Could Private Universities Face an Adverse Selection Problem?

George Akerlof’s ultra-famous paper “The Market for Lemons: Quality Uncertainty and the Market Mechanism” introduced adverse selection as a consequence of information asymmetry. Akerlof noticed that in markets where sellers have more information than buyers, the average value of the good tends to go down, even for those of high quality, which causes sellers of high quality goods to exit the market eventually leading to a market collapse. Buyers are weary that unscrupulous sellers may be looking to rip them off so they avoid buying higher quality goods, “peaches,” and instead only buy ones of lower quality “lemons.” Since they can’t be sure that paying the price of a peach actually gets them a peach, buyers settle for paying the price of a lemon. The obvious problem here is that people who are actually selling peaches can’t get anyone to pay the price of a peach so they eventually exit the market hoping they can sell their peaches somewhere else or resort to selling lemons themselves.

A similar problem may lay in the future for non-top tier private universities in the U.S. Despite ample data suggesting that people who go to college earn much more than people who don’t, in recent years there’s been a growing sentiment in popular culture that going to college, particularly expensive universities, is a bad investment because of the debt many people accumulate going to school. By now everyone’s heard the horror stories of poor senior citizens who have yet to pay back all their loans 50+ years after graduating from college. Stories like these are putting pressure on politicians to make proposals like that of Hillary Clinton which would make public colleges and universities free for families making less than $125,000 annually.

If both private and public college tuition continues to rise I’d say it’s likely this kind of proposal will eventually get passed. And when it does, mid and bottom tier private universities will have to battle to hell or high water (10/10 recommend the movie by the way) to keep enrollment numbers up. This is troubling for these private universities, especially if the Whitworths and Willamettes of the world aren’t actually a better product than public universities, something that’s still very much up for debate. But I’ll give them the benefit of the doubt and assume they are; even under the assumption that bottom and mid tier private universities are better than public universities they’ll struggle to attract students because of the problem Akerlof described.

Imagine an Akerlof-like market for a university education where we assume private universities are peaches and public universities are lemons. Right now, the difference in price between public universities and private universities is not drastically different for many families earning less than $125,000 a year. But under a proposal like Clinton’s the price for lemons will be grossly different than that of peaches. This will cause buyers’ willingness to pay for universities that aren’t top tier to be lower than what most middle and bottom tier private universities cost which is anywhere between $50,000 and $60,000. And because buyers of college education are suspicious that these private universities are selling them a fake bag of goods and it’s in fact not a good investment to go to a private university opposed to a public university, enrollment at private universities is sure to plummet. Like sellers of peaches in Akerlof’s original paper, private universities will either have to reduce their tuition to match public universities or close their doors, a scary thought for someone like me who appreciates the environment and opportunities a small private university like Puget Sound affords me.

Unless of course private universities can somehow convince enough buyers that they are actually a superior product to public universities by, as Akerlof suggested, using signaling techniques. Private universities already do a LOT of signaling: they champion their small student to teacher ratios, reference their “tight-knit” communities and diversity, and Liberal Arts schools make abstract claims that Liberal Arts educations are the best. But signaling is going to have to get a lot stronger, possibly even misleading, if private universities like Puget Sound are going to survive under a free public university system. They might have to resort to privately funded studies showing their graduates earn more than graduates from public universities or that the lifestyle at a private university is far better than that of a public university. Even if one or both of those things isn’t true, signals made with doctored data could be the only way to attract high achieving students looking to maximize the return to their college investment.

This all might seem like a far-fetched argument at best, I admit it might be, after all free tuition is anything but a certain proposition. But if public universities ever do become free in the United States, things definitely won’t be peachy for private universities.

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