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In 1980, Howard R. Bowen’s revenue theory of cost was put forth to explain the financial trends of higher education. The basic idea was that colleges and universities will spend everything they have, so if you increase their revenue, you should expect their costs to go up too, creating a spiral.

In the decades since, we have witnessed the implications of this theory. It has now become apparent that American higher education has an insatiable appetite for more money; it is a black hole that cannot be filled.

Colleges are referred to as “cookie monsters” who “seek out all the resources that they can get their hands on and then devour them” (the higher education scholar Ronald G. Ehrenberg) and to “compulsive gamblers” for which “there is never enough money to satisfy their desires” (the former Harvard University president Derek Bok).

The main reason for this is that competition in higher education is based on reputation. The nonprofit status of most institutions of higher education and the principal agent problem (the fact that you typically don’t know that those you’ve hired aren’t acting in their own interests instead of yours) also contribute to the problem.

Spending and Reputation, a Costly Competition

The academic literature shows that when people don’t know the true quality of something, they tend to rely on the reputation of the supplier. For prospective students, it is virtually impossible to know the true quality of an undergraduate degree: the student purchases the service only once, participates in the provision of the service, the service provided is a capital asset, there is no secondary market for degrees, and the value of the degree may not be known for years after it is purchased.

If students and the public were certain about academic quality before they attended or donated to an institution, they would have no need for reputations. But because they are uncertain about quality, they rely on reputation. Knowing this, colleges compete based on reputation.

Unfortunately, this reputation-based competition contributes to the revenue-to-cost spiral because more spending is helpful in improving a reputation. The direct relationship between expenditures per student and reputation is demonstrated in Figure 1, where spending per student is on the vertical axis and the U.S. News & World Report “reputation” score is on the horizontal axis.

The figure clearly reflects the public’s perception that “price is a prior indicator of quality.” In effect, reputation competition becomes a race to spend as much as possible per student, since expenditure is a proxy for quality.

As reputation increases, the institution receives more funding from donors, grants and research contracts. The institution is less dependent on tuition, it has more diverse revenue sources, and it is wealthier.

Source: IPEDS, U.S. News & World Report

Thus we observe an untargeted “pursuit of excellence” as colleges strive to be the “very best that they can be in almost every area of their activities.” Over all, the colleges’ behavior is best understood as “prestige maximization.

Nonprofit Status

Costs at nonprofit institutions are capped by revenue. While they cannot run chronic deficits, nonprofits exist to provide as much service as possible, and internal constituents can always find ways to use financial resources. Therefore, nonprofit institutions spend all the revenue they have, implying that when revenues rise, costs rise. Among colleges and universities, any increase in student ability to pay lifts the lid on revenues and costs follow.

The Principal/Agent Problem

The principal/agent problem is capitalism's Achilles heel; it exists whenever one group makes decisions supposedly in the interest of another group. As an example of the problem, suppose your car is broken. When you (the principal) take your car to a mechanic (the agent), you would like to get it fixed at the lowest cost possible. But the mechanic is better off if you spend more money, giving him an incentive to recommend unnecessary repairs. In this and many other instances, there is a difference between the actions the principal would like to see occur and the incentives of the agent to actually take those actions.

The problem in higher education arises because the interests of faculty members, administrators, and trustees (the agents) are not the same as the interests of students, parents, alumni, donors, and taxpayers (the principals). Since the agents make the decisions, they can pursue their own self-interest rather than the principal’s interest. The problem is well-known among professionally managed for-profit firms, despite the many constraints on agency abuse in the capital markets. Comparatively, there are few constraints on agency abuse in higher education. P/A problems always result in costs that are higher than necessary, contributing to higher education’s dismal cost control record.

How to Break the Spiral

The combination of quality uncertainty (and therefore competition based on reputation), nonprofit status, and the P/A problem leads to a persistent revenue-to-cost spiral. Because the spiral consumes any new funding, it undermines attempts to improve college access. Therefore, establishing effective cost control ought to be a prerequisite for any increase in higher education funding designed to improve access.

Fundamentally, the revenue-to-cost spiral will not be broken until uncertainty about college quality is reduced. This uncertainty leads to competition based on reputations, so larger expenditures are always in the institutions' interest under quality uncertainty. However, if output measures (by which we mean the value they add through teaching and research) were designed, the focus of competition would shift from its current reliance on reputation and prestige (who can spend the most) toward the more beneficial type of competition based on who provides the greatest value (who can produce the most value added education per dollar).

While reducing uncertainty about quality is essential, there are a number of complementary reforms that could also help break the revenue-to-cost spiral. Accreditation currently suppresses innovation and restricts competition, largely because the accreditors have been “captured” and now promote the interests of the institutions they are supposed to be regulating. Reform could correct these undesirable tendencies.

Moreover, the principal/agent problem can be addressed by improved transparency regarding the source and use of funds and operating policies such as teaching loads and staffing ratios. Before institutions can align teaching incentives, they must undertake serious studies to measure teaching productivity; once this is accomplished, professors can be rewarded for the quality of their teaching instead of just the quality of their research.

Lastly, institutional constraints could be strengthened by reforming governance arrangements and providing financial and other disclosures so that the media and other watchdogs could provide more oversight.

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