODUCTION This chapter discusses the relationship between regulation and the functioning of markets. In particular it will look at government regulation and the degree of competition in the higher education market. The structure of this chapter is as follows. The next section introduces briefly some ideas about markets, competition, government coordination and efficiency. It also briefly touches upon the changing role of governments in regulating the market. Section 3 introduces some additional concepts, like regulation, self-regulation and market failure. Here, the discussion briefly summarises the well-known origins of market failure and the arguments for government intervention. Section 4 presents an extensive discussion of the relationship between regulation and performance, based on the theory of industrial organisations. The different types of regulation in general as well as examples of government regulation in higher education are presented. Attention is paid to regulation dilemmas that emerge as a result of the fact that universities are becoming more and more like hybrid institutions, combining a public mission and a commercial line of activity. Moving from regulation to deregulation, section 5 discusses the idea of vouchers as a means of injecting market forces into the highly regulated higher education systems. It is argued that the competition induced by vouchers will most certainly lead to re-regulation by the government to redress undesirable effects. Finally, section 6 presents a number of concluding remarks on the roles to be played by government in the higher education system. The all too familiar issue of finding a balance between regulation and market forces is revisited. 2. COMPETITION WHERE POSSIBLE, REGULATION WHERE NECESSARY… The market mechanism, that is, the ‘invisible hand’ of Adam Smith, ensures that, in the case of shortages of a specific good or service, the relative price of that good will rise, while an excess will lead to a lower price. In other words, the discipline of the market will lead to an efficient allocation of goods and resources. In a free market with perfect competition, prices carry all the information on the basis of which decisions with respect to demand and supply are made. In short, then, the 87 P. Teixeira, B. Jongbloed, D. Dill and A. Amaral (eds), Markets in Higher Education: Rhetoric or Reality, 87–111 © 2004 Kluwer Academic Publishers. Printed in the Netherlands.

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competitive market is a powerful regulator. Ever since the work of Adam Smith, the key notion in economics has been that a decentrally organised market with prices sending out signals is a better system for collecting and interpreting information than the government as the institution that centrally coordinates decisions. A central planner will not have the information on the specific individual preferences of citizens for the many products and services. It is totally impossible to accurately form estimates of the total demand for thousands of products, to motivate the millions of producers to satisfy this demand, and to be aware of the available technologies or the quality of the workforce. Moreover, it is equally impossible to monitor and control the activities of the managers and employees of millions of firms. It is no wonder then that supply and demand do not balance in a centrally led economy. And, given the fraud, nepotism and rent seeking that exist in the nomenclature, firms and labour unions, it is no wonder that, even in economies that are less heavily steered by a central coordinating institution, many calls are heard to reduce the extent of government intervention and regulation. The growing complexity of our society only seems to strengthen the case for relying on markets to make the decisions. The power of the market lies in the actual and potential competition for scarce resources that can be used in a variety of ways to meet the preferences of consumers. Competition between suppliers ensures that prices will adjust to reflect market scarcity. Economists call this a situation of allocative efficiency, or Pareto efficiency. Pareto efficiency is a situation in which no individual (or group of individuals) can improve their utility without negatively affecting that of others. In the case of less than perfect competition, prices will be less flexible; price adjustment will not lead to a situation of Pareto efficiency. Goods and services will not be allocated in full accordance with demand and supply. Strictly speaking, the model of perfectly competitive markets is not very realistic. Its assumptions are far from being satisfied. In reality, one has to allow for transaction costs, scale effects, less than perfectly informed individuals, less than perfectly mobile production factors and non-homogeneous goods. Apart from that, competition takes place not only through prices, but also by means of quality, aftersales services and the range of products offered by providers. Markets may also function imperfectly because of the abuse of monopoly powers. In monopolistic markets the suppliers set the price and prices are set above marginal costs. This leads to profits for the monopolists; it causes allocative inefficiencies and a less just income distribution between suppliers and consumers. Moreover, according to Leibenstein (1966), monopolies have a tendency to operate in a cost inefficient (or internally cost inefficient) way. This claim is supported by empirical evidence. Compared to monopolistic market structures, competitive markets are more likely to be responsive to the wishes and needs of clients, and competitive markets generate more incentives to use resources in an economic way (see Scherer and Ross 1990; Massy in this volume). In other words, competition leads to cost efficiency, meaning that entrepreneurs/managers use their production factors in such a way that costs are minimised. While internal (or static) efficiency is part of the model of perfect competition, dynamic efficiency is not. Dynamic efficiency prevails when innovations in products and processes are initiated and adjustments to changing technologies and needs are

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carried out smoothly. The relationship between competition and dynamic efficiency however is problematic. There are arguments that suggest that, on the one hand, cooperation between providers in markets is necessary to bring about high-risk technology innovations, but, on the other, entry into the market needs to be relatively easy for new providers in order for them to introduce and develop creative ideas. The latter idea is close to the notion that innovation sometimes may need to be stimulated by the use of non-market instruments. Collusion and other noncompetitive measures to create such externalities (or spillovers) are examples where the invisible hand of market competition is assisted by the visible hand of government regulation. This will be explored further below. This sketch provides a background for the discussion on markets, competition and (de-) regulation. It illustrates that, because of unmet conditions, free markets are not a realistic option for most sectors of economic activity. Centrally steered systems also are not an option, because of the problems governments would have in fine-tuning the system. In terms of the industrial organisation literature (Scherer and Ross 1990: 37) this means that only a ‘third best’ option is available which comes down to stimulating competition as a function of regulation. The leading principle then is: “Competition where possible, regulation where necessary” (Kay and Vickers 1988: 287). This approach takes into account that market failures may occur and that national interests (e.g. equality of opportunity, income redistribution, innovation) may be at risk, calling for government regulation. In any case, this principle comes down to a repositioning of government. The question is: What instrument of intervention may be used by the government to create more competition and markettype behaviour in the sector, given specific manifestations of market failure and given specific government goals? It comes down to the issue of striking the right balance between competition and regulation; finding out when and how to intervene and where the marginal benefits of regulation no longer outweigh the marginal costs. This approach may be interpreted as a step in the direction of a ‘state supervising’ system (Van Vught 1989). Instead of a heavily regulated control system, a system is established with more room for market-type coordination, thus emphasising individual (i.e. decentralised) decision making by providers and clients. This development may be characterised by means of figure 1 below (see Van Asseldonk, Berger and Den Hartigh 1999; Jongbloed 2003a). The left part of the figure shows a traffic junction with traffic lights on all four corners regulating the flow of traffic. Creating acceptable queuing times requires substantial effort in terms of programming the traffic lights. One would have to first study the intensity of the traffic at that exact location, incorporate ‘real time’ information on traffic flows in response to the duration of red and green signals, install traffic lights for pedestrian crossings and prevent the lights from turning green all at the same time. This is our analogy of the state control model. The right side of the figure pictures our analogy of the state supervision model: a roundabout. There are no traffic lights and only one simple rule regulating the traffic flows. That rule is: the traffic on the roundabout has priority. This system of coordinating traffic flows does not require an extensive information system. The flow of traffic is much smoother compared to the intersection/traffic lights system.

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Figure 1. Coordination systems: The crossing versus the roundabout

Elsewhere (Jongbloed 2002), it has been argued that in today’s networked society where heterogeneous and unpredictable behaviour is key, self-steering instead of regulation may be a more appropriate model to coordinate the decisions in a higher education system. Coordination (steering and control) cannot take place anymore through increasing interventions and regulations by the government. Instead, the government (the national as well as the supranational) will have to rely on designing clever frameworks or ‘rules of the game’ for the interaction between individual clients and individual providers. These rules of the game are what Douglass North (1990) has termed institutions and consist of both informal constraints and formal rules. Looking at the roundabout picture, one might be tempted to believe that in today’s higher education system the role for the national government is diminishing. However, that would be taking the analogy too far. Instead, the role of the government will have to be redefined. The centrality of human capital in today’s knowledge-driven economy requires that governments carefully arrange the frameworks, boundaries and playing fields for the providers of higher education. Government policies will have to support the building up of high-level skills and knowledge-intensive goods and services. The range of policies available covers competition, science and innovation, policies aimed at assisting firms by means of incentives and subsidies, and policies aimed at facilitating firms’ access to and handling of technology. Government policies increasingly will have to strengthen the networks between firms, knowledge producers (e.g. universities) and government, using a wide range of facilitation mechanisms that seeks to intensify formal interactions as well as informal interaction between the agents in these networks. The question is not how much government, but rather what can government do and how can it do that best? This amounts to a new paradigm for government (Dunning 1997: 60) where:

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… government should eschew such negative or emotive sounding words such as ‘command’, ‘intervention’, ‘regulation’ and replace them by words such as ‘empower’, ‘steer’, ‘co-operative’, ‘co-ordination’ and ‘systemic’.

3. CONCEPTS: GOVERNMENT INTERVENTION, SELF-REGULATION AND MARKET FAILURES Before proceeding further, it is necessary to be more specific about concepts and theories regarding regulation, government intervention and market structure. Regulation may be defined as government-imposed restrictions affecting individuals’ or organisations’ freedom to decide – their rights and liberties. The freedom to decide or choose relates to the eight areas that have been defined in the introduction to this volume as conditions for a market. Regulation is often supported by the threat of sanctions. Regulation can take the form of laws, controls and rules imposed by government (or, rather, parliament), but it can also take the form of private laws, norms and self-regulation. The difference between state-imposed regulation (the ‘visible hand’) and self-regulation will now be explored a little further. Government regulation of decision making in markets is based on a number of reasons. First of all, markets can produce too much or too little of goods and services from society’s point of view. This type of market failure arises for various reasons, most of them already discussed in the introduction to this volume: x x x x

monopoly powers and the existence of barriers to entry externalities (spillover effects) information asymmetries (hidden action, hidden information) free-rider problems.1

Secondly, there may be a reason for governments to intervene through regulation because of wider social goals, such as: x x x x

correcting unequal bargaining power (due to uneven distribution of income and wealth) protecting the interests of future generations preventing socially (morally, politically) undesirable behaviour (e.g. discrimination) protecting ‘endangered species’ (goods that are undervalued but nevertheless important from a societal or cultural point of view).

The first argument leads to the correction of differences in opportunity among otherwise equally talented individuals who seek an education. The instrument that can be mentioned here is student financial support. An example that belongs to the second category of reasons listed above is the need to stimulate innovation and find solutions to (future) problems of a social, economic or environmental nature. Affirmative action policies and regulation are examples of the third set of intervention arguments. The need to protect training programmes and research in

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areas that are important from a cultural point of view but would otherwise attract insufficient resources is an example of the fourth argument for government intervention or regulation. All four examples are based on value judgments; in the end, politicians (parliaments) need to decide on the emphasis to be put on social policy goals and issues of distributive justice. The efficiency arguments and the social policy goals call for government intervention. Government intervention in the higher education market consists of four different types: x x x x

regulation (e.g. with respect to quality and quantity) finance (e.g. through subsidies, taxes, fees, loans, vouchers, income transfers) public provision (e.g. public universities) information/communication (to improve decision making).

In particular, strong government intervention is called for in the case of pure public goods, because the market will underprovide such goods (market failures). Government intervention is also relatively strong in the case of quasi-public goods that are characterised by the significant externalities inherent to their production. Externalities will be discussed more extensively below. For the moment we only point to the fact that public production (public goods) or public subsidies (public or quasi-public goods) determine the production of goods that, due to externalities, are underproduced by the free market. Public financing and production will not be discussed here; that discussion will be left to other chapters in this volume. Instead, this chapter will look more closely at regulation as an instrument to enhance efficiency2 and equity in the higher education market. There are different types of regulation, differing according to the room left to markets. According to the regulation definition given above, regulation seeks to change the behaviour of individuals and groups – to affect the market process (market structure and market conduct). One may distinguish the following forms of regulation: x x x

state-imposed regulation self-regulation enforced self-regulation.

An example of state-imposed regulation is the regulation of quality on the goods and services market. In the case of higher education, one can point to accreditation and standards with respect to curricula content. Government agencies (e.g. inspectorates), buffer organisations and other public regulatory agencies are charged with the monitoring of behaviour. They will have to outline acceptable and unacceptable behaviour – often in consultation with the sector itself – agreeing on standards to be imposed on processes or outcomes. They will have to have means for identifying non-compliance and often will use penalties and/or rewards to achieve compliance. When the emphasis is on financial incentives and rewards, the

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use of the regulatory instrument comes close to the use of (public) funding as an instrument. Self-regulation emerges in the private sector through binding, private law-based norms that have been agreed upon by a representative set of providers or ‘stakeholders’. One can think of certification, norms and mutually agreed quality standards and criteria for the recognition of providers, products and programmes. Next to prices and contracts, these forms of self-regulation work towards achieving some kind of order in the market (or higher education system). Self-regulation is preferable to government regulation when specific knowledge or information is primarily held by the sector itself. Apart from that, self-regulation can constitute a more flexible and more tailor-made alternative to laws and government regulation. Codes of conduct are an interesting example of providers agreeing to meet sectorwide principles. For higher education institutions that are active in income generating activities by means of contract research it can mean that they agree to fair pricing and not to use public funds to cross-subsidise activities carried out in competition with the private sector. It means that the sector itself monitors its members to see whether the code of conduct is respected. Self-regulation may also take place through independent private institutes that award a recognised trademark or certificate as a sign of suppliers meeting specific quality standards. Accreditation certificates given by independent agencies or boards are a natural example when it comes to higher education. We can point to professional organisations in fields like engineering or business as examples. When the sector (or ‘industry’) develops its own arrangements and the government provides legislative backing, such as in the case of peer review in teaching or research, one can speak of enforced self-regulation or conditioned selfregulation. The government promotes self-regulation and at the same time connects it to specific conditions or policies. It usually means that the government is one of the agents influencing the shaping of self-regulating practices. An example from the Netherlands is the quality assurance system for teaching, where the higher education providers themselves are responsible for monitoring the quality of degree programmes, and the Ministry of Education can withdraw public funding should the assessment indicate poor quality (see Salerno’s Dutch case study in this volume). In higher education, the norms of academic professionalism act as systems of self-regulation. The ethical norms of the professoriate assure that academics spend their time and attention on a mix of activities that is in the public’s interests as well as the interest of higher education institutions and the professoriate’s collective selfinterests. In fact, the professionalism of the professoriate may make explicit stateimposed regulation redundant. One might even argue that relying on the ‘ethicality constraint of the university’3 could prevent unintended consequences of the accretion of governmental regulations and act as a counterbalance to the potentially harmful (to the public’s and the student’s interests) pulls of competition and prestige seeking by universities and colleges. Other examples of self-regulation are covenants or contracts. Contracts are negotiated between government and institutions in such a way that the rigidity of law is avoided. Government and private (or semi-public) organisations enter into voluntary agreements, for instance, to promote a specific outcome that is in the

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interest of society as a whole, or to reduce the negative externalities of unrestricted market behaviour. This signing up of contracts may have a positive effect on the acceptance of policies and may reduce the (transaction) cost of monitoring and control. Like state-imposed regulation, self-regulation may negatively affect the functioning of markets, for instance when monopolies or oligopolies collude to reduce rivalry or drive suppliers out of business. In the case of abuse of market power, governments may apply antitrust policies or regulation. The set of publicly funded higher education providers is sometimes regarded as a cartel that has enjoyed protection from outside influences. An open market structure, in the sense of low barriers to entry (and exit), the freedom to set prices and determine quantity (i.e. enrolments) and quality, is believed to provide incentives for providers to operate in an efficient way. However, there may be reasons for the government to continue the protection of the public providers – examples are the government’s wish to prevent a ‘thinning out’ of public resources and protecting particular providers for cultural and regional reasons. After discussing three types of regulation it is worthwhile mentioning that the most fundamental type of government regulation, which is often taken for granted, is the creation of the basic (or bare) essentials that any society (say market) needs in order to function properly. These ‘bare essentials’ are underlying the various types of transactions (exchange of goods, services, information and resources) that take place in society. One of the basic functions of government is to ensure that citizens are not confronted with exorbitant ‘transaction costs’ (Williamson 1989). Transaction costs are connected to the gathering of information, negotiation and specification of contracts, and the monitoring and enforcement of contracts. A free market economy cannot function properly without a minimum degree of public regulation. This regulation shapes and guarantees the ‘basic order’ and, in particular, the property rights in the system. Government regulation ensures that economic agents (citizens) do not only agree on (transaction) prices but also agree on product quality, contract conditions (length, intertemporal aspects, sanctions) and other aspects connected to the exchange of goods and services. If this basic legal infrastructure is absent, transaction costs will be high and economic activity is likely to be less than optimal. Given this legal (or institutional) framework, markets sometimes fail to reach an efficient, socially optimal, allocation of goods and services. The invisible hand of the market then needs to be assisted by the visible hand of government regulation. Government regulation can take several forms. Earlier in this section, three types of market failures were distinguished: (1) monopolies; (2) externalities; and (3) information asymmetries. The remainder of this section will discuss these three types of market failures in more detail and connect them to government regulation. The first type of market failure, market power, can manifest itself in concentration and collusion of providers through monopolies and oligopolies. In itself, concentration is not a ‘bad’ phenomenon, as it may be the outcome of successful entrepreneurship (through product differentiation and innovation) or positive economies of scale.4 Market power may be the logical outcome of competition in a market. However, market power can also be the consequence of

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developments such as mergers, alliances and acquisitions. When power is concentrated in a restricted set of providers, this may have negative consequences for the wellbeing of consumers and providers who, in the production ‘chain’, are dependent on, or linked to, the colluding providers. While market power can be the outcome of a ‘natural selection’ process it may also be the result of ‘unnatural practices’. For instance, specific exclusion practices by incumbent providers towards new providers (e.g. cartelisation) or specific types of self-regulation by incumbents may stand in the way of a proper functioning of the market. Such restricting practices can take various forms, like mergers, price agreements,5 etc. In short, excluding practices leads to barriers to entry for new providers. Government regulation in the form of antitrust policies may be called for when there is sufficient evidence of collusion or otherwise protectionist behaviour by provider concentrations. Regulatory agencies (‘watchdog supervisors’, see Laffont and Tirole 1993) have been created by national (or supernational, in the case of the European Union) governments to monitor producer behaviour in the market for private goods. With higher education becoming to be regarded as a (private) good, subject to the conditions of the GATS agreements, such agencies may also be overseeing the higher education market in the near future. Baumol, Panzar and Willig (1982) in their ‘theory of contestable markets’ have argued that, where economies of scale and scope lead to a concentration of economic power, the decisions with respect to prices and volumes can still turn out to be allocatively efficient, even without government intervention. They suggest that, if the markets are sufficiently contestable (i.e. open to new providers) oligopolies/monopolies will be disciplined in their behaviour. The ‘threat’ of new providers entering the market then will force incumbent providers to refrain from protectionist policies. Barriers to entry are not necessarily all due to regulation and collusion, but may also be caused by the existence of high ‘sunk costs’.6 However, contestability is a necessary, not a sufficient, condition for an allocatively efficient monopoly without government intervention. Another condition that would have to be met is ‘sustainability of prices’. Sustainability means that the monopolist can stay in business given existing prices, and potential new providers do not have a way of entering the market due to the fact that the costs of entry are higher than the expected revenues. If prices are unsustainable, and incumbent providers are operating in a multi-product market, they may face the threat of ‘cream skimming’, meaning that the new entrants focus on profitable segments of the market and existing providers are left with the rest of the activities. External effects is another manifestation of market failure. These so-called spillovers occur when the utility of one individual (A) is directly influenced by the activities of another (B) without B taking this into account when making decisions with respect to those activities. External effects may be either negative or positive. Negative means that, from an allocation perspective, too much activity is taking place (e.g. emission of pollution), while positive externalities are an indication of too little activity (e.g. education and fundamental research).

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According to Ronald Coase (1960), negotiations between the parties involved can lead to an acceptable solution, even without government intervention in the distribution of property rights. This negotiation results in a voluntary contract between A and B where the external effects are ‘internalised’ and an optimal allocation on the basis of decentrally taken market decisions is reached. The conditions that have to be met here are: (1) there is only symmetrical information (see below); and (2) the transaction costs of negotiation are smaller than the transaction cost of government regulation. Often, these conditions will not be met in practice: asymmetrical information exists. Moreover, individuals are not behaving rationally. All of this stands in the way of a socially optimal solution – especially if the effects of a transaction lie in the future. When talking about externalities, it is useful to make a distinction between private goods and public goods. In the case of a private good, most of the benefits and costs accrue to the individual consumer. For a public good, most of the benefits accrue to society in general – it is a commodity whose benefits are indivisibly spread among the entire community, whether or not particular individuals desire to consume the public good. Pure public goods are characterised by non-excludability (nobody can be excluded from their consumption) and non-rivalness (consumption by individual A does not affect individual B’s consumption of the same good). The classic example of a public good is national defence. In the case of public goods, the market will not experience incentives to produce optimal quantities of the good. If goods are characterised by strong positive external effects but exclusion is technically possible, one speaks of quasi-public goods. Examples are knowledge and information goods, such as education and fundamental (or basic) technological research. The market will not provide optimal quantities of such goods because other providers and consumers can make use of the good once it is produced: the ‘free rider’ effect. Therefore, to stimulate the production and consumption of such goods, government policies are called for. On the one hand, the policies subsidise education and research in order to let as many individuals as possible reap the benefits. On the other hand, to stimulate the generation of research by the market it may be necessary that governments create exclusiveness, either by charging a price to the users or by protecting intellectual property by means of patents. In this way a market for intellectual property is created. While these policies diminish externalities, they do stimulate innovation in the long run because of efficiency incentives. This points to a dilemma. High subsidies create external effects, but this comes at the expense of a supply that, from a market-oriented perspective, is less efficient. In higher education, we see more and more governments introducing user charges (through introducing or raising tuition fees), making higher education more exclusive. However, many governments do not stimulate competition between providers or enhance user choice. The supply side is largely protected from market behaviour. The unequal distribution of information is an important source of market failure (see also Dill and Soo in this volume). Because individuals are not fully informed, they will either not engage in transactions or agree on sub-optimal transactions. Recalling Coase (1960), insufficient information is an important source of

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transaction costs which stand in the way of agents engaging in contracts. Even before contracts are agreed upon, a danger of adverse selection (hidden information) exists. Once contracts have been drawn up, the danger of moral hazard (hidden action) exists. Here, we can point to game theory and principal agent theory: information asymmetries stand in the way of an efficient allocation. Information asymmetries between consumers and producers occur in many markets – in particular, in markets where the degree of uncertainty in product or service quality is relatively large. For some goods and services, quality is only revealed after the use of the product. One speaks of ‘experience goods’; there is an ‘ex ante uncertainty’ that causes market failure (see Dill and Soo in this volume). Information problems also show up in the case of goods where even after purchase or consumption the consumer is unaware of the ‘real’ quality of the good. This is a case of ‘ex post uncertainty’. One often speaks of ‘trust goods’ (Kay and Vickers 1988). The consumer only ‘purchases’ goods from providers they can trust, that is, either providers are known to possess the ‘right’ (professional) qualifications or they have no incentive to cheat consumers. If the provider is a non-profit organisation, consumers often will have more trust in the quality of the good. If uncertainties and risks play an important role in the market, corrective action may be called for to prevent providers from taking advantage of consumers or consumers taking advantage of producers. Regulation – by government or the providers themselves – aims to protect consumers and/or providers. This leads to rules on product quality, conditions imposed on providers and the supply of product information. Accreditation, quality assessment, student guides and protection of recognised providers are some of the obvious examples from the higher education field creating barriers to entry and determining public funding for selected providers. Again, it is not necessarily government that is called upon. Monitoring, screening, signalling and selection can also take place through independent quality inspection agencies acting independently of the government or created by the providers themselves. Sometimes information problems are tackled through certificates, standards (e.g. ISO), guarantees, insurance and rules relating to consumer protection. Part of this is the result of government action, part is the result of more bottom-up initiatives. While earlier, in the case of externalities, the problem of finding the ‘right’ balance between social benefits and private benefits was discussed, here the presence of information asymmetries posing a similar problem is considered. On the one hand, the prevention of hidden action and hidden information may call for protectionist measures (aimed at providers and/or consumers). On the other, however, the need for creating a broad range of choices for consumers and a sufficient degree of competition between suppliers calls for restraint in terms of regulatory actions. Again, the question is: Where does government step in and where can it leave corrective measures to the market, or to self-regulation? The trade-off is between the benefits of a reduction of market failures and the institutional or transaction costs that result from policy intervention and the bypassing of markets.

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4. GOVERNMENT REGULATION AND GOVERNMENT FAILURE Regulation may fail because the desired effect is not achieved or the cost (either in an institutional or economic sense) may be much higher than the benefits of regulation. The first is connected to the effectiveness of the policy instruments. The second relates to the cost efficiency of regulation. Different types of regulatory failure will now be considered. The discussion will include legal and institutional costs of regulation as well as the effect of regulation on economic performance. In particular, the negative consequences that regulation may have for competition will be analysed. 4.1. Regulation and Effectiveness There is a large policy analysis literature that addresses the discrepancy between policy goals and the results of applying regulation and other policy instruments. Geelhoed (1983) relates the discrepancy to three main causes. In the first place, not all potential instruments can be used as a regulatory device. For instance, some types of regulation (e.g. discrimination) may be socially unacceptable, while others are only of limited use. For higher education, an example is the introduction of selection and access restrictions in universities. Social pressures may prevent such legislation from being introduced. Secondly, when looking at policy effectiveness and policy or transaction costs, the reactions of the objects of regulation (the organisations, individuals, citizens) are important. The effects of regulation fall into two categories: direct effects and indirect effects. When it comes to the direct effects of regulation, the question is to what extent the actual impact matches the intended outcome of regulation. Do the goals need adjusting, or do the regulatory instruments need adjusting? The indirect effects of regulation include the unexpected and unintended effects, often observed in areas that originally were not the areas that the regulation was addressing and frequently the areas that were neglected at the time the policy was designed. Policy costs are the costs of applying the policy and are a part of the effects of regulation. To begin with, there is the cost of preparing, designing and implementing regulation and decrees issued by the government. Monitoring costs are part of this; these are the costs incurred due to the information asymmetries that exist between principal and agent. Other policy costs are less obvious – they relate to the costs incurred by other agents – outside the government. Regulation may impose a burden on organisations and individuals – it sometimes unintentionally restricts the freedom to manoeuvre and leads to compliance costs. As an example, research assessments in higher education are believed to have high compliance costs. Thirdly, regulation may have all kinds of combined effects. When governments increase regulation, the rules will often have to be more detailed and complicated. Regulation often calls for additional regulation; interest groups will request regulation for their territory if they feel that other areas are protected by regulation. Moreover, due to rapid developments in society and in technology, regulation may turn out to be out-of-date or difficult to adjust, once it is introduced. Regulation in one area also has the potential to interfere with regulation in another. All in all,

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regulation tends to lead to high transaction costs – especially if it is of a traditional ‘command and control’ type that dictates standards and conditions to be met by providers. Breyer (1982) therefore prefers government intervention by means of taxation, charging, tradable rights and the definition of service liability. This is more like steering through incentives instead of steering through decrees. 4.2. Regulation and Efficiency Regulation can have important consequences for the efficiency of the system. Currently, the belief is held that most regulation represents a burden on economic activity and deregulation leads to increased efficiency. The chapter will now look more closely at this relationship, in particular, at the different kinds of efficiency. The supposed increase in economic efficiency due to deregulation can be categorised into three types: 1. 2. 3.

an increase in internal efficiency of organisations (production requires fewer resources); an increase in allocative efficiency (supply is matching/meeting consumer demands more closely); an increase in dynamic efficiency (more incentives for innovation in processes and products).

The first type of efficiency stresses the idea that deregulation and, therefore, more freedom to decide on the choice of activities and resources will encourage providers to search for better ways of providing their services. As a result, the service will be produced against lower costs. In other words, regulation is believed to harm market-oriented behaviour because decentralised coordination by means of price mechanisms is bypassed. The increase in allocative efficiency is caused by the fact that competition either leads to a lower price (making the service more attractive to more consumers) or leads to a product with higher quality. In some cases, competition may lead to higher prices, but even then the price/quality ratio is more favourable for consumers. Dynamic efficiency increases due to the fact that competition encourages providers to look for new products that are differentiated from existing ones (thereby decreasing the intensity of competition). Differentiation can be either horizontal (other products) or vertical (better quality). Connecting our discussion to the ‘economics of regulation’ (Stigler 1971) and the stylised version of the structure-conduct-performance model from the theory of industrial organisations (Scherer and Ross 1990), regulation can be tied to the market structure or the conduct of the market. Structural regulation addresses the issue of who gets access to the market; which providers are allowed to engage in particular activities. The structure of the market is characterised by the number and size distribution of providers and their clients, the degree of physical or subjective differentiation distinguishing competing providers’ services, the presence or absence of barriers to the entry of new providers, the shapes of cost curves, the degree to

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which providers are vertically integrated (e.g. from pre-higher/tertiary education to postgraduate training) and the extent to which individual providers produce a diverse set of services (see Scherer and Ross 1990: 4–5). (The issue of barriers to entry was discussed earlier in the chapter.) When they are powerful enough, providers sometimes lobby for entrance barriers, making it difficult for new, competing providers to enter the market.7 For higher education, the regulation of market structure includes financial and legal requirements (e.g. with respect to the financial health of new entrants), infrastructure requirements (the size, location and condition of buildings, health and safety conditions) and requirements relating to staff (type of training/degrees held by staff) and programmes (accreditation, in particular, the contents, length and structure of degrees). An important piece of regulation for higher education concerns the right to start a new degree programme or a new institution. This issue is perhaps best seen as a process where governments decide: a) what entities to, and not to, recognise as legitimate providers of higher education; b) which of the recognised and nonrecognised providers will receive public funding; and c) how that funding will be distributed within the sector (Jongbloed and Salerno 2002: 22). The decisions on each of these topics affect the structure of the higher education market and the extent to which new, often private, providers can set foot in the market. Figure 2. The structure-conduct-performance model

structure

conduct

Regulation of structure

Regulation of conduct

• regulation of entry/exit • regulation of competition • protection of intellectual property rights • funding and recognition of providers

• • • • •

regulation of price regulation of quantity regulation of capacity regulation of quality regulation of inputs

performance

Administrative regulation • tax/fiscal rules • accountability requirements

Market structure in turn is affected by a variety of basic conditions. One is the general legal framework within which providers operate. Another set of conditions that is more of an institutional nature (see North 1990) consists of the dominant socio-economic values of the community of providers and consumers. For instance,

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does society witness a move to a more individualised society, characterised by more heterogeneity and unpredictability and individuals engaging in increasingly volatile forms of interaction (Jongbloed 2002)? This institutional framework is shaped, to a large extent, by public policies, including the use of regulatory and financing instruments. An example from higher education would be the degree of workforce unionisation: are workers organised in collectives to bargain for salary rises and other employment conditions? And, if so, do employers have to conform to collective agreements on pay rises? The second type of regulation is conduct regulation, where regulation places restrictions on decisions with respect to price (tuition fees) and volume (for instance, the number of publicly funded student places in a university or in the higher education sector as a whole). Conduct also extends to such matters as cooperative arrangements between providers (either overt or tacit; mergers and alliances), investment in facilities (through taking out loans), providers’ behaviour on input markets (recruitment of staff, students, purchasing equipment) and output markets (differentiation and diversification strategies), innovation strategies (research and development), marketing and legal tactics. Conduct regulation affects the market behaviour of providers and the degree to which they can compete. Conduct regulation may also extend to the quality of the services provided, making it difficult to be distinguished from structural regulation. Generally, one might argue that structural regulation affects the incentives of providers to behave in a particular way, while conduct regulation affects organisational behaviour itself. Structural regulation is sometimes argued to be more effective and cost efficient than conduct regulation. The reason is that conduct regulation leads to transaction costs, because the presence of principal-agent problems (information asymmetry) requires the regulator to collect information and monitor performance. In any case, both types of regulation affect the extent of competition in the market. For higher education, the various types of conduct regulation may be categorised into three sub-sets. Following Volkwein (1987), we can distinguish regulation on: x x x

academic matters (i.e. institutional mission, programmes, student selection) personnel and governance matters (i.e. terms of employment, institutional management) financial matters (i.e. budgetary control, audit, access to revenue/capital markets).

The first area of conduct regulation is closely connected to the topic of academic freedom. With governments and other large funders increasingly demanding value for money, the degree of academic autonomy may come under threat, implying that restrictions on the mix and contents of the services offered by higher education institutions limit their ‘opportunity set’, including the possibility for institutions to deny entry to students who apply for a study place at the institution. Accreditation, recognition of degree programmes and quality assessments in teaching and research are examples of regulation (part of it self-regulation, and partly state-imposed) on

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academic matters. Also, in the interest of students, there is some degree of interference in academic matters. ‘Consumer protection’ regulation not only includes checks on the quality of academic programmes and procedures to handle student complaints, but also extends to the publication by providers of information on programme requirements and graduate achievements (see Dill and Soo in this volume; also Cave 1994). Governments may ask institutions to report on the academic achievements of their students in order that students are better informed of the quality of degree programmes. This is a kind of administrative regulation affecting the performance of education providers. Regulation of the academic services provided also includes controls over what services are provided to whom, and where the emphasis of the institution’s teaching and research activities lies. Regulatory authorities may also require institutions (public as well as private) to seek approval for new programme proposals before they qualify for public funding or before enrolled students qualify for student support. While quality control is one concern, another is the regional distribution of programmes across the country. Regulatory authorities sometimes are sceptical about new programmes that might compete with (i.e. ‘duplicate’) existing programmes at other public or private institutions (Thompson and Zumeta 1981). Regulation of personnel matters includes restrictions on the number of academic and non-academic positions, the approval of appointments, staff classification systems and salaries. As concerns the latter, the so-called collective agreements on salaries are an important element of conduct regulation in the area of personnel matters. It is a fact that employees of the public higher education institutions are often considered civil servants. Salary policies affecting civil servants in other parts of the public sector therefore will often affect the higher education sector as well. The civil service status implies that merit pay will normally be absent in public institutions. This makes it difficult for public higher education institutions to compete with the private sector in attracting and retaining the most talented individuals. This is particularly true in fields with severe shortages, for example, natural sciences, computer sciences, etc. (Ferris 1991: 105). ‘Appointive autonomy’ also includes tenure issues, appraisal systems, working hours and other workplace regulations. Some of these issues will be determined by national regulation (e.g. in collective agreements), others by self-regulation or even on an institution by institution basis. National laws and regulations also affect the higher education institutions’ mechanisms for governance and management. For institutions’ stakeholders to have a say in some of the key decisions, specific bodies and committees will have to be in place. Examples are academic boards and programme committees. Governance and management regulations also define the roles and responsibilities of the heads of institutions and the roles of their senior managers. The third area of conduct regulation relates to financial autonomy. This stretches into areas such as budgetary controls, restrictions on charging tuition fees, control over how financial resources are used and generated, and the way institutions have to meet accountability requirements.8 Financial autonomy is often connected to the issue of whether the higher education institution receives a lump sum budget from the public funding authorities or an itemised budget. In the first case, the institution

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is free to spend its revenues in the way it considers most appropriate to achieve its objectives. In the second, spending is prescribed and the public budget is only to be used for particular items (equipment, salaries) or functions (teaching, research). In most countries, the public core funding for higher education institutions is currently primarily provided as a lump sum (Kaiser, Vossensteyn and Koelman 2001). Itemised (or earmarked) budgets are used for the development and implementation of specific innovations, and usually a small part of the teaching budget is reserved for this. State regulation over financial matters also includes the control over non-state (non-public) revenues, that is, tuition revenues and revenues from sponsored research and auxiliary activities (such as net income from bookstores, room rent, etc.). As far as control over prices charged to consumers (i.e. students, contract partners) is concerned, one can observe regulatory agencies (ministries, executive budget agencies, legislators) exercising control over tuition fees and crosssubsidisation patterns. In most countries around the world, state authorities set the fees (Jongbloed in press) in order to control the price of admission and to make higher education affordable for all qualified students, irrespective of means.9 We take the opportunity here to discuss more extensively the problems associated with the regulation of institutions that are increasingly active in managing a diverse portfolio of, on the one hand, traditional tasks, such as teaching and research, and, on the other, entrepreneurial (income-generating) activities. According to many observers and researchers (e.g. Koelman and De Vries 1999; In ‘t Veld 1995), marketisation in higher education results in higher education institutions becoming hybrid organisations, that is, “bodies which operate in both the public and the private domains, fulfilling public duties as well as developing commercial market activities” (Van Twist and In ‘t Veld 1999: 3). They are increasingly becoming a mixture of a governmental institution and a commercial enterprise. This trend is believed to lead to a more customer-oriented, efficient and innovative higher education system (see e.g. In ‘t Veld 1995) with providers being encouraged to perform better because they have to compete with others. Hybrid organisations are believed to be more interested in new developments and innovations because of their need to distinguish themselves from competitors. This makes them adopt a more enterprising attitude, searching for ways to improve efficiency, to innovate their products and to increase product quality. While one of the advantages of hybrids is that they can generate revenues through their commercial activities, this is also regarded as one of their potential disadvantages. Hybrid organisations are sometimes accused of unfair competition, in particular if they use their public revenues to subsidise commercial activities. Crosssubsidisation of commercial activities enables them to charge prices that are lower than those of private competitors. This sometimes makes politicians argue for a splitting up of hybrids into a public part and a private part. This would also take away the danger of academics jeopardising the core mission – the public duties of their institution. Market activities may bring in large benefits for staff who are directly involved, leading them to disregard their public duties. Conflicts of interest also manifest themselves in research publication practices. Autonomy and

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professional integrity may also be harmed when academic staff offer themselves as consultants to the highest bidder. The practical issue for the government is how to deal with the challenges and risks of hybrid higher education institutions. Realising that the option to simply prohibit the existence of hybrid organisations is out of the question, the only option available for the government seems to be to find ways of regulating hybrid organisations. The regulation then would have to foster the strong elements of hybrids while bringing the risks arising from hybrids under control. Van Twist and In ‘t Veld (1999: 15–16) argue: It is necessary to come to acceptable details of composite forms that are oriented on government as well as on market. Acceptable are those composite forms that can reduce the contradictions in the impulses connected to hybridity to allowable proportions. Thereto specific arrangements have to be designed.

The regulatory arrangements suggested by Van Twist and In ‘t Veld (1999) include conditions that relate to the public tasks of higher education institutions as well as conditions arising from their activities in the private domain. With regard to the first, the regulations would have to ensure that the public duty (teaching and research) of the higher education institution may not be endangered and students should not become victims of entrepreneurial activities. The goal of the hybrid is to strive for some interconnection between commercial activities and the core business of the institution. The conditions with respect to the private (for-profit and not-for-profit) activities would have to ensure that there is no unfair competition between higher education institutions and private enterprises. This means that there should be distinct agreements on the nature and proportion of the commercial activities. The responsible leaders of the higher education institutions (deans, directors, presidents and other managers) would need to monitor and guard these issues, perhaps with some overseeing/supervisory body (e.g. Board of Trustees). Clearly, accountability is the central issue. Higher education institutions will need to be accountable for their public duties as well as their commercial activities. Transparency, monitoring and reporting will become crucial issues – in particular, with respect to institution and department costs and revenues from commercial activities. Explicit rules and standards will need to be agreed upon and need to be codified in higher education institutions’ internal policy documents. To a large extent, this regulatory framework may be constructed through initiatives of the higher education institutions themselves. Codes of conduct, pricing strategies, reporting and accounting practices may be formulated through self-regulation initiatives or covenants. With universities and colleges increasingly becoming hybrid organisations, they should be accountable regarding their public tasks (through monitoring) as well as their commercial activities (through warranty of quality). Marketisation, therefore, will go hand in hand with internal as well as external regulatory arrangements.

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5. VOUCHERS: A WAY OF INCREASING COMPETITION? The developments towards mass-individualisation, the knowledge society and lifelong learning place new demands on higher education – on the organisation of the sector as a whole as well as on individual higher education institutions (Jongbloed 2002). This will have consequences for the way in which the sector is managed, funded and regulated by public authorities. However, due to the heterogeneity and unpredictability in markets, public authorities cannot centrally plan and manage the higher education sector. As argued in section 2, self-regulation by students and higher education institutions themselves may have to be the leading principle. This implies that choices made by students and other demands placed upon higher education institutions are driving the system. For the funding of the higher education sector this would imply a large degree of demand-side financing. In the research literature (e.g. Levin 1983) vouchers are often propagated as a powerful means of introducing demand-side financing. Students (or prospective students) would receive a bundle of vouchers (or entitlements) to buy educational services from higher education institutions. The voucher represents a certain amount of money (an ‘entitlement’) to be spent on approved higher education programmes (Blaug 1967). A voucher scheme represents a specific way of funding (higher) education. Instead of the government allocating subsidies directly to the providers of education, the government is channelling the subsidies through students (i.e. the consumers). To secure their funding, higher education institutions therefore will have to compete for students and consequently are believed to shift their focus from satisfying government bureaucrats towards the needs of their customers. Thus, a voucher scheme contains incentives to strengthen student choice and competition. In a voucher scheme, the providers of higher education are forced to be responsive to the needs and preferences of their customers (i.e. students, business). Providers are forced to compete and students are encouraged to seek the provider that best satisfies their demands. In doing so they can choose from a range of providers. Vouchers, therefore, constitute a marketoriented type of funding of higher education. An essential element of a voucher scheme is that individual students are receiving government subsidies – either in terms of real money, or in terms of entitlements to a given amount of education – to be spent at the educational institution of their choice. Vouchers thus are a form of demand-side funding. Student choice drives the funding. This is in contrast to a system of supply-side funding where educational institutions are funded directly on the basis of the number of students they enrol or the number of diplomas they confer. The crucial aspect of the voucher idea is freedom to choose and this, according to Barr (1998), would require that education is not only provided by public institutions but also – or at least in part – by private institutions. So, students would be allowed to cash their vouchers also at accredited private institutions that – just like the public ones – comply with specific quality standards. The voucher scheme can also be extended to include on-the-job training programmes. Most of the voucher schemes proposed in the academic literature address compulsory education. Regarding higher education and other forms of post-

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compulsory education, voucher schemes are rare (Jongbloed and Koelman 2000) and hardly ever leave the drawing board stage (e.g. the voucher model proposed in Levin 1983). However, there is an often-overlooked example to be found in the US, namely the Pell grant. The Pell grant has characteristics of a voucher model. The US federal government, in 1972, in confronting a major decision point in how it should come to the assistance of institutions of higher education, both public and private, came to a very clear rejection of federal block grants, and an equally clear embrace of vouchers (then referred to as basic grants, now Pell grants), albeit need-based, and never a true entitlement (i.e. always depending on the adequacy of a particular year’s appropriation). The Pell grant is quite clearly a voucher in that it is given directly to students without regard to academic merit (or even ‘academic promise’), programme of study, or institution at which the voucher may be used (including both private not-for-profit and private for-profit institutions). However, the Pell grant is not very generous and is never the single source from which institutions derive their public funding for education. According to Barr (1998), two questions are central for a discussion about vouchers in higher education. The first question is: Are students capable of making informed choices? Barr comes to the conclusion that in higher education consumer tastes are diverse, degrees are becoming more diverse, and change is increasingly rapid. The most important reason for these developments is the increasing complexity of our post-industrial society. In Barr’s opinion, students are more capable than central planners of making choices on what they want to study and where they want to study. In his view, the goal of consumer sovereignty can be regarded as more relevant for higher education than for compulsory education. The second question is: How useful is competition? Barr concludes that it is a huge mistake to think that a simple-minded voucher model (higher education institutions competing for students; the ones attracting large numbers flourish, others keep on struggling) is the only approach to competition. He argues that “vouchers should be thought of as a continuum, from zero per cent constrained (‘law of the jungle’) to 100 per cent constrained (‘pure central planning’) or anywhere in between” (Barr 1998: 352). Policy makers should consider a variety of constraints in choosing their position on this continuum: 1. Protecting subjects. Some courses (e.g. classics) need special protection, others need less protection. This can be arranged by tying some vouchers to specific subjects. 2. Protecting institutions. For reasons of regional balance it could be necessary to tie vouchers to universities in particular parts of the country. 3. Protecting individuals. There are good reasons to offer larger vouchers to students from low income families. 4. Protecting quality. One of the bests arguments in favour of competition is that competition creates a strong incentive for higher education institutions to offer quality to their students. Nevertheless, at the same time it is important to protect standards, for example, by monitoring quality and publishing the results.

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All in all, Barr (1998) concludes that vouchers call for a regulatory role for the government in order to foster both educational and distributional objectives. The degree of competition is a political matter with different possible policy answers. We would like to add to Barr’s conclusion that vouchers are not the only approach to competition. While vouchers are theoretically attractive and often suggested as a useful funding mechanism in today’s lifelong learning context that stresses flexible learning routes and custom-built curricula, the goals to be achieved most not be lost sight of. If the aim is to have institutions compete for students, one has to bear in mind that vouchers are not the only approach to competition and – because different voucher models exist – would also go hand in hand with some degree of government regulation. If policy makers feel that a more market-oriented education system should emerge, with competition between providers and student choice driving the system, they may also want to consider some alternatives to vouchers. There is in fact very little fundamental difference between a voucher system and a system in which the government allocates a formula-based grant on the basis of the institution’s enrolment – even in the case of students studying during irregular periods during their lifetime. So, why introduce vouchers? There can only be one argument: to make students realise that the choices they make imply that the government is investing on behalf of them and – in return for that – the educational institution is supposed to deliver a service. However, making students realise this by giving them a voucher is somewhat artificial, since the voucher does not represent ‘real money’ in the sense of being part of the student’s free disposable income. Therefore, well-informed student behaviour may be more effectively enhanced if they make a contribution to the cost of their education themselves.10 Since the benefits of higher education and other forms of postsecondary education to a large extent will accrue to the individual who receives the education, there is a strong case for charging a fee to the student. However, in order to have tuition fees play a role in informing students about the range of choices they can make in postsecondary education, the fees will have to have some relation to the quality – and therefore the costs – of the services delivered to the student. This implies that a market-oriented way of funding postsecondary education requires a deregulation of tuition fees (Jongbloed 2003b). The providers of education and training would have to be free to set the level of the fees they charge to their students. Fees would not have to cover the full cost but should be higher for more expensive programmes. Institutions then would charge differential prices to reflect their differential costs.11 The only exception to this general rule would be that programmes that produce relatively large external effects would receive a larger government subsidy, thus enabling a smaller fee to be charged. Such a deregulation of fees could easily take place without an introduction of vouchers. Public funds still could be allocated to the providers of education on the basis of the number of students enrolled and the programmes they take. Funds, then, follow the student in two ways: through market-driven fees as well as through enrolment-based grants.12 Both of these mechanisms imply a substantial degree of competition in the higher education sector.

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6. CONCLUSIONS In this chapter, it has been argued that there are many reasons why governments intervene in the higher education market through regulation and other instruments of intervention. Governments will try to ensure that society’s demands are satisfied at minimum cost, that higher education providers deliver high quality services and that the higher education system is accessible to all talented individuals. However, with growing levels of fiscal stress, many governments are introducing market forces into the highly regulated higher education systems in order to make providers of higher education and research more responsive to the demands of society and raise the levels of efficiency in the system. The introduction of market forces takes place through deregulation and policies aimed at increasing competition between providers – either within the set of often heavily subsidised and monopolistic public providers or between public providers and private providers with the latter allowed entry into the higher education market. Deregulation is not a goal in itself; it is intended to give more room to the market, that is, to decentralised decision making by students and providers of higher education. It would be a misconception to equate deregulation with marketisation. On the contrary, to let the market function properly a powerful system of rules is necessary. In the first place, there is a need to create an institutional framework that builds trust among the agents in the market, assuring them that contracts are fulfilled, that service quality is acceptable and that the market is transparent. Secondly, a set of rules and regulations will be needed to oversee market entry and exit – preventing providers abusing their market power. However, reasons to limit competition will always be brought forward – in particular, if next to efficiency, equity considerations are considered. Regulation of market structure and conduct of providers (and their clients), though, is always an imperfect substitute for competition due to transaction costs and other economic costs of non-market (government) failure. Apart from regulating the degree of competition among public and private higher education institutions, there remain other important roles for government to play. Government retains a major influence and exerts substantial power over the working of the higher education system. While it is no longer controlling the system as a central planner, it does have several roles to play. The first role for government lies in financing, thus promoting the external effects of investment in higher education. Furthermore, government will have to act as a facilitator in allowing higher education institutions to attract private funds (e.g. through tuition fees and entrepreneurial activities). A second role lies in the provision of student support and ensuring students have access to loans (private, public) and, where necessary, grants. This task is aimed at promoting access and equity. This goal cannot only be accomplished by using incentives and financial instruments. Non-financial instruments, regulation and supplying information are also called for. The third role of government lies in quality assurance. Again, this is not a financial instrument, although the outcome of quality assurance exercises may have consequences for the financial resources that flow from the public purse to institutions and students. Regulation needs to be in place to ensure that higher

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education institutions deliver education and degrees that meet national and international quality standards. Governments may require higher education institutions to publish timely and accurate performance information in their yearly reports, or facilitate agencies that inform students, their parents, employers and the general public about the performance, costs and quality of the teaching and research that take place in universities and colleges. We have argued that marketisation policies will lead to a system where individual demands and decisions drive the system and we have used the ‘roundabout’ metaphor to illustrate this. Market-type mechanisms seek to strengthen the link between private – that is, individual – preferences and private contributions and create incentives to improve efficiency. Government regulation and funding then will have to emphasise demand instead of supply. A system of demand-side funding through vouchers was discussed, but it was argued that some of the intended goals of voucher systems might also be realised by means of pricing policies and quantity regulation (or rather the absence of quantity regulation). Differential tuition fees by field or institutional type would affect the composition of higher education demand, act as price signals and raise additional revenues for the sector. Another example of more market-oriented policies is the introduction of competitive funding for research – competition, not only for public funding, but also for private research contracts. Institutions, thus, respond to various markets and generate revenues from many sources. The dilemma that immediately arises, in particular, in systems where higher education is primarily a public affair, is whether entrepreneurialism negatively affects the public tasks of the institution: Does it endanger the teaching function? Is fundamental research neglected in favour of applied (and more immediately profitable) research? Are research results kept secret or even compromised by industry demands? All of this illustrates that regulatory frameworks and self-regulatory initiatives will be needed. It also shows that the answers to market failures and non-market failures are to a large extent dependent on the society’s view of higher education, on traditions, cultures and ideologies. This chapter has shown that regulation affects the static as well as the dynamic efficiency of the system and that the particular type of government regulation will depend on the particular market failure to be addressed. The issue whether regulation produces better results than more market-oriented (say competitive or pricing) approaches, however, remains problematic. The country case studies contained in this volume will hopefully shed some light on this. NOTES 1

2 3

The non-exclusiveness and non-rivalness of the services (education, research) produced by higher education imply that innovators are unable to appropriate all the benefits from their efforts and therefore may be inclined to under-invest in education or research. This may call for protection of property rights (e.g. patent systems). Efficiency under the respective guises of: productive efficiency (least cost provision), allocative efficiency (in the Pareto sense) and dynamic efficiency (making best use of resources over time). See also Massy in this volume. This term derives from Bruce Johnstone.

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4

Positive economies of scale are present when an increase in inputs with a given factor leads to a more than proportional increase in output. 5 For instance, ‘predatory pricing’, where cartel members engage in aggressive price setting strategies (prices set below marginal costs) to deter new providers from entering the market. One can point to prestigious private universities in the US that use their immense endowments to offer large scholarships to bright students, thereby luring them away from competing (public or private) universities. See Breyer (1982). 6 Sunk costs are costs that have already been incurred, and which cannot be recovered to any significant degree. 7 Quoting Stigler (1971: 6): “The butter producers wish to suppress margarine and to encourage the production of bread”. Strong regulation of competing sectors (providers) is profitable, and so is the deregulation of a sector that provides a complementary service. 8 Although the latter may also be included under the heading of administrative regulation (see figure 2). 9 It is not just the regulation of tuition fees that affects the price of admission – student support (grants, loans, scholarships), selection mechanisms and capacity limits (i.e. restrictions on available, publicly funded, student places) all have an effect on the student enrolment decision. 10 Another way of strengthening well-informed behaviour is to monitor quality and publish the results. Monitoring can be done by inspectorates, accreditation bodies, newspapers, etc. 11 A model like this is currently in use in New Zealand. 12 Instead of basing grants on enrolments alone, they may be based on a combination of enrolments and student performance (e.g. the number of credits accumulated by students), or student performance alone (see, e.g., the Danish model of funding higher education).

REFERENCES Barr, N. The Economics of the Welfare State. 3rd edn. Oxford: Oxford University Press, 1998. Baumol, W.J., J. Panzar and R.D. Willig. Contestable Markets and the Theory of Industry Structure. New York: Harcourt, 1982. Blaug, M. “Economic Aspects of Vouchers for Education.” In Beales, A., M. Blaug, E. West and D. Veale (eds). Education: A Framework for Choice. 2nd edn. London: Institute of Economic Affairs (IEA), 1970, 23–47. Breyer, S. Regulation and its Reform. Cambridge: Harvard University Press, 1982. Cave, M. “Why Students Need (Consumer) Protection.” Royal Economic Society Newsletter 87 October (1994): 18–20. Coase, R. “The Problem of Social Cost.” Journal of Law and Economics 3.1 (1960): 1–44. Dunning, J.H. “Technology and the Changing Boundaries of Firms and Governments.” In OECD. Industrial Competitiveness in the Knowledge-based Economy. The New Role of Governments. Paris: OECD, 1997, 53–67. Ferris, J.M. “Competition and Regulation in Higher Education: A Comparison of the Netherlands and the United States.” Higher Education 22 (1991): 93–108. Geelhoed, A. De interveniërende staat, aanzet tot een instrumentenleer. The Hague: SDU/Ministerie van Binnenlandse Zaken, 1983. In ‘t Veld, R.J. Spelen met vuur. Over hybride organisaties. Den Haag: Vuga, 1995. Jongbloed, B. “Lifelong Learning: Implications for Institutions.” Higher Education 44.3/4 (2002): 413– 431. Jongbloed, B. “Flexible Fees: Great Expectations and Critical Conditions.” Paper presented at the 16th CHER Annual Conference, Porto, Portugal, September, 2003a. Jongbloed, B. “Marketisation in Higher Education, Clark’s Triangle and the Essential Ingredients of Markets.” Higher Education Quarterly 57.2 (2003b): 110–135. Jongbloed, B. “Tuition Fees in Europe and Australasia: Theory, Trends and Policies.” In Smart, J.C. (ed.). Higher Education: Handbook of Theory and Research, vol. XIX. Dordrecht: Kluwer, in press. Jongbloed, B. and J. Koelman. Vouchers for Higher Education? A Survey of the Literature. Enschede: CHEPS, 2000. Jongbloed, B. and C. Salerno. Funding and Recognition: A Comparative Study of Funded Versus Nonfunded Higher Education in Eight Countries. Vol. 92 in series ‘Beleidsgerichte Studies Hoger

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Onderwijs en Wetenschappelijk Onderzoek’. The Hague: Ministry of Education, Culture and Science/SDU, 2002. Kaiser, F., H. Vossensteyn and J. Koelman. Public Funding of Higher Education. A Comparative Study of Funding Mechanisms in Ten Countries. Vol. 84 in series ‘Beleidsgerichte Studies Hoger Onderwijs en Wetenschappelijk Onderzoek’. The Hague: Ministry of Education, Culture and Science/SDU, 2001. Kay, J. and J. Vickers. “Regulatory Reform in Britain.” Economic Policy 9 (1988): 285–351. Koelman, J. and P. de Vries. “Marketisation, Hybrid Organisations and Accounting in Higher Education.” In Jongbloed, B., P. Maassen and G. Neave (eds). From the Eye of the Storm. Higher Education’s Changing Institution. Dordrecht: Kluwer Academic Publishers, 1999, 165–187. Laffont, J.J. and J. Tirole. A Theory of Incentives in Procurement and Regulation. Cambridge, MA: MIT Press, 1993. Leibenstein, H. “Allocative Efficiency Versus X-efficiency.” American Economic Review 56 (1966): 392–415. Levin, H.M. “Individual Entitlements.” In Levin, H.M. and H.G. Schütze (eds). Financing Recurrent Education. Sage: Beverly Hills, 1983, 39–66. North, D.C. Institutions, Institutional Change and Economic Performance. Cambridge: Cambridge University Press, 1990. Scherer, F.M. and D. Ross. Industrial Market Structure and Economic Performance. 3rd edn. Boston: Houghton Miffin Company, 1990. Stigler, G.J. “The Theory of Economic Regulation.” Bell Journal of Economics and Managerial Science 2.1 (1971): 3–21. Thompson, F. and W. Zumeta. “A Regulatory Model of Governmental Coordinating Activities in the Higher Education Sector.” Economics of Education Review 1.1 (1981): 27–52. Van Asseldonk, A.G.M., L.J.W. Berger and E. den Hartigh. Naar een economie van heterogeniteit en onvoorspelbaarheid: kennisvragen voor de Nederlandse managementwetenschappen. Den Haag: Adviesraad voor het Wetenschaps- en Technologiebeleid, 1999. Van Asseldonk, T. Massa-individualisering: Geld verdienen aan de grillige consument. Alphen aan den Rijn: Samsom, 2000. Van Twist, M.J.W. and R.J. In ‘t Veld. “Public Organisations in the Market Place. Risks, Profit Opportunities and Conditions for Existence.” NIG Working Papers, no. 99–95, 1999, Enschede. Van Vught, F.A. Governmental Strategies and Innovation in Higher Education. London: Jessica Kingsley, 1989. Volkwein, J.F. “State Regulation and Campus Autonomy.” In Smart, J.C. (ed.). Higher Education: Handbook of Theory and Research, vol. III. New York: Agathon Press, 1987, 120–154. Williamson, O.E. “Transaction Cost Economics.” In Schmalensee, R. and R.D. Willig (eds). Handbook of Industrial Organization I. New York: North Holland, 1989, 135–182.

GERAINT JOHNES

THE EVALUATION OF WELFARE UNDER ALTERNATIVE MODELS OF HIGHER EDUCATION FINANCE

1. INTRODUCTION There are three reasons why government should fund expenditures on services. Firstly, market failure might occur; hence public goods are often paid for through the tax system, and government is also active in areas where externalities are to the fore. Secondly, the provision of services might provide an effective means of redistribution. Thirdly, services may be provided through the government if they are regarded as a merit good. At a basic level, education qualifies under all three criteria. Improvement in the general level of literacy, numeracy and other basic skills helps those who become more literate or numerate, to be sure, but it also helps others to communicate with them – and so education confers externalities. At primary and lower secondary levels, where education is universal (or near universal), resources are diverted from wealthy taxpayers towards poorer households. Equally, education is regarded by many as a ‘good thing’, and some people might under-invest in it if left to their own devices.1 It is not at all clear, however, whether any of these three arguments should apply to higher education. The main beneficiaries of higher education, it is agreed, are the students themselves. Whatever contribution education makes to their productivity is reflected (in a free labour market) in their subsequent remuneration. The beneficiary pays principle thus suggests that the burden of paying for education should be borne by the student – though, depending on the nature of capital markets, this might require special arrangements to be made to ensure both the availability of loans and a suitable repayment mechanism. Yet, in almost all countries, governments make very substantial subsidies to education at this level. In this chapter, two approaches will be used to investigate the nature of the balance between public and private provision in higher education. The first is to develop a simple model which shows how the externality argument may reasonably be used to qualify the beneficiary pays principle. The second is to examine how the higher education system has responded to structural change in a number of European countries over the last 15 years; differences in the experiences of different countries will allow conclusions to be drawn about the conditions under which private higher education is likely to flourish. Throughout, the focus of interest is on the funding of higher education, not the ownership of higher education institutions. 113 P. Teixeira, B. Jongbloed, D. Dill and A. Amaral (eds), Markets in Higher Education: Rhetoric or Reality, 113–125 © 2004 Kluwer Academic Publishers. Printed in the Netherlands.

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The chapter proceeds as follows. In the next section, a simple theoretical model is developed which allows back-of-the-envelope calculations to be made to evaluate the degree of public intervention that optimises social welfare. In the third section, the recent history of higher education in some European countries is discussed; these histories are then interpreted in the context of the theoretical model presented earlier. Finally, conclusions are drawn. 2. A SIMPLE MODEL There has been a considerable amount of recent literature on the appropriate means for funding higher education. Recent examples include the Greenaway and Haynes (2003) report, Chapman (1997) and Barr and Crawford (1998). These have generally been supportive of reforms that shift the burden of paying for higher education away from the general taxpayer towards the student. The argument is, essentially, that the main beneficiary should bear the main burden of the cost of tuition. This follows from the user pays principle and – to mainstream economists, at least – has not been regarded as particularly contentious. Consequently, economists have not hitherto challenged themselves with the question of how to come up with estimates of the benefits of the user pays principle in this context. This section represents a first attempt to tackle this question.2 In order to do so, I shall develop a model which is quite general, and which is capable of accommodating conditions under which private funding of higher education is more efficient, equally efficient, or less efficient than the publicly funded alternative. The model will allow us to appreciate why the funding of higher education has become a politically contentious issue in many countries, in spite of the near consensus amongst economists in favour of the user pays principle.3 It is important to note two things about economic models of the kind developed here. Firstly, the model attempts to provide a distillation of factors that are deemed to be the most important in analysing education finance; the aim is to provide a representation that captures the main issues yet (and this is the important point) is simple enough to facilitate understanding why governments may or may not be involved in funding higher education. The model is not supposed to be real; it is supposed to be a distillation of reality. Secondly, decision makers in the model are assumed to act rationally; this assumption is necessitated by the difficulty involved in modelling irrational behaviour. The model is formalised as follows. Individual i receives disposable income of Yi where Yi = (Y0 + siTi)(1-W)

(1)

where Y0 is a constant, si is a binary variable4 that indicates whether or not i has attended tertiary schooling, W is the (proportional) rate of income tax, and Ti is a stochastic variable which is assumed to follow a uniform distribution and which varies between some strictly negative number and some strictly positive number.

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This last variable is intended to measure the innate ability to benefit from schooling. Tax in this model is paid solely for the purposes of financing education. It would be possible for the tax rate to equal zero if all education were paid for privately. Alternatively, if the tax rate exceeds zero there is some element of subsidy for education. We shall suppose that there is a single period, and that incomes and expenditures are incurred at the end of this period. Note that, for simplicity, we suppose that future income gains represent the only gain to education. Education is assumed to take place instantaneously. This means that educated and uneducated individuals alike have the opportunity to earn an income.5 Direct costs of education are covered by the cost term, c0. This cost may be paid entirely by individuals, for example, by securing a loan – in which case the tax rate is zero and the loan must be repaid at the end of the period. Or the cost may be borne entirely through the tax system. In this case the government pays for each educated worker’s education, and the rate of proportional tax is set so as to offset this cost exactly. For each worker, i, net income is defined as Yi-ci where ci is the private cost of education to i in the tth period. Where education is paid for privately, this will either be c0, if the individual is educated, or zero, if not. In this case W=0. Where education is paid for entirely through the tax system, however, ci will equal zero for all individuals – but in this case W>0. Suppose individual i undertakes schooling iff (Y0 + siTi)(1-W) - ci t Y0(1-W)

(2)

that is, iff the discounted value of post-schooling income (net of costs) is at least as great as the discounted value of income if no schooling is undertaken. In solving the central problem of this chapter, it will be necessary to work from a definition of social welfare. To provide a general definition, let social welfare, W, be defined as a weighted sum of the net incomes of all workers. Unit weight is attached to the incomes of uneducated workers, while a weight of V is attached to the incomes of educated workers. This specification of the welfare function is quite general: setting V=1 implies a utilitarian welfare function, while setting lower values of V implies the attachment of a higher weight to the net income of the less welleducated workers. As we shall see later, the most interesting values of V lie in the range 0