The tyranny of private schools

By Dr Sheheryar Banuri

Should the government restrict private schools’ ability to increase fees? It’s an intriguing question, with a complicated (and ideology laden) answer. On the one hand, fee increases are necessary to maintain the quality of service delivery (i.e. to adequately compensate teachers and maintain facilities in the face of inflationary pressures). On the other hand, it’s important to keep education affordable, particularly when its production has such large positive spill overs for society. Given that the value of education is so high, it seems like there is no limit to fee increases.

There are arguments on both sides, so let’s cut through some of the clamour and talk about economics. Let’s start with the basics. In a pure market, there are a certain set of assumptions that must be satisfied to achieve pure competition. Once these assumptions have been satisfied, the equilibrium (or market) price is the most efficient price and achieves the highest degree of economic efficiency. What are these assumptions? We need a large number of buyers and sellers, we need free exit and entry into the market, we need perfect information, no transaction costs, homogenous products, rational buyers and no externalities (there are other assumptions, but these are the most relevant). Let’s face facts… the market for education is not a purely competitive market. There is no perfect information, there are large transaction costs, the products are certainly not homogenous, there is a much larger number of buyers (relative to sellers), among other factors. Finally, most countries have a large public education system that runs in parallel with the private market, so there is already a considerable degree of regulation .

So, applying free market theory has its limitations in this context. This market structure also calls for a certain degree of regulation to ensure smooth operation. This much is straight out of economics 101: when a market is not purely competitive, regulation is needed to correct the market imperfections. But it is not entirely certain whether price regulations are needed. For this, we need to take a deeper look at buyer and seller behaviour.

The behaviour of economic agents

Let’s start with the buyers. While there are a considerable number of schools in most urban centres, there are in fact, only a few that are feasible for most households (usually due to geographic proximity and quality). In selecting a school, parents face considerable “transaction costs” just to initiate the exchange (for example to pay registration fees and uniforms etc.). Furthermore, schools are themselves able to differentiate and compete on the basis of price and quality (only one of which is perfectly observable to the buyers).  Hence, there are direct transaction costs (paying of registration fees at the beginning of a student’s enrolment, arranging alternate transportation, for example), and there are indirect transaction costs for switching (such as search costs to find a school of equal or higher quality at the same or lower price, and psychic costs associated with the child for switching schools). This effectively means that once a school has been selected, it is very costly for buyers to switch.

Next let’s switch to the sellers. They are competing against a select few schools that are in similar quality/price bands in a limited geographic area, and indeed, not against the entire market. Furthermore, they are also aware of the transaction costs involved in switching. Therefore, it is perfectly rational for each school to increase their fees up to the point at which buyers are indifferent between staying at the school and switching. Therefore, schools can rationally choose an increase in fees every year that is bounded by this. If each school chooses this way, fees can increase to just below the point of indifference, and no buyer movement will occur.

Of course, schools still have to compete for new entrants, and can do so on the basis of prices and/or quality. This exerts downward pressure on school fees, such that (at least at the point of attracting new entrants) schools have an incentive to keep fees low. For both the reasons above, there is a theoretical ceiling for fee hikes every year, and as long as these are at an acceptable threshold for buyers, there is no real reason for regulation.

Collusion in service provision

This condition holds as long as schools don’t collude. If one assumes no collusion, price hikes become routine and small. However, let’s remember that private schools differentiate themselves on two factors, price and quality, and a third geographic factor that is also relevant. Therefore, when analysing the competitive environment, private schools may have many competitors in the overall market, but few competitors in their particular space. The fewer the competitors, the easier it is to collude on prices, which would then predict large simultaneous price hikes across the schools. It is difficult to observe or prove collusion, but it is probable given the small market.

The major challenge to collusion is, of course, the fact that this relationship is a weak one.  In fact, if all the schools increase prices, one can simply undercut them and increase market share. Well, one thing that is important to remember is that each school faces a capacity constraint. Therefore, while a school can undercut prices substantially to get more students, they need to have the capacity to absorb the excess students. If they can absorb additional students, then the collusive agreement might just be “cheap talk” (i.e. not binding). However, schools operate at capacity, then the collusive relationship can be particularly strong.

Need for price regulations?

The bottom line here is that due to the nature of the market for education, parents select schools once, and don’t switch very often. Schools realise this, and enact small price hikes if collusion is not present. If collusion is present, large price hikes may be likely. However, this does not imply that price regulations are the remedy. In fact, price regulation can be quite harmful if the large price hikes are not due to collusion, but for other reasons (such as hyperinflation), leading to an overall reduction in quality as large segments of the workforce may seek employment elsewhere, or facilities are not maintained appropriately.

There are a few other remedies to consider, such as strengthening anti-trust laws, or enacting an anti-collusion legal framework, so as to provide direct deterrents for engaging in collusive behaviour. Further remedies might be to reduce regulations to allow for free entry into the market (and indeed, provide incentives for entrepreneurs to participate in the market). Increasing the number of sellers in the market makes it difficult for the sellers to collude. What is entirely clear, however, is that price regulation is an all too simple (and typically ineffective) solution to a far more complex problem.

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