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The Revenue-to-Cost Spiral in Higher Education

By Robert E. Martin

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June 30, 2009

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A complete copy of The Revenue-to-Cost Spiral [384KB] is available for download as an Adobe Acrobat file compatible with Adobe Reader.

The cost of higher education has been rising rapidly. “The Revenue-to-Cost Spiral in Higher Education,” by Robert E. Martin, explains why. The cause is the incentives inherent in the nature of higher education.

The rewards and penalties facing college and university administrators virtually force administrators to seek more revenues rather than cut costs. And success in obtaining revenues—ironically—creates enormous upward pressure on costs because there is no pressure to control costs to earn a profit.

Higher education is a nonprofit sector; both profit and even clear ownership are missing. Martin compares higher education with the broader profit-seeking economy, where cost must be controlled if firms are to survive. He finds that higher education, due to its nonprofit nature and its focus on building reputation, spends just about everything it gets.

Executive Summary

Critics of higher education tend to focus on symptoms—rising costs, grade inflation, ideological bias, and the abandonment of traditional core courses. Such symptoms are a signal of a more fundamental problem, the structure of incentives in higher education.

The chief focus of this paper is on the rising costs in higher education and the incentives that push those costs up. Over the past thirty years, increases in the cost of higher education exceeded the increases in service-sector costs and even health-care costs.

This paper shows that an increase in revenues will actually spur greater expenditures, causing the revenue-to-cost spiral of the paper’s title. The incentives that push costs up stem from several sources:

  • The nonprofit status of most higher education institutions

  • The principal/agent problem

  • “Shared governance”

  • The role of reputation

  • The fact that education is an “experience good”—something whose value cannot be ascertained until after it is purchased. (Education is, in fact, the consummate “experience good”).

To identify the origin of higher education’s perverse incentives, this paper compares for-profit firms and non-profit organizations. While for-profit firms are flawed, they have more effective ways of addressing incentive problems than non-profits such as colleges and universities do.

The principal/agent problem is a universal problem, but one that particularly affects higher education. It occurs when the agent, someone who is supposed to act on the principal’s behalf, chooses his or her own interest instead; that is, when the interests of the principal and agent are not properly aligned. The agents in higher education are faculty, administrators, and board members. The principals are students, parents, alumni, and donors. The principal/agent problem always shows up as costs that are higher than necessary. Higher education’s dismal cost control record is the classic symptom of principal/agent problems.

The principal/agent problem in higher education is made worse by the absence of a market for ownership and control. That is, no potential takeover group is looking over the administrator’s shoulder to see how well resources are managed—and figuring out how the university could be more efficiently run under new ownership. There is also little government regulation (except for state institutions) and only a few private groups engage in oversight. In other words, the checks on the principal/agent problem in higher education are weak compared to for-profit firms. Ironically, principal/agent problems in for-profit firms are widely recognized, but their absence in higher education largely ignored.

Shared governance in higher education evolved in part to address the principal/agent problem. Faculty members, administrators, and board members should act as a natural check on one another. In order for this to work, however, communication among the three groups of agents should be open, and that openness is missing. Administrators and boards insist on a “chain of command” that undermines the potential benefits of shared governance.
The importance of academic reputations creates other incentives that increase costs and impair quality. As academic reputations rise, the school attracts more and better students, more contributions, and more grants. The school becomes wealthier and obtains a more diverse revenue stream.

Since reputations are damaged by controversy, the role of reputation gives governing boards a bias against cost control and toward raising more revenue—because cost control is controversial and increasing revenue is not. Similarly, if the administration and the board attempt to raise faculty productivity or to raise standards for tenure and promotion, those actions, too, will be controversial and therefore something they will avoid.

Reputations are so important because higher education services are probably the most complex type of what economists call an “experience good.” College is an infrequent, expensive purchase whose success depends as much on a student’s ability and effort as the input of faculty. Thus, the educational value added by a school is difficult to determine. The popularity of college rankings reveals how important quality information is to students and parents but also how little is provided by the institutions themselves.

Because the quality of higher education is difficult to measure and is only revealed with a lag, reputations can last for years, whether deserved or not. This durability creates principal/agent problems that lower quality and make the cost of entry for new “start-ups” much higher. The lack of entry reduces competition, making the principal/agent problem worse.

Given these incentives, a perverse result occurs: an increase in revenues actually spurs greater expenditures. Expenditures go up as soon as revenues go up. Without a goal of profit, administrators spend all the operating revenue rather than cut costs to carve out a profit. These expenditures stemming from revenues then become new costs that must be covered the next year. With costs constantly going up—reflecting the increases in revenues—the university must emphasize fund raising. This is the revenue-to-cost spiral.

How to end this spiral? Greater transparency is the first priority. Higher education institutions should be required to have transparent financial statements, which should also include key operating characteristics and reflect uniform accounting standards.

Other reforms to change the current incentives could include pay-for-performance contracts for faculty members and administrators, changes in governance (including modifications of shared governance) and accreditation, as well as the competition that is likely to come from entrepreneurial for-profit schools.

 


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