An excerpt from

Saving Alma Mater

A Rescue Plan for America’s Public Universities

James C. Garland

Where the Money Comes From

Do Universities Have a Bottom Line?

Question: Why do economists predict their results to three significant figures?
Answer: Because they have a sense of humor.

This old joke about the dismal science underscores the fact that real markets do not replicate the simple, idealized models that economists use to illustrate basic principles. For even the most straightforward commodity transactions, complicating factors—taxes, regulations, social costs, buyer irrationality, and so forth—inevitably fog up the quantitative predictions of simple market analysis. In the process of explaining the real world of business and commerce, corrections grow on economic theories like so many Malthusian warts, leading to models that may account for a market’s general behavior but have little predictive value. As is sometimes said, with enough variables one can fit a curve to the skyline of New York, but the curve can’t then predict the location of the next skyscraper.

But at least in the business world there is an overall metric for gauging success, and of course that metric is profit. While General Motors may use many internal measures of performance—market share, sales growth, customer satisfaction—all of these are in service to the corporation’s overall profitability. In the language of mathematics, internal performance criteria are independent variables and profitability is a dependent variable. In the end, only the dependent variable matters. That is the reason stock market investors care so much about corporate profits; the actual line of business being financed by their investments may even be of little interest to them except insofar as it provide insights into profit potential.

By contrast, in higher education there is no bottom line except in the sense that colleges must live within their budgets. However, colleges do have a large number of internal performance benchmarks. Many are quantitative but nonfinancial: student SAT scores, graduation rates, win/loss record of the basketball team, percent occupancy of dormitories, number of National Academy of Sciences faculty members, number of pizzas consumed in dining halls. They have many intangible performance benchmarks as well: personal growth of graduates, beauty of the campus, quality of advising and job counseling, contribution to human understanding by English department poets. Furthermore, one can fill a ledger book with college financial benchmarks, including bond quality ratings, federal grant and contract dollars, endowment investment returns, and growth in alumni giving. But all of the benchmarks that ultimately differentiate good universities from mediocre ones are not rolled up into a single criterion of overall performance. In higher education there is nothing analogous to profit, and without this basic metric it is hard to know whether, say, hiring a Nobel laureate for the chemistry department faculty is a smart investment of institutional resources.

A second factor that muddies the economics of higher education is school-to-school variability. Higher education is an industry in which no two organizations produce equivalent products. This is the problem that plagues college ranking systems, the most widely read being the one published annually by U.S. News and World Report. For example, in 2008 the magazine ranked the College of William and Mary thirty-second and the University of Michigan twenty-sixth. But the two institutions are so fundamentally different from one another that this comparison provides little meaningful guidance to prospective students. The fact that most ranking services try to use a quantitative methodology and data-gathering protocol can never overcome the intrinsic apples-to-oranges problem of institutional diversity. And just as there is no bottom line to gauge a university’s overall financial performance, there is no qualitative measure of its usefulness to society. Which is better: University A, which has Nobel laureates on its faculty, conducts research valued at hundreds of millions of dollars, recruits students from all fifty states whose SAT scores top the charts, and charges $40,000 tuition, or University B, which admits nearly all applicants, most of whom come from nearby working-class neighborhoods, has extensive remedial programs for underprepared students, offers evening and weekend classes for working adults, and charges $4,000 tuition? The answer is clearly in the eye of the beholder.

Despite their broad differences, however, all colleges and universities share one trait in common: they all need money to survive. And the fact that most of that money is influenced greatly by social, demographic and economic forces highlights the importance of making sense of higher education’s complex marketplace. Until the academic marketplace is sufficiently understood, policy makers will be hard-pressed to redress the system’s more egregious shortcomings and prop up its shaky financial underpinnings.

The University Balance Sheet

Like all commercial organizations, public universities must pay their bills. Because universities are service providers, their biggest payments each month go to their thousands of employees; typically about 70–80 percent of university budgets are for salaries, wages, and benefits. What is left over pays for a hodgepodge of expenses: fertilizer for campus lawns and gardens, bandwidth for Internet gateways, airline tickets to faculty professional meetings, debt service on construction loans, laboratory equipment for beginning physics professors, service contracts for office equipment, and so forth. The largest public universities write checks that total well over two billion dollars a year. Because these payments don’t dribble out at a constant rate, and because income from government and tuition payments arrives in lump sums, universities always keep a balance in their accounts to handle expenditure fluctuations. Depending on the size of the school, this cushion, or “float,” can average throughout the year to more than a hundred million dollars; university budget officers invest the float in short-term financial instruments so the funds are not sitting idle until needed. Closely related to the float are the institutional cash reserves. As the name implies, the reserves are not budgeted for any specific purpose but are held back to pay for emergencies, to make up for temporary cash shortfalls, and to pay for unpredictable cost increases. Bond rating agencies closely monitor a university’s reserves, because they are a key indicator of its financial health.

When times are tough, as they often are in public higher education, a school’s chief financial officer will carefully monitor the sizes of the school’s float and reserves, because if they shrink too low the results can be disastrous. One late payroll will precipitate an institutional crisis. Missed payments will drive away suppliers of crucially needed goods and services. Any sign of a shaky financial footing will quickly erode the university’s credit rating, raising interest rates and potentially preventing access to capital markets. Because nobody wants to stay aboard a sinking ship, a financial crisis will cause the best faculty and staff to dust off their résumés and send prospective students flocking to their backup schools.

Furthermore, most state governments monitor the cash balances of their public colleges, and alarm bells will sound in the state capitol if these drift too low. In fact, if the situation becomes really grim, state government is likely to step in and wrest control of the institution from management. At this point, the reputation of the institution has been devastated, the careers of its senior officers destroyed, and the education of thousands of students placed in jeopardy. The financial meltdown of a public university would inevitably precipitate a statewide political, financial, and social crisis. Because of this fact, of all the priorities of university presidents and their governing boards—hiring top-notch teachers and researchers, satisfying accrediting agencies, attracting a diverse student body, keeping the curriculum up to date—paying the bills trumps the rest.

For a public university, the money needed to pay all those bills pours out of a very large number of spigots. The largest are state subsidy, student tuition and fees, gift income, and research contract and grant income, but to these one can also add investment returns, interest on student loans, dormitory charges, dining-hall meal sales, room rentals in the university hotel and conference centers, ticket sales to campus sporting and cultural events, merchandise and retail sales, facility rental charges, catering income, parking receipts and library fines, bookstore receipts, TV and radio licensing income (for sporting events), and royalties on patents. The list goes on and on, and if the university is home to a medical school and hospital it goes on and on for a very long distance.

This multiplicity of sources contrasts with the revenue profile of most corporations, which typically receive most of their income from product sales or through billing for services. Dependence on a small number of revenue sources helps a business focus its energies, because all corporate activity can be judged against the potential impact on those sources. Historically, the primary source of revenue for public colleges has been a subsidy from their state government, but because the quality of a university’s teaching and research was not linked to the size of its subsidy, this beneficial focusing influence was lost. Unlike corporations, public universities have had few purely financial incentives to improve themselves and become more productive.

Although universities have a great many sources of income, nearly all of them have strings attached. What this means is that with few exceptions, the dollars are not fungible. Income from the university conference center cannot be used to hire the basketball coach. Money intended for construction cannot be used to raise faculty salaries, and tuition income cannot be used to build a new wing on the chemistry laboratory. Gifts from alumni nearly always have constraints; a gift intended to create a faculty chair in philosophy cannot be used to provide scholarships for music students. This lack of transferability often leads to misunderstanding and public criticism: how can the university be building a new ice hockey arena when the dorms for first-year students are dilapidated? The answer is that the alumnus who gave twenty million dollars to his alma mater was interested in ice hockey and not in student living conditions.

The New Era of Tuition Primacy

The relative sizes of university revenue spigots have changed greatly over the past several decades. Although a half-century ago the largest revenue source for public campuses was their state government appropriation, that percentage has been in steady decline for several decades. At Miami University, roughly 70 percent of the campus education budget came from this single source. Today, about 70 percent of Miami’s revenues come from tuition and only about 15 percent from state appropriation, a percentage that declines slightly each year. The percentages vary from school to school, but the decline in state support relative to tuition income is a universal phenomenon. Cornell economist Ronald Ehrenberg has noted, for example, that the average state appropriation per student at public campuses across the nation dropped about 10 percent between 1985 and 1995. This drop was compensated for by an increase in the tuition share of college expenditures from 23 percent to 32 percent. By 1998 that percentage had grown to 37 percent, and by 2005 it had soared to almost 50 percent. For most public campuses, undergraduate student tuition is now the largest source of income for educational programs.

This transition to tuition as the key revenue source is having a profound impact on public university operations. Students have no influence over the state appropriation that a college receives, but they have a great deal to say about its tuition revenue. If students have choices about where to attend college, then a college’s tuition income becomes intrinsically linked to its performance. (The final chapter of this book contains recommendations for increasing college choices for students.) If the college has the freedom to set its own tuition level, its administrators now have to think carefully about pricing its services competitively. And even if its tuition is set by a state legislature, governor, or an external controlling authority, the college must maintain its enrollments in order to protect this revenue source.

Thus there is now a growing financial incentive for public universities to implement careful strategies for recruiting and enrolling students and doing right by them once they set foot on campus. In contrast to prior decades, public universities are increasingly discovering that their financial future is shaped by student demand. This discovery is requiring a campus gestalt shift that can be beneficial for students and the public but is also causing wrenching changes in a campus culture that evolved under a different set of rules.

How Campus Officials View Tuition

Within public university budget offices, attitudes about tuition charges are gradually changing. During the era when a state appropriation was their primary revenue source, campus administrators knew that enrollments were only slightly dependent upon what students were charged. Because the cost of a student’s education was so heavily underwritten by the state, student demand depended only weakly on tuition levels. In other words, low public college tuitions attracted millions of students generally but did not significantly influence their choice of which public college to attend. Nonfinancial considerations, such as academic reputation, curricular offerings, and proximity to home and family, were the primary drivers of enrollment decisions.

Because enrollments were only modestly dependent upon tuition, public universities that had the freedom to set their tuition tended to treat it as an independent parameter that could be used to meet expenses. For example, as a dean at Ohio State University, each year I would submit to the central administration a list of “new program” requests for my area, the College of Mathematical and Physical Sciences. Such requests might include laboratory equipment for new professors, salary lines for additional instructors, upgrades for the college’s computers, and so forth. In the central offices of the university, my list and those from other deans were vetted by senior administrators and rolled in with projected salary raises, benefits, utilities, plant maintenance, and other university-wide expenditures. In the end, a budget was constructed that reflected the next year’s total university revenue needs.

As part of this process, the university also looked at its various sources of revenue, state appropriation in those days being the list’s five-hundred-pound gorilla. In spite of considerable lobbying efforts, however, the university normally had little influence over its future appropriation. In fact, about the only real control the university had over major revenues was setting the next year’s tuition increase. But it would be an oversimplification to say that tuition was the fudge factor that enabled the university to bring its income into balance with expenditures. The actual process involved a great deal of expense trimming, scaling back expectations, and making numerous compromises, and as part of this process, the potential ramifications of different tuition increases were explored. A key consideration was avoiding backlash from state legislators and the public. The university’s annual tuition increase was always splashed across newspapers in Ohio and inevitably generated complaints. The university was thus careful to keep its tuition increase in line with those at other Big Ten universities so it would not attract criticism by being out of step with its peers. There was also a genuine desire among campus leaders to keep increases as low as possible, in order not to harm struggling low-income students. The final proposed percentage increase was the outcome of a careful balancing act between the university’s needs and its public responsibilities.

Often all this agonizing came to naught. In many years, the Ohio legislature simply stepped in at the last minute and imposed a systemwide cap on tuition increases that was inevitably lower than what the university needed. Furthermore, this cap was frequently accompanied by an only minimal increase (or even a decrease) in state subsidy. Faced with this twin blow to its revenue base, the university would immediately abandon its hopes for improvement and move into a retrenchment mode, in some years freezing salaries, laying off workers, cutting operating budgets, canceling searches for vacant positions, and deferring building maintenance.

In strategy sessions at Ohio State, the impact of tuition increases on enrollments was seldom a consideration. In those years, the university admitted nearly all applicants, and while enrollments fluctuated with business cycles and the success of the Buckeyes football team, the next year’s tuition increase was not a major driver of the numbers. In other words, of all the many considerations that led Ohio State into setting its tuition, the laws of supply and demand were virtually irrelevant.

But today, public universities are in a high-tuition/low-subsidy environment in which they ignore supply and demand at their peril. From an economic perspective, the downside of this new era is the insecurity of a weakened government safety net. The upside is that public campuses, if they make the right strategic decisions, now have some measure of influence over their destiny. And the practical consequence of this changing era is to send public campuses into a single-minded search for tuition revenue.

Who Decides How Much Students Pay?

In contrast to private colleges, where boards of trustees set tuition rates, public campuses typically have little authority to do so independently. A state-by-state survey of public university tuition policies showed that only five states—Delaware, Illinois, Michigan, Pennsylvania, and Wyoming—granted sole authority to their public institutions to set tuition rates. Thirteen other states allowed individual institutions to set rates, but only within a framework of approved guidelines.

The more common pattern is for public college tuition to be determined by an external authority, such as a governor, state legislature, statewide coordinating body, or systemwide governing board. In some states, tuition-setting criteria are based on an explicitly stated philosophy, the most common of which (sixteen states) is that tuition should be as low as possible. Whether the standard is stated explicitly or not, nearly all states emphasize affordability and access as important considerations in their philosophy. As a practical matter, tuition decisions entail yearly incremental adjustments to a base tuition, and as a consequence the public and the media tend to focus on the announced percentage change rather than examining whether the base itself reflects good value or is comparable to that in other states. State decision makers take into account many considerations before announcing a tuition increase, and these may actually have little to do with any underlying philosophy. Typically, states will agree to larger tuition increases if public appropriations are being cut (and smaller increases if the reverse).

In many states, tuition adjustments take the form of “caps” that are imposed on public colleges that otherwise would be able to set their own tuitions. Occasionally some horse-trading takes place, where colleges are given a choice of either accepting a subsidy increase or raising tuition. In 2007, for example, Ohio governor Ted Strickland proposed a 5 percent annual subsidy increase for colleges that agreed to freeze tuition. Individual universities within Ohio then had the opportunity to weigh the revenue implications of each option and make their choice accordingly. Generally speaking, states do their best to make informed and responsible decisions about tuition adjustments. They factor into their decisions the desires of taxpayers for minimal increases, the needs of the colleges, the level of public subsidy to campuses, unemployment rates in the state, financial aid policies, and other considerations that most reasonable people would agree are appropriate. Furthermore, many policy makers want to be better informed about the issue, giving rise to a flurry of commissions, study groups, and workshops charged with studying college affordability.

What states do not do, however, is to allow the forces of supply and demand to influence their decisions. Thus in nearly all states there is an implicit assumption among policy makers that tuition setting at universities by central controlling authorities will better serve the public good than will the impersonal forces of the academic marketplace. Great philosophical battles have been fought over the relative merits of free markets versus regulated markets, and there is little to be gained by again laying out the arguments. Suffice it to say that economists generally believe that government price-fixing of any good or service seldom accomplishes its purpose without creating corollary problems that ultimately dwarf short-term benefits. Here most of us would agree that history is on the side of the economists. Furthermore, the decaying state of public campuses and the growing costs of a college education suggest that one should at least inquire whether ignoring market influences is really desirable in higher education.

Breaking the Cycle of Mutual Finger-Pointing

For whatever reasons, when a state authority sets a low ceiling on allowable tuition increases, it can deprive a campus of the revenue it needs to cover costs. A school in this situation must then make do the best it can, which in the past has often meant minimal or no salary raises for employees, hiring temporary instructors instead of regular faculty, enlarging class sizes, and cutting back services. Despite such problems, public officials are often reluctant to allow universities to set their own prices, believing that the educational marketplace will not impose the constraints needed to prevent runaway tuition increases. To justify their view, legislators can point to many years in which tuition increases at public universities exceeded the inflation rate. To them, a key reason for these large increases is inadequate cost discipline caused by inefficiency and wasteful practices. Thus they see regulating tuition as a way both to protect taxpayers from painful price increases and to pressure decision makers on public campuses to become more committed to reining in expenditures.

Naturally, public college presidents see the problem differently. They often lay the blame for high tuition charges at the feet of lawmakers, whose perceived lack of sympathy for their schools’ fiscal needs has resulted in inadequate public subsidy. Had state support kept up with the growing responsibilities of their campuses, presidents argue, then students would not have been forced to shoulder an ever-growing share of their educational costs.

In my opinion, each side is partially correct: the problem of rising public college tuition is driven by a combination of declining state subsidy levels and the inability of universities to exercise the cost discipline that is common for well-managed organizations outside academia. But finger-pointing only perpetuates the cycle. As I will show in future chapters, neither state governments nor public universities can reverse this trend by treating the symptoms; state governments cannot print dollars to make up for inadequate appropriation levels nor regulate campuses into submission over containing costs; and public university leaders cannot by themselves provide the incentives needed to improve the efficiency of their campus operations. What is required is a cooperative effort to rewrite the fundamental relationship between the two parties.

An important key to that new relationship lies in understanding how the forces of supply and demand operate in the academic marketplace. Can competition really restrain prices, if public colleges mostly enroll students from their immediate neighborhoods? Would decreased government regulation lead to runaway tuition? How does state subsidy influence student demand? Do tuition controls succeed in forcing universities to curtail expenditures? These are the kinds of questions policy makers need answers to if they are to break the discouraging cycle of rising prices and deteriorating campuses.

Copyright notice: Excerpt from pages 11–21 of Saving Alma Mater: A Rescue Plan for America’s Public Universities by James C. Garland, published by the University of Chicago Press. ©2009 by The University of Chicago. All rights reserved. This text may be used and shared in accordance with the fair-use provisions of U.S. copyright law, and it may be archived and redistributed in electronic form, provided that this entire notice, including copyright information, is carried and provided that the University of Chicago Press is notified and no fee is charged for access. Archiving, redistribution, or republication of this text on other terms, in any medium, requires the consent of the University of Chicago Press.

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James C. Garland
Saving Alma Mater: A Rescue Plan for America’s Public Universities
©2009, 290 pages, 7 line drawings, 3 tables
Cloth $27.50 ISBN: 9780226283869

For information on purchasing the book—from bookstores or here online—please go to the webpage for Saving Alma Mater.

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