Arnold Kling

Subsidies Raise Prices

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Steve Pearlstein uses his column to explain some freshman economics.

What two things do a college education, health care and housing have in common?

One is that the price of these things has been rising at least twice as fast as other prices. The other thing is that they are all subsidized by government...

Let's take college tuition...But the reason, in the end, that they do raise prices is, like any business, because they can. And one of the big reasons they can is the ever-increasing amount of public money pumped into the system in a losing effort to keep college "affordable." In effect, these well-intentioned subsidies have the perverse effect of shielding colleges from the kind of market discipline that would have forced them to hold down prices by constantly improving their productivity and efficiency, as happens in just about every other industry.


For Discussion. How could subsidies be constructed so that they serve to help the intended beneficiaries (poor people wanting to attend college) with minimal effect on the overall cost of college?


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TRACKBACKS (3 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/162
The author at The Liberal Order in a related article titled The Effects of Subsidies writes:
    Steven Pearlstein provides a pretty good assessment of the effects from subsidizing education, health care, and home ownership. For example: Let's take college tuition, which this year rose at a rate of 11 percent at public and 6 percent at [Tracked on December 1, 2004 6:47 PM]
COMMENTS (12 to date)
KipEsquire writes:

I don't disagree at all with your main thesis, but in the case of college tuition (and perhaps healthcare), an alternative explanation is that those industries are extremely labor-intensive. It's excruciatingly difficult to squeeze productivity gains out of a college professor (nothing personal!), so the relative price of college must rise compared to, say most manufactured goods.

spencer writes:

All 3 industries -- housing, education, & health-- are essentially shielded from foreign competition. That may or may not be the reason they have rapidly rising prices. But it is just as logical, or maybe more so than the fact that they receive special tax treatment. I have seen no evidence that these industries tax treatment is the direct cause of more rapidly rising prices.

These are also 3 industries where growth is above average -- is this because of special tax treatment, or because of natural market forces ?

I do not know, but I do not know that it is because of their tax treatment either.

Lawrance George Lux writes:

Provide a Minimum Wage program for qualified students, I have written on this before. Insist they take at least 12 Credit hours per Semester(granting 4 hours per week per Credit hour), and compelling Instructor signiture of Class attendence. lgl

Boonton writes:
All 3 industries -- housing, education, & health-- are essentially shielded from foreign competition

I suppose housing is but why do you say that about the other two? There are plenty of people who travel overseas for college. There are also plenty of people who go overseas for healthcare. A while ago the NY Times had an article about people who go to Iran for nose jobs. Even with travel expenses, the operation there is a fraction of what it costs in the US and is of comparable quality.

For Discussion. How could subsidies be constructed so that they serve to help the intended beneficiaries (poor people wanting to attend college) with minimal effect on the overall cost of college?

I often ask this when the subject of vouchers comes up. If every parent in the US was given a $3K per year voucher why wouldn't every private school simply raise their tuition by $3K per year?

Two fronts; the demand side and the supply side:

1. Demand side means you have to find a way to get the person receiving the subsidy to share in cost savings. If the subsidy is meant to cover all or most of the cost (such as universal health coverage via voucher) then make a portion of the voucher refundable...perhaps into a 401K type account...if the person doesn't use it. So there's an incentive to choose a lower cost option.

2. Supply side, if you subsidize supply you can neutralize the inflationary aspect of a demand subsidy. For example, say we subsidize an over-capacity in hospital beds and clinics. There's a homeland security argument for this since we may need extra medical capacity to be quickly available in the event of a bio-attack or pandemic.

3. Demand reduction subsidy- This is logical, if you subsidized something that reduces demand for healthcare then you won't see a demand-push increase in health prices. An obvious example, if you prevented an outbreak of a disease with a mass vaccination program then the demand for treatment will be a lot less.

Another example is subsidizing doctors visits. This is attacked to no end whenever the issue of medical insurance comes up but people forget why HMO's started to subsidize visits (with a cheap $10 co-pay) in the first place. The idea was that it is cheaper to catch a medical problem during a routine exam than to wait until it becomes a dire emergancy. If done correctly, this type of subsidy will nto result in increased healthcare costs.

Robert Schwartz writes:

Let me guess. Do not subsidize consumption. Subsidize production. Remove legal regulations and guild work rules that restrict productivity.

To that end. Do not subsidize tuitions.

Underwrite expansion of public and two year college systems (I think President Bush made a point of this in his acceptance speech).

Abolish tenure. Relax excessive Ph.D. requirements. Most undergrad courses can be taught by Masters level teachers.

Stop relying on residential colleges. Unsupervised 18 year olds get themselves into excessive trouble. Let them live at home.

Use technology more. Why have live lectures for econ 101. Put it on a DVD give every student a copy. Hire instructors to run discussion q&a sessions where the DVDs are watched and written materials and problems sets are reviewed. Instructors can be MA's. Housewives who want to work p/t.

none of this is rocket science. Its just trying models that are used in busineses other than education. The 16th century has ended, its time for the 21st.

Boonton writes:
Abolish tenure. Relax excessive Ph.D. requirements. Most undergrad courses can be taught by Masters level teachers.

Already done. Quite a few intro courses were taught by non-PhD's when I was in college over 6 years ago.

Use technology more. Why have live lectures for econ 101. Put it on a DVD give every student a copy. Hire instructors to run discussion q&a sessions where the DVDs are watched and written materials and problems sets are reviewed. Instructors can be MA's. Housewives who want to work p/t.

none of this is rocket science. Its just trying models that are used in busineses other than education. The 16th century has ended, its time for the 21st.

Even though its not a role I play often I will play the conservative here. There's a reason some things have been done since the 16th century and even before, its because they work. Being taught in a small group by a good teacher who can adjust his or her style based on the individual reactions she receives works quite well. I don't doubt that you can 'mass produce' some education just like food can be mass produced but it is foolish to think that there will be no cost in terms of quality.

Like food, this cost will be acceptable for schools targetting the bottom of the market but it will not be acceptable for a 'premium' school. The manager of a four star seafood restruarant will not care that McDonalds' technology can serve 'fish filets' at a fraction of the cost and time.

Arnold Williams writes:

The problem with the question is that it does not address the extensive network already in place for college loans and grants from the colleges themselves to say nothing of other federal, and state sources. The colleges know that they are above the market for many students, and subsidize some students' attendance, usually with a fairly rigorous financial disclosure.

The marginal cost is less than the stated cost of tuition, and all a subsidy from the government would do is expand the college's opportunity to add more students until their marginal cost and receipts were again equal.

Jay writes:

I think the problem partly lies in where the subsidy is given. If the subsidy is given to an established producer of a good or service there is no incentive to increase efficiency. If the subsidy is given to the person who is consuming the good or service then there is an incentive to the producer to raise the price.

Maybe one answer would be to only use subsidies to encourage competitors to existing producers. The current barriers to entry into the fields of education, healthcare and housing are fairly formidable. It takes a lot of capital, and there is a tremendous amount of regulatory red tape involved in opening a new university or hospital. I think that as long as the barriers to entry into the market are high it makes sense to subsidize entry into the market.

The alternate answer would be to lower the barriers to entry. I can see that would maybe happen with universities as a physical campus becomes less important, but personally I think that lowering the standards for hospitals might be a bad idea.

Boonton writes:
The marginal cost is less than the stated cost of tuition, and all a subsidy from the government would do is expand the college's opportunity to add more students until their marginal cost and receipts were again equal.

In other words, subsidizing college would result in more people going to college. Isn't this the intended purpose of the subsidy to begin with?

Jon writes:

The problem with Steve Pearlstein's argument is that over the past 5 years, the government subsidy for housing, in the form of mortgage interest deductibility, has decreased because tax rates have fallen.

Deb Frisch writes:

The government subsidizes the housing market by allowing people to deduct billions of dollars in mortgage interest. It subsidizes universities via the billions of resarch funding provided by NIH, NSF, NASA, EPA, etc.

The government subsidizes health care by allowing businesses to deduct it as an expense and taxing people on it as income who opt out of the employer plan. It also subsidizes it by having patent laws that are very protectionist.

Pearlstein noted:

"After all, if an employer is willing to spend $9,000 to give your family comprehensive health care, few people would choose to take the $9,000 in cash, pay $2,000 in taxes on it, and use the remaining $7,000 to buy their own insurance."

Shouldn't Uncle Sam allow employees to have the cash equivalent of their health insurance policy tax free?

Then the choice would be "employer-provided health care" or "buy own and have $2000 cash." There would be an incentive to opt out of the boss' plan to compensate for the transaction cost.

Isn't it in Sam's best interest to take a smaller slice of the pie in order to let the market do its thing?

Boonton writes:

Of course gov't also subsidizes the supply side of both housing and education. Most schools are treated as tax-exempt 'non-profits' instead of profit making corporations. Housing builders/owners benefit from aggressive depreciation provisions in the income tax code that allow them to turn a profitable rent producing house or building into a business loss for tax purposes.

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