The public is in a foul mood over increasing college costs and student debt burdens. Talk of a “higher education bubble” is common on the contrarian right, while the Occupy Wall Street crowd is calling for a strike in which ex-students refuse to pay off their loans.

This week, President Barack Obama held a summit with a dozen higher-education leaders “to discuss rising college costs and strategies to reduce these costs while improving quality.” The administration plans to introduce some policy proposals in the run-up to the presidential campaign.

Any serious policy reform has to start by considering a heretical idea: Federal subsidies intended to make college more affordable may have encouraged rapidly rising tuitions.

It’s not as crazy as it might sound.

As veteran education-policy consultant Arthur M. Hauptman notes in a recent essay: “There is a strong correlation over time between student and parent loan availability and rapidly rising tuitions. Common sense suggests that growing availability of student loans at reasonable rates has made it easier for many institutions to raise their prices, just as the mortgage interest deduction contributes to higher housing prices.”

It’s a phenomenon familiar to economists. If you offer people a subsidy to pursue some activity requiring an input that’s in more-or-less fixed supply, the price of that input goes up. Much of the value of the subsidy will go not to the intended recipients but to whoever owns the input. The classic example is farm subsidies, which increase the price of farmland.

A 1998 article in the American Economic Review explored another example: federal research and development subsidies. Like farmland, the supply of scientists and engineers is fairly fixed, at least in the short run. Unemployed journalists and mortgage brokers can’t suddenly turn into electrical engineers just because there’s money available, and even engineers and scientists are unlikely to switch specialties. So instead of spurring new activity, much of the money tends to go to increase the salaries of people already doing such work. From 1968 to 1994, a 10 percent increase in R&D spending led to about a 3 percent increase in incomes in the subsidized fields.

“A major component of government R&D spending is windfall gains to R&D workers,” the paper concluded. “Incomes rise significantly while hours rise little, and the increases are concentrated within the engineering and science professions in exactly the specialties heavily involved in federal research.”

The study’s author was Austan Goolsbee, then and now a professor at the University of Chicago but until recently the chairman of the president’s Council of Economic Advisers.

Goolsbee did similar research, with similar results, on the effects of investment tax credits for capital equipment. Much of the benefit of such subsidies, he found, goes not to the company buying the new equipment but to the manufacturers who make it. A 10 percent investment tax credit raises equipment prices by 3.5 percent to 7 percent.

Like the scientists and engineers who benefit from R&D subsidies, the workers who make capital equipment also capture many of the subsidies’ benefits. Their wages go up, Goolsbee found, by 2.5 percent to 3 percent on average and as much as 10 percent, depending on the workers’ particular characteristics.

Goolsbee declined a recent request to comment on the subject, but the parallels to higher education are hard to miss.

In the short-term, the number of slots at traditional colleges and universities is relatively fixed. A boost in student aid that increases demand is therefore likely to be reflected in prices rather than expanded enrollments. Over time, enrollments should rise, as they have in fact done. But many private schools in particular keep the size of their student bodies fairly stable to maintain their prestige or institutional character.

The new breed of for-profit institutions has grown much faster than its nonprofit competition. Traditional private colleges expanded their enrollments 27 percent from 1999 to 2009, an increase of about 664,000 students, while for-profit private colleges grew 478 percent, by almost a million students.

Figuring out exactly what’s going on is tricky, because colleges price discriminate, offering steep discounts to some students while charging list prices to others. Treating published tuition as the real price of a college education is like believing the sticker price on a used car.

Some of the most elite schools, which could theoretically jack up their prices the most, face the most pressure from alumni and others to use their ample financial resources to extend more student aid.

At the most selective private schools, as defined by the College Board, federal grants and tax benefits for the average student are indeed lower than at less-selective schools, both as a percentage of all aid and in absolute dollars. These selective institutions’ own grants to students are much larger than elsewhere. Yet even after all this aid, they have the highest net prices: an average of $16,577 net tuition and fees (not including room, board and other expenses), compared with $10,823 for moderately private selective schools.

On the whole, it seems that universities are like the companies making capital equipment. If the government hands their customers the equivalent of a discount coupon, the institutions can capture at least some of that amount by raising their prices ― especially when demand for their product is increasing independent of aid, because a college degree promises to pay off in higher wages. They can then pay their employees more or simply not economize as they might otherwise have to do. Federal aid may also allow institutions to shift fundraising efforts away from drumming up scholarships and toward raising money for buildings, new programs or big-name professors.

This doesn’t mean that colleges capture all the aid in higher tuition charges, any more than capital-equipment companies get all the benefit of investment tax credits. But it does set up problems for two groups of students in particular. The first includes those who don’t qualify for aid and who therefore have to pay the full, aid-inflated list price. The second encompasses those who load up on loans to fill the gaps not covered by grants or tax credits only to discover that the financial value they expected from their education doesn’t materialize upon graduation.

That’s the situation many young people find themselves in today, which is one reason for their anger. The other is a widespread feeling, which the recession has intensified, that higher education is unfairly insulated from the everyday competitive pressures most people have to cope with. Instead of having to find ways to operate more efficiently and deliver ever-more value without raising costs, the way private-sector managers do, college administrators seem able to pass higher and higher bills on to their customers and the public.

A good chunk of the educated public has decided that college educators are decadent and lazy. Many are positively lusting to see higher education get its Detroit-style comeuppance.

This attitude is unfortunate and often unfair, but it’s the direct result of decades of federal policies. Any strategy to reduce college costs needs to look beyond traditional subsidies to remove some of the insulation that stifles innovation and feeds public resentment. 

By Virginia Postrel

Virginia Postrel is a Bloomberg View columnist. She is the author of “The Future and Its Enemies” and “The Substance of Style,” and is writing a book on glamour. This is the first of a two-part series on the economics of higher education. The opinions expressed are her own. ― Ed.

(Bloomberg)