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08 September 2010

Is there really a bubble in U.S. higher education?

Today, one way or another, we're going to find out! First, let's define just what a bubble is:

An economic bubble exists whenever the price of an asset that may be freely exchanged in a well-established market first soars then plummets over a sustained period of time at rates that are decoupled from the rate of growth of the income that might be realized from either owning or holding the asset.

Here, we'll consider the asset to be one year of college education at a four-year institution, whose price is given by the cost of tuition and any required fees for attendance.

The income that might otherwise be realized from either owning or holding the asset then actually turns out to be income itself! After all, the mostly likely alternative for an individual who might otherwise be in college is for them to be working instead. For our purposes, we'll use U.S. median household income to represent this income that might otherwise be earned in our analysis.

We'll next determine if the changes in the average college tuition and required fees over time are decoupled from changes in median household income.

Nominal Average Annual Tuition and Required Fees vs Median Household Income in the United States, 1976 through 2008 The chart to the right reveals what we find when we visually depict the level of average college tuition against median household income over the time from 1976 through 2008.

We find that there is indeed a building bubble in U.S. higher education, which we see is clearly represented by three separate periods in which the growth of tuition decoupled from the growth of U.S. median income.

These periods of tuition inflation largely coincide with periods of recession or slow job growth in the United States, from 1990 to 1993, 2000 to 2004 and from 2007 to the present. That these distinct phases of tuition inflation have occurred during recessionary periods, while tuition costs have steadily paced household income in healthier economic conditions, suggests that U.S. higher learning institutions have been the beneficiaries of a remarkable amount of insulation from economic circumstances during these periods.

But the key observation we take away from the chart is the evidence given by a dog that didn't bark.

Here's what we mean by that - prior to the recession that began on December 2007, the largest single recession in the U.S. in the post-World War 2 era was that which ran from July 1981 through November 1982, and in terms of unemployment rates, it still outclasses the December 2007 recession.

But unlike the other recessions that ran from July 1990 to March 1991 and again from March 2001 to November 2001, the nominal average price of tuition remained closely coupled with nominal median household income.

What that evidence means is that the cost of tuition can remain coupled to median income even during significant changes in economic circumstances, such as a severe recession, and has done so in the past.

Bursting Bubble So when we observe where changes in tuition are decoupled from changes in U.S. median income, we can identify those periods as being when the inflation of a bubble in U.S. higher education occurred.

That bubble has a very real price for today's college students. If the close coupling between median income and average college tuition that existed between 1976 and 1990 were still in effect today, the average annual cost of college tuition at a four-year institution would be over $5,000 less than 2008's average level of $12,075.

Likewise, we find that tuition would be over $3,000 less if the linear trend that existed from 1994 through 2000 were still in effect today.

Ultimately, like a housing bubble or a bubble in the stock market, we strongly suspect that today's highly inflated tuition is not something that can be sustained indefinitely.

Elsewhere in the Blogosphere

Mark Perry finds there may well be a bubble in college textbook prices too!

Image Credit: Izismile.

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