Groundbreaking economic finding during higher education policy development?

Today’s Guardian carries a piece entitled Plans for tuition fees in disarray, ministers say. There is concern that many universities are planning to charge students fees of more than £6,000, which means that the average of £7,500 for which the Government had budgeted is looking inadequate.  The implications for public spending are considerable. The piece contains the following observation:

Privately, ministers admit they have become victim of the so-called Giffen good, an economic theory in which people consume more as the price rises.

This statement is a worry. It certainly lends support to the argument that a little knowledge is dangerous. If higher education were a Giffen good then that would be a groundbreaking finding in economics. It would be surprising: not least because no one seems to have spotted it before.

It would be a major finding because microeconomics treats Giffen goods largely as a theoretical curiosity. No Giffen good is widely accepted to have been identified in practice. A Giffen good is effectively an inferior good for which the income effect outweighs the substitution effect: so when price rises it takes a larger share of low income households’ available budgets. This has been summarised in the conclusion that the demand curve for a Giffen good would slope upwards, rather than downwards as it would for a normal good. Economists usually search for Giffen goods among staples – rice in China, potatoes in Ireland during the famine, etc – but in most cases the search has led to the conclusion that the observed pattern of consumption can be explained using more standard demand theory.

The situation in higher education is rather different. We are dealing with a market for an experience good, where pre-purchase information is inevitably imperfect, with strong irreversibilities and high switching costs. It is market where there are significant reputation effects.

We can layer on top of that the observation that up until now the prevailing policy narrative has been that all UK degrees are of equal value. Whether that narrative was credible is beside the point. The idea that a market involving differential pricing will develop is premised on the belief that some universities are willing to declare publicly that, on the contrary, their degrees are not in fact worth as much as those of other institutions. They might argue the degree is cheaper because it is more efficiently delivered. But the consumer has no way of verifying that claim.

The net result will be providers deciding to signal quality through charging higher prices. And once some providers declared an intention to charge higher tuition fees that will change the incentives for the remainder.

This is certainly a situation in which the simple textbook account of demand being inversely related to price and competition forcing suppliers to price in line with quality doesn’t really hold. But it hasn’t got anything to do with Giffen goods.

A social democratic government committed to decommodification might be forgiven for – or be accused of – a relatively weak grasp of how markets work. On the other hand, a government committed to marketisation might be expected to have a strong understanding of how markets work in practice, rather than relying on simplistic basic textbook accounts. Yet every time you encounter someone from government willing to invoke an argument with clear economic origins they give every indication of not having a strong grasp of the concepts. As I say, it’s a worry.

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  1. Regrettably, this is not a groundbreaking phenomenon as you suppose. If HE was a Giffen good, the individual would buy more degrees a the price went up.

    What we have here is a special case of the Signal Extraction Problem – a long established phenomenon that applies particularly for servces that consumers can only test the quality by using them, particularly if they are likely to use them once only. The HE institutions are using price as a signal for quality. They are using the perception that potential consumers have that a higher price indicates the higher quality of the product. The consumer, often erroneously, reasons that only a high quality product could have such a high price.

    This effect is compounded by the phenomenons of Premium Pricing and Conspicuous Consumption. The act of attending an expensive university for the consumer is an indication of the consumer’s own self worth and status. This happens for much the same reason as people buy and wear designer labelled products when other non-labelled products may objectively be similar or better quality.

    For an amusing example of these ideas I suggest viewing episode 4 of season 2 of the 1970s TV show The Fall and Rise of Reginald Perrin where Reggie has Grot Enterprises which has a lot of useless junk to sell. It won’t sell until he hits on the idea of selling it at vastly inflated prices.

    Perhaps Social Democrats have a much deeper understanding of forms of market failure than economic liberals committed to inappropriate marketisations!

    • @al mcintosh – Thanks for your comment. I don’t think we’re disagreeing. My point was that whoever it was in government who invoked the concept of a Giffen good didn’t understand what one was, nor how rare they are in practice. Using the terminology sounds good and ‘technical’ but it doesn’t mean it advances our understanding of what is going on very far.

      • How sure are we that it wasn’t Wintour and/or Snowdon who don’t know the difference between Giffen and Veblen? After all, they and their subs have all cheerfully repeated the error.

  2. The problem is that the Government has come up with a system which means that it makes little difference to most students whether they pay £6K or £9K tuition fees, because their repayments end up being the same regardless.