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Sunday, May 13, 2012

Equity Financing of College Education: Problem Lies in Adverse Selection

An organization called FixUC has made a proposal to scrap tuition for University of California and replace it payment of 5% of post-college earnings for 20 years.  The organization proposes that the federal government take the pre-agreed percentage of income from former students every year and send it to UC.  If UC needs immediate cash, it could sell the collection rights (equity).  I have long toyed with the idea of equity financing of college education - universities offering education for a pre-agreed share of post college income of students, and have come to feel that it has many benefits but is only plausible if we can realistically tackle the economic problem of adverse selection.

But first, what are the benefits?  In addition to opening access to higher education to all talented students regardless family economic status (improvement in equity), the equity financing model would turn universities into investors and incentivize them to identify the students who are most likely to be productive and attempt to churn out productive graduates (improvement in efficiency).  Although the FixUC plan has proposed a 5% flat rate, universities would quickly realize that they should offer lower rates to students with good track records to entice them to enroll, while much higher (perhaps even prohibitive) rates will be necessary for unmotivated students.  Some universities might even tie an offer for a lower rate with the student majoring in a specified field with lots of employer demand - nursing, for example.  All this discourages mediocre students from enrolling in relatively useless majors only to find out at graduation that a life of crushing debt awaits them.  In the current state of affairs, that crushing debt would contain some federal money, so everybody should be concerned.

What problems must be tackled before equity financing of college can work?  Here is an illustration of the adverse selection problem:  Imagine two excellent students, A and B.  Both are academic superstars and have a stellar list of extra-curricular activities.  Both get admitted to BigName U. and Prestige U.  BigName U. offers equity financing, while Prestige U. accepts traditional tuition payment only.  Now, assume that A has no interest in making money while B plans to go into a highly lucrative career.  A will choose BigName U.'s equity financing, while B will pay tuition to Prestige U.  Pretty soon, BigName U. will find that it needs to increase the offered income percentage, since its graduates are not making as much money as originally predicted!  This will exacerbate adverse selection, since only people expecting to go into less renumerative careers will choose BigName U.!

This problem is similar to the adverse selection problem in individual health insurance market.  The relatively sick are more likely to want to purchase health insurance, so insurance companies must charge high premiums.  The high premiums further discourage healthy people from purchasing individual health insurance.  Health insurance companies attempt to pick out healthier people and offer lower premiums, but they cannot do so perfectly.  In the equity financing model of higher education, prospective students would be wise to list their membership in their high school finance interest group but hide activities that suggest disinterest in money.  The predominant form of private health insurance in America is employer sponsored insurance, and that is because of the problem of adverse selection.  In this model, a health insurance company agrees to take on all workers of an employer - this largely eliminates the adverse selection problem.

For higher education, universities could come together and agree to institute equity financing.  This could work for top universities - the Ivy Leagues and top liberal arts colleges already have amazingly similar tuition and financial aid policies.  They clearly collude - and for a good reason: no single school can afford to have a substantially more generous financial aid because then it would be swamped by students in need of financial aid, so they agree to share the burden of supporting students from low income families.  But outside the top few, the number of universities is so high that such private-level collusion is not possible.  The middle range is arguablely where the efficiency gains really lie - pricing out the unmotivated and incentivizing students towards more useful majors.  For equity financing to be a real possibility, the federal government needs to offer strong incentives for universities to adopt equity financing model (or even force it).  The federal government already underwrites a large portion of higher education in this country, so it has buttons it can press.

Some readers might ask, why not simply fund higher education with tax dollars, like they do in Europe?  Such a system needs to be tied with a mechanism to enforce some quality control among the students.  In France, some public universities are clearly designed to be eliter than others, and there are not enough university spots for everyone.  In Germany, you can choose to enroll in any public university, but students are flunked out ruthlessly and graduation is by no means guaranteed.  No country in the world has ever handed out higher education diploma to anyone who wants it.  It wouldn't be called higher education if it was that easy, would it?  But if socialized higher education was instituted in America, my hunch is that it would quickly degenerate into a chain of public diploma mills due to political reasons.  Equity financing of university education takes the power AND responsibility to determine who's qualified away from government officials and to individual universities, who would be in better position to determine who's up to the cut or not.  In my view, that's capitalism at its best.     

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