HIED810:

Introduction

This lesson will focus our attention on the economics of higher education and the critical role that planning and resource management can play in times of economic pressure and uncertainty.

Paul Brinkman (2006) states that Institutional Researchers, unlike Financial Officers or Accountants, are in a unique position to objectively analyze cost data and develop planning scenarios for reducing costs or increasing revenues. He offers an economic model of costs as an explanatory paradigm, and encourages the use of economic tools to identify, compare, and interpret costs in various contexts within higher education.

John Cheslock (2006) supports Brinkman’s position and provides the perspective of an economist in the analysis of costs and revenues, including the implications of price discounting on revenue projections in higher education. The final reading for the lesson is an article by Zemsky, Wegener and Massy (2005) regarding the congruence between mission strengths and market opportunities, perhaps the key question for higher education leaders and planners.

Lesson Objectives

At the end of this lesson you will be able to:

• define key economic concepts and their importance to higher education today;
• understand and analyze various costs and revenue models for higher education;
• explain why is it important to be “mission-centered and market-smart” in today’s changing external environment;
• think critically about the application of these concepts in contemporary situations confronted by institutional research professionals.

Road Map

Pre-Reading Commentary

The assigned readings provide you with frameworks and concepts to help you better understand higher education revenue and cost models and how to apply economic principles to institutional research (e.g., tuition revenue, state appropriates, financial aid, gifts, marginal costs, fixed costs, variable costs, etc.).

Think about these questions as you complete the readings: 

• How can higher education institutions restructure in response to financial challenges?
• How can institutions reallocate resources to meet these challenges?   
• To what extent should institutions be more responsive to market forces and respond more like the business sector?

Resource Management Framework

Resource management is a challenging task. The task is made somewhat easier, however, if one has some basic frameworks that can be used to make sense of the situation. The goal of Lesson 3, is to provide some of those frameworks.

If a decision is being considered within a higher education institution, these frameworks can help one identify important considerations related to that decision. These frames can also help identify what data are needed to help further the discussions that are needed in order to come to a decision.

Within economics, the principle of benefit-cost analysis is often promoted. The idea is that if you're facing a decision-- in other words, you're thinking about whether or not to adopt a particular new policy-- you should try to state the benefits and the costs associated with this new policy. And optimally, measuring the benefits and costs and then quantifying them, and comparing them. But even if you can't measure them, at least being able to clearly state what are the benefits and the costs, so you can sort of talk through them.

It's sometimes tricky to figure out what should be included as a cost, or not. Often, people include things in the cost category that shouldn't be included. And sometimes, they fail to include things that should be included.

And there are some concepts from economics that are helpful in trying to think about what should be included that cost category. We'll go over four of those concepts: variable versus fixed, average versus marginal, and opportunity and sunk costs.

Variable vs Fixed Costs

The first set of concepts is going to, in many ways, lay the groundwork for the next three. This first set focuses on variable versus fixed costs. Included below are some of the textbook definitions of the two.

• Variable costs - costs that do vary with the quantity of output produced.
• Fixed costs - costs that do not vary with the quantity of output produced.

Using this as a basic example, you can see why this is an important distinction when you're thinking about a decision. Because fixed costs are things that you probably don't need to pay a lot of attention to, because they're going to be the same regardless of whether you say yes or no to the proposal on the table.

Now, a key point-- is something variable or is something fixed? Because often it really is a nuanced question. And one of the major parts of that nuance is the time frame being analyzed.

Let's say you're thinking about closing a program, and the leadership of the institution is trying to understand how much money will be saved as a result of the program closure. Well, it really depends upon the time frame. You think of the next two years-- you may not save that much if a lot of the faculty in the program are tenured. Or, a lot of the personnel in the program are on five-year contracts, then you're probably not going to save a lot of money in the short run. But, if you think 20 or 30 years down the line, or maybe even six years down the line, depending on the time horizon of the people working in that unit. Then, all of a sudden, the costs will vary with whether or not that program is eliminated. There's some nuance here, so you have to sometimes put your thinking cap on to really distinguish whether something's variable or fixed.

Average vs. Marginal Costs

The variable-fixed distinction is very helpful, because it makes it easier for one to understand the concept of a marginal cost. To talk about that concept, let me provide the textbook definition of marginal cost next to the definition of average cost.

• The average cost is simply the total cost divided by the quantity of output. So you could estimate the total amount of cost, then divide it by the number of students. Or, the total cost divided by the number of programs at an institution.
• The marginal cost is saying, if we decide to expand what we're doing-- either growing enrollment, or adding a new program, or putting in a new policy-- what would be the change in our costs that is driven by this new policy, this new approach?

This is really what we're going to care about whenever we're trying to help support decision-making. If you want to understand the economic consequences of a decision, you want to compare marginal cost and marginal revenue. If we do this, these are going to be the change in our costs-- that's the marginal costs. And this is going to be the change in our revenues, the marginal revenue. One of the key points made in economics is that you want to be thinking about things on the margin-- what's the marginal cost, what's the marginal revenue.

If you're trying to support decision-making through data, it's much easier to estimate the average cost than it is the marginal cost. Because the average cost, you can simply say, here's what's going on now and let me just take data for right now, and let's compute the average cost with those data. Marginal cost is much trickier because it's more saying this is what's going to happen if we put this policy in place. And until we build a time machine for the future, we're not going to be able to go to the future, obtain the data of what happens when you put this policy in place, and then come back and produce the estimate of the marginal cost. We have to try to produce a sound estimate of what will be the change in cost, due to this new policy.

Opportunity and Sunk Costs

Now, the next two cost concepts are going to be fun, because they're both helpful in two types of venues. The first venue is the context associated with this course-- making decisions within a college or university. The second venue is one's day-to-day personal life. And I'll touch upon that for each of these concepts, after going over the use of these concepts within the college or university decision-making process.

Brinkman states that the fundamental meaning of cost is always to be found in foregone opportunities. The logic underlying his statement is related to this idea of opportunity cost, which is whatever must be given up to obtain some item. Most of the time, when we think about if we're going to obtain something, whether it's a new policy, a new program, stronger students at your institution in terms of their academic preparation. When we think about what will it cost to do this, certain things immediately come to mind. But there are other important costs that won't come to mind as much. And the nice thing about opportunity cost, and structuring it in as whatever must be given up to obtain something-- using that framework will help us to identify some things that won't be as prominent in our minds.

So let's give a couple examples and run through those.

So now let's think about a decision or policy under consideration within a college or university. A lot of these times, you're going to think about personnel costs. What's the cost in terms of personnel of this new policy activity? This is a very easy activity when you're thinking about hiring-- you're thinking about something that would require you to hire someone new. When you think about, OK, we'd have to hire this many positions, and the cost associated with this position is this much, then it's easier to estimate those costs.

But it's much trickier when you're thinking about making a decision, or putting in a policy that would cause people who are already working at your institution to have to do more things as a result of your decision. Because in many cases, unless there's a lot of slack in your organization, these individuals will do less of other activities in order to do these new activities. Or, maybe they'll still do those old activities, they just won't do them as well. And you can't put a dollar sign, easily, to these foregone activities as a result of this new policy. And so this is where you have to think about, well, what are these costs? How do we make sense of them in the decision-making process?

Now, let's talk about how to apply opportunity cost to one's day-to-day life. Because as I promised you, these concepts are also helpful in that venue. Here is a personal example.

But I've always enjoyed opportunity and sunk cost because not only are they helpful in the day-to-day professional life, but they're really often helpful guides in other venues as well.

Now, the concept of sunk cost is the opposite, in ways, of the concept of opportunity cost. Let me explain what I mean by that. The opportunity cost idea is typically helpful because it helps you identify things that should be included as an important cost associated with the decision, but which you wouldn't include if you relied upon the normal thought process of a human being.

Sunk cost, in contrast, helps you identify those costs that you would include if you used the normal thought process, but in reality shouldn't be included in the decision making process. Consider the following definition.

• Sunk cost -  a cost that has already been committed and cannot be recovered.

Because a sunk cost cannot be recovered, it won't be influenced by what decision you make. It should be ignored in the decision-making process.

Let me give a couple of examples. One from the perspective of working within a college or university, the other from the perspective of one's day-to-day life.

And if you don't believe me, consider the following example from day-to-day life.

So we've gone over a number of concepts now. It makes sense to talk a little bit about application. And so let's just summarize the concepts. When we're examining a potential decision, we should compare marginal revenues with marginal costs. That is, we should compare benefits and costs. And, when thinking about, what are the benefits and what are the costs, we should think about what is going to be altered by this particular decision.

When we think up our list of costs, we want to include all relevant costs. And the concept of opportunity cost helps us identify things that are foregone, that we wouldn't normally think of. We don't want to include things that are not relevant, that are not associated with this decision. So the concepts of sunk cost or fixed cost can help us do that.

Challenges to the Decision-Making Process

So how do we apply these concepts in practice? In reality, so much of it's going to depend upon context-- the particular decision, the particular institution. What are the revenues and costs associated with that decision in this context? Often, it can be challenging. So let's talk about some of the challenges that typically occur in practice. One is trying to come up with a good estimate of the marginal revenue, or the marginal cost. It's easy to talk about averages, but figuring out how something's going to change because of a decision will also be hard. And this is especially hard with revenue because it often depends upo, how many more students we are going to attract if we do this. That's a difficult thing to estimate.

Another thing is how do we assign costs to particular activities or programs. The classic one is we may want to figure out the instructional costs associated with the academic activities on campus. But at that higher education institution, we might be also performing research or we might be doing lots of outreach. So how do we isolate the effects of instruction, especially when we have a large number of personnel doing multiple activities? And typically, what people do, not because it's a perfect solution but because there doesn't seem to be a better option,  is to simply assign these costs to the various categories with a certain percentage i.e. 40% research, 40% instruction, and 20% service, or something like that.

And finally, it's often difficult to identify, but really especially to communicate costs that lack dollar signs. Just because something can easily be converted to a dollar value doesn't mean it's really important. And so you need to really think hard about how to value those things that cannot be easily quantified.

Mission Oriented Decision-Making

To this point, we have just been examining revenues and costs. But that really provides an incomplete picture of decision-making on a college or university campus. Because the vast majority of college universities are not-for-profit. And so they're not fixated on simply having revenues exceed costs. Instead, they're really fixated, often, on mission attainment.

Zemsky, Wegner, and Massy provide a nice framework for continuing to consider revenues and costs, but also incorporating this idea of mission attainment. They say, you engage in an activity if the marginal mission attainment plus the marginal revenue exceeds the marginal cost. And I like to just slightly alter that, to say-- you engage in the activity if marginal mission attainment exceeds marginal cost minus marginal revenue. To think about that even further, it's really marginal mission attainment is greater than the cost of the activity. Because most activities on college and university campuses lose money, and so the question is, is this a good investment?

Now, let's play with this framework a little more. I find it most helpful to think about this if I frame it in three ways. If I think about the activity, and think about whether the activity is mission-neutral, whether the activity is pro-mission, or whether the activity is anti-mission.

Mission-Neutral

First of all, if the activity is mission-neutral, then it's a pretty simple idea that you would engage if the marginal revenue exceeds the marginal cost. You wouldn't engage in the activity if the marginal revenue was less than the marginal cost. So, for any sort of activity that really doesn't further the primary goals of the college or university, but could have a financial implication on it, it's a simple calculus of, do the revenue exceeds the cost.

Pro-Mission

Now, let's think about activities that could be pro-mission. In this case, you simply need to decide whether the marginal mission attainment is greater than the net financial loss. That is, we're going to spend a certain amount of money on the philosophy department. And so the question is, is the mission attainment from the philosophy department worth that investment? And it very well may be, because that may be central to the particular institution.

Occasionally, you have activities that are both pro-mission and produce net financial gain. Those are quite easy decisions, in that regard.

Anti-Mission

Now, you also have, occasionally, activities that are anti-mission, that you are concerned could distract students from things that represent the primary goal of the institution, or could have other negative consequences. Then you have that very tough decision of whether that decline in marginal mission attainment is less than the net financial gain. That requires really hard thinking about whether you're willing to sacrifice or lay down your mission so that you can have a net financial gain which could then be invested in things that will help you achieve your mission.

Zemsky, Wegner, and Massy also frame this using these ideas of market-smart and mission-centered. And they talk about this idea of cross-subsidies. That is, you have these different activities on campus. An institution can engage in new, sort of market-smart activities that could then supplement the mission-centered activities. What are they pushing? In this chapter, as they say often, there's this fight between well, should we do this particular activity that's related to market, or should we do this particular activity that's related to our mission?

They're saying well, in certain cases that market-related activity will generate positive net revenue that you can then use to then do more of the mission-centered activities. So it's not that you have to choose between the two. You can actually do more of both. To think that, you always have to make sure that that market-smart activity is actually producing that positive net revenue.

If it is, this is really an important idea, because it could help higher education institutions continue to meet their mission during difficult financial times. But it can also be a dangerous idea, in that institutional leaders can become so fixated on the market that they forget the mission, and that the market is really a means to the end. The market is something we engage in, in order to generate funds that will allow us to attain our mission.

It's just a means to an end. But if one's not careful, the market can become the end, and the primary focus now becomes on the amount of revenue generated, and there's very little consideration of the mission attainment.

Activities