The Gateway Customer Effect: A Higher Education Market Failure
Alexandros M. Goudas May 2020
Higher education institutions have been experiencing a general decline in revenues from public sources for decades. The Great Recession caused a sharper reduction in public revenues, primarily from lower state appropriations. A modest increase in federal monies during the past two decades mitigated this trend slightly (Archibald & Feldman, 2018; Pew Charitable Trusts, 2015; SHEEO, 2015). Institutions have therefore had to depend on tuition increases as a greater share of revenue. According to the State Higher Education Executive Officers Association (2015), the share of revenue from tuition has been rising steadily from approximately 25% in 1990 to 35% in 2007. The recession caused revenues from tuition to jump to nearly 50% in 2013 (p. 22). Compounding the problem, enrollments in both four-year and two-year institutions have been in decline after the recession (Nellum & Hartle, 2016).
Since postsecondary institutions are now being forced to rely more on tuition for funding, many have resorted to an approach involving the direct recruitment of new students. It is now quite common for institutions of higher education to utilize strategies that mirror for-profit corporations’ marketing tactics to grow and maintain enrollment numbers (Marcus, 2019). For-profit institutions of higher education have always engaged in this market behavior (Bonadies et al., 2018), yet even nonprofit, open admissions institutions such as community colleges are changing their marketing approach: They often compete directly and more intensely with each other in smaller markets; they promote themselves heavily through media such as television, radio, and online; they are courting international students and high school students; and their marketing resembles commercial enterprises (Marcus, 2019; Smith, 2017, 2019). Thus public colleges have essentially become free-market competitors, using corporate tools of competition, supply and demand, and sales to increase enrollment numbers, i.e., revenue.
It is not so simple for postsecondary institutions to enter into the free-market system and function as corporate entities, however. For free-market capitalism to work as intended, participants acting within its structure must adhere to its basic tenets. It is commonly accepted among economic theorists that a functioning free market is based on several assumptions or prerequisites. Specific to higher education, first, supply and demand only work in a system in which consumers, i.e., students, have access to reliable and trustworthy information about the products or services they purchase. Additionally, consumers must be able to conduct cost-benefit analyses of the costs and values of degrees. Supply and demand depend upon consumers’ rational calculation of a product’s utility. Samuelson and Nordhaus (2010) stated, “In the theory of demand, we assume that people maximize their utility, which means that they choose the bundle of consumption goods that they most prefer” (p. 84). Applied to higher education, the assumption is that consumers in the market are able to rationally assess the value of a postsecondary degree from a particular college, calculate its utility, and pay for it accordingly.
Unfortunately, two market failures inherent in higher education economics and finance practices impede students’ and institutions’ ability to function appropriately within a free-market system, especially when organizations attempt to recruit students as a primary means for increasing enrollment and revenues. Both lead to increased exploitation of students. The first is a type of imperfect competition endemic to education (and to other areas such as health care, prisons, and nursing homes) that I term the gateway customer effect. The second is the well-known economic concept of imperfect information. In this paper, I discuss each of these higher education market failures, the compound negative effects on students due to their confluence, and recommended changes in marketing, regulations, and funding structures to lessen their harm on vulnerable students.
Explaining the Gateway Customer Effect
A Brief Background of the Distant Payer Market Failure
In a book about the results of increasing privatization of K-12 public schools, Education and the Commercial Mindset, Abrams (2016) discussed how for-profit companies attempted to increase outcomes and make a profit simultaneously, primarily through the use of private charter schools. Abrams noted that at no time in the past few decades have any of these private education enterprises turned a profit. Moreover, for-profit charter outcomes were neutral or negative, with numerous harmful externalities. To explain why, Abrams cited Hansmann (1980), who combined several public domains into a group that all suffer from market failures of a similar nature: “Hansmann argued that schools, nursing homes, hospitals, and relief agencies…do not fit the commercial model because of a particular type of ‘market failure.’ In the case of schools and relief agencies, the recipient is not the purchaser” (p. 175).
This phenomenon of the consumer (i.e., recipient) not being the direct payer (i.e., purchaser) has been observed in prior economic literature as applied to such public spheres as health care, the prison system, and nursing homes. For example, noted economists Enthoven and Kronick (1989) highlighted the problem when they stated that “health plans have little or no incentive to improve their efficiency in order to serve a few cost-conscious customers if most of their customers are not cost conscious” (p. 30). The lack of cost-awareness to which they refer is a result of a significant distance between the customer and the payer. In other words, in the health care market, it is unclear who the customer is—the patient, insurance, or employer—and this gap drives up the cost of insurance and overall health care in the U.S.
The prison system displays a similar breakdown in the economic market. Davidson (2013) observed the distant payer phenomenon in a private business practice that occurs in over half of U.S. prison commissaries: “While the prisoner may be the end-user who hands her money over for shower shoes or a radio, it’s the prison staff…that decides which commissary company will be on premises and what products prisoners can choose from” (para. 3). Davidson continued to highlight the issue by posing a trenchant line of questioning: “Private businesses are generally quite good at meeting their customers’ needs. The question is what their customers need. Or more precisely, who their customers are. Are they the taxpayers, the prisons or the prisoners?” (para. 8).
Finally, Konetzka et al. (2015) stated, “It is well known that market failures in health care contribute to lower quality for consumers” (p. 819). The authors then applied this breakdown specifically to nursing homes: “Market failures are frequently amplified in long-term care, where demand is driven by people who are often among the most vulnerable—the frail elderly with cognitive impairment—and who are potentially less able to search out and use information about quality” (p. 820). Therefore, nursing homes often market to elderly people to access their insurance, retirement, and government assistance, yet these seniors are not in a position to be able to assess the value of a nursing home before entering it or while living there.
Abrams (2016), however, appears to be the first to apply the distant payer phenomenon to the realm of education economics when he termed the K-12 student the “immediate consumer” (p. 174). In a 2017 op-ed in the Los Angeles Times, Abrams outlined his line of reasoning: “Education is complex and the immediate consumer, after all, is a child or adolescent who can know only so much about how a subject should be taught. The parent, legislator and taxpayer are necessarily at a distance” (para. 9). Because of this problem, all parties involved in payment are unable to determine whether they are maximizing their utility in K-12 schools, and therefore, for-profit companies are able to provide lower-quality education and exploit students with impunity.
The Distant Payer in Higher Education: The Gateway Customer Effect
Using the term the gateway customer effect (GCE), I apply Abrams’s (2016) idea to higher education and extend it by incorporating the phenomena of both the distant payer and its accompanying negative effects. Under the GCE, postsecondary students are gateway customers, as viewed by institutions that wish to court them to increase revenue from sources, primarily tuition, which essentially equals federal appropriations, i.e., Pell Grants. In other words, the gateway customer is the start of a higher education funding chain, and in order to receive substantially more monies than the student fees or tuition received from a student gateway customer, the institution must first secure the student by enrolling them. The most common negative effects that stem from this GCE funding structure in higher education range from a relatively benign increase in commercial marketing to unethical marketing and recruitment practices, such as outright lying about student loans and the value of a degree from for-profit institutions.
To demonstrate how the GCE works, data from the USDOE (2015) show how the typical college student is the spearhead for additional funding. After enrolling in college, the average student will contribute a small share of institutional revenue from tuition and fees (20% for four-year publics and 17% for two-year publics), but institutions would then have access to federal dollars, and up to as much as a third of revenue from state funding. This is contingent upon enrollment numbers and various state appropriation structures, such as enrollment-based funding, which was typical in states until a recent shift to a mixture of outcomes-based funding (Hearn, 2015). In spite of the gradual move to outcomes-based funding approaches, many states still use a mixture of enrollment and outcomes called formula funding (Ward et al., 2019). Critically, however, postsecondary institutions now rely more heavily on tuition. For instance, two-year colleges receive much of their tuition through students’ access to federal Pell Grant dollars, which are contingent on the student enrolling in their institution.
For-profit institutions in higher education have always viewed students through the lens of revenue generation and thus contributed to the GCE (Bonadies et al., 2018); however, due to lower state revenues, stagnant federal dollars, lower enrollment, and an increased reliance on tuition, public institutions have now begun to treat students as gateway customers more frequently. In fact, it is quite common for two-year colleges to be more engaged in recruiting and marketing to increase enrollment. They also focus heavily on raising retention to keep students at their institutions. As Cohen et al. (2014) summarized in their book on community colleges, most states use a funding structure that is based on the number of units—whether numbers of students, credits, etc.—and therefore, two-year institutions try to increase these units to generate higher revenue:
Under the unit-rate formula, the state allocates funds to colleges on the basis of a formula that specifies a certain number of dollars per unit of measure, which may be full-time student equivalent (FTSE), the number of students in certain programs, the credit hours generated, or some combination of measures. This pattern is in use in a majority of the states. (p. 155)
The GCE encompasses not only the phenomenon of the distant payer in higher education, but also the negative consequences that necessarily result when both for-profit and nonprofit postsecondary institutions choose to make recruiting students a primary strategy to maximize enrollment as a revenue generator. It is this combination that is most damaging for vulnerable postsecondary student populations, much like the elderly in nursing homes, the prison population, and patients in health care.
Negative Outcomes as a Result of the Gateway Customer Effect
There are several negative outcomes resulting from the GCE. For example, depending on calculation methods, some for-profit colleges taking Title IV funding can make over 90% of their revenue from federal dollars, and a large number of these entities make over 80% of their revenue from the federal government (Kelchen, 2017). Because these institutions know they must enroll students to access this funding, they resort to relentless advertising, predatory marketing, and misleading at-risk students (Bonadies et al., 2018; Kanelos, 2008). Remarkably,
half of the students at these schools are people of color, according to Nick Glakas, president of the Career College Association lobbying group, who gave this figure during a 60 Minutes interview in 2005. A full 70 percent are first-generation college students—a number that is much higher than at most nonprofit colleges and universities. (p. 14)
Furthermore, a large proportion of federal revenue going to for-profit institutions comes from government subsidized loans that these entities promote directly to students. This results in higher default rates. In fact, 30% of students who start at for-profits default on their college loans, a rate which is seven times greater than students who start at public institutions (Gonzales et al., 2019). These institutions reap fees, tuition, and other monies from students through these loans, and the government typically subsidizes the interest on those loans, which is an indirect public cost born by taxpayers and funneled to for-profits. Very few for-profit colleges report data on student debt, yet calculations have shown that 83% of graduates from four-year, for-profit institutions had substantial loans (p. 14). Even worse, Baum et al. (2018) found that “the share of 2015-16 bachelor’s degree recipients who borrowed $50,000 or more for their undergraduate studies ranged from 7% of those who earned their degrees at public institutions to 32% of those who graduated from for-profit institutions” (p. 4).
For-profit institutions are 42% of all Title IV postsecondary institutions in the U.S., but only 9% of total enrollment (Ginder et al., 2018). Therefore, the limited total enrollment in for-profits attenuates the more extreme negative effects of the GCE. Nevertheless, public colleges’ increased reliance on tuition dollars, e.g., federal Pell Grants, has forced four-year and two-year public colleges to mimic for-profit marketing approaches to raise enrollment numbers and increase revenue.
For example, two-year public colleges have vastly expanded their marketing to high school students in an attempt to increase enrollment (Smith, 2017). This has negative effects on both public school funding and college funding, as well as on low-income students based on the individual state funding structure for dual enrollment. Four-year public institutions, on the other hand, have also begun marketing to students like for-profits. For instance, Rhoades (2006) argued that “not-for-profit institutions behave more like private enterprises, as the relationship between public and private entities shifts” and that this “is a shift of public subsidy to entrepreneurial activities” (p. 385). Newfield (2016) also spent significant portions of his book The Great Mistake: How We Wrecked Public Universities and How We Can Fix Them arguing that the negative effects of privatization in higher education are the primary drivers of poor outcomes and student inequality.
The GCE and its reification in higher education markets is essentially yet another means by which postsecondary institutions are engaging in corporatization and privatization. It appears that the more postsecondary institutions use corporate tactics, the more inequality and abuse there is and will be in the market system.
Imperfect Information and Its Negative Effect on Postsecondary Students
Compounding the problem of the GCE and an enrollment-based revenue strategy is the market failure of imperfect information. Also known as information asymmetry, this concept is a well-understood economic phenomenon (Samuelson & Nordhaus, 2010). Hansmann (1980) described imperfect information this way: “Because of this separation between the purchasers and the recipients of the service, the purchasers are in a poor position to determine whether the service they paid for was in fact ever performed, much less performed adequately” (p. 847). Simply put, the further the distance the consumer is from the product or service, in actual proximity or in knowledge of its efficacy, the less able the consumer is to judge the value of that product or service. This causes instability and abuse in conventional market interactions.
Adams (2016) applied it to K-12 public education, but others have discussed the problem of information asymmetry in higher education and how it causes market failures. For example, Dill and Soo (2004) outlined three types of imperfect information that exist in higher education markets. First, there is a “principal-agent” problem because since students “can be considered ‘immature consumers,’ the state may stand in for the consumer and act on the students’ behalf to ‘purchase’ higher education”; second, information asymmetry in the postsecondary realm could be considered a “consumer protection” problem because colleges “may produce or publish information about their academic programs that is misleading or not in the interests of prospective students and/or the public” and students are “lacking valid knowledge” to understand these programs’ quality; finally, aside from information asymmetry on the part of students, “because of the distinctive properties of universities, the producers [i.e., postsecondary institutions] may have imperfect quality information as well” (p. 63).
In other words, both postsecondary students and institutions are not in a position to fully understand the quality of the degrees they obtain and confer. Combine this with aggressive marketing and dubious practices to secure vital revenues as a result of the GCE, and the result is a slew of potential negative effects, from simple fraud to the overestimation of the value of degrees, even by high-status universities (Murakami, 2020). As another example, as a result of the GCE in postsecondary graduate student market, masters and doctoral students sink hundreds of thousands of dollars into graduate programs by taking out loans that account for 40% of all federal student debt, even though graduate students only comprise 15% of total enrollment in college (Miller, 2020). Moreover, approximately 60% of student loan holders are not able to pay down any amount on their principal within three years of graduation (Webber, 2017), which suggests that for many, loans may be quite burdensome and counterbalance the benefits of a college degree (Murakami, 2020).
The compound effect of the distant payer phenomenon and imperfect information, on the part of both students and institutions, makes the GCE in higher education so detrimental for students, taxpayers, and the public in general. Steps need to be taken to mitigate it and prevent future damage.
Solutions to the Gateway Customer Effect and Imperfect Information
Archibald and Feldman (2018) criticized the current economic model of higher education by arguing that “supply and demand in reasonably competitive markets isn’t the appropriate model to apply to tuition-setting in higher education, except possibly at for-profit institutions” (p. 14). Newfield (2016) argued that privatization in all forms has harmed public postsecondary outcomes, and Hansmann (1980) and other scholars have explained the reasons behind these market failures.
Tragically, most students who enroll in for-profits, and many in nonprofits, are experiencing real economic pain due to predatory marketing, misleading loan terms, valueless degrees, and unnecessary debt that is not balanced by improved post-graduation labor market outcomes (Armona et al., 2018; Bonadies et al., 2018). Other students who attend four-year and two-year public colleges may take on more debt than they require and may not benefit from a college education as much as they would if they had not been marketed to, and this is especially true for many graduate students (Miller, 2020). Clearly steps need to be taken to change the funding structure of higher education to address the confluence of the GCE and imperfect information market failures.
There are several immediate steps regulatory agencies could take to limit damage due to this combined market failure. One obvious step is to severely limit for-profit and nonprofit predatory marketing and borrowing practices. Lowering the extremely high amount that for-profits can earn from federal revenues, from 90% to 50% or even 33%, would be a simple change in the law that would have an immediate cooling effect on these businesses. More stringent regulations on marketing could also be enacted by the USDOE. A better idea, but not politically viable perhaps, is to completely ban for-profit institutions from the market of higher education. Since for-profit college outcomes are so consistently negative (Armona et al., 2018), this would eliminate the greatest amount of harm due to the GCE and imperfect information. Finally, the unnecessarily complicated and misleading nature of loan award letters could easily be addressed by requiring uniform and clear wording (Burd et al., 2018), and risks from loan awards and disbursements could be shouldered more by institutions (Webber, 2017).
A more complicated approach is to address the dependency of the postsecondary institution on student enrollment numbers. One means by which this can be attained is to lessen the ties that federal and state appropriations have to student enrollment. Fortunately, some higher education state system funding structures are already independent from institutional enrollment numbers to some extent, yet more can be done. For instance, Ward et al. (2019) made a comprehensive case for a strategic alignment of three areas of funding—appropriations, tuition, and financial aid—to address inequities in the system and improve access and outcomes for students of color and low-SES students.
Perhaps a simpler model is to implement versions of free college at scale. Newfield (2016) argued that privatization-based tactics “led to a well-known decline in US college attainment, in large part by damaging the colleges attended by most low-income students and students of color” (p. 257). He also noted that the institutions “serving the most students spend the least amount on their education” (p. 271). One of Newfield’s solutions was to spend more on the majority of students and allow for free college. This recommendation might indeed help solve the GCE and imperfect information market failures. Of course, there are significant barriers and complexities involved with current models of free college across the nation, most of which are currently offered at community colleges (Harnisch & Lebioda, 2016).
However, other models, such as the City University of New York’s Accelerated Study in Associate Programs (ASAP), a model which began in New York City and was replicated in Ohio, have shown that it is possible to double graduation rates at two-year public colleges for a modest increase of $2,000 per student per year (Miller et al., 2020). The scalability of this replicated reform is dependent upon funding, but at the very least, there is now a viable model that shows it is possible to provide free college for high school graduates their first two or three years at two-year public institutions. It would also buoy transfers, enrollment, and graduation at four-year colleges.
Most importantly, under a properly regulated free college proposal, there should be other strings attached. First, caps should be set on the number of contingent faculty employed at institutions. This is because free college would create a demand that would stretch capacities at most public institutions. Therefore, institutions may again resort to maximizing enrollment numbers to increase overall revenue. To prevent the GCE and imperfect information from further harming students, institutions receiving money for free college should be required to have restrictions on how those dollars are spent on instruction. Limits on overhead, administrative costs, part-time faculty, unnecessary spending, and other traditionally wasteful spending would have to be coenacted.
Truly free college, meaning highly regulated models that avoid restricting low-income student access (Poutré & Voight, 2018), as well as other necessary regulations, would therefore mitigate the current GCE and imperfect information market failures in thousands of postsecondary institutions, both for-profit and nonprofit, and potentially help millions of at-risk students across the nation. As Rhoades (2006) proclaimed, “The boundaries between academic, practitioner, and change agent are hard to delineate: We are active players in our higher education system, and our choices, as individuals and as members of larger groups and social movements, matter” (p. 384). When postsecondary policymakers and practitioners allow harms to persist and harm students, they are making a choice. Participation by postsecondary institutions in the GCE is a choice reinforced every day, and thus it can be changed. It only requires a combination of political will, leadership, incentives, and disincentives.
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