Gwartney Institute Blog

As I predicted, Biden’s latest policy announcement spelled the end of the student loan payment pause which began during Covid-19 lockdowns. However, ending the pause alone would be too unpopular so, along with that news, Biden announced student loan forgiveness.

Individuals making less than $125,000 a year will have $10,000 of their federal student loan balance removed if the order proves successful.

Many side-effects of the policy have been targeted for criticism. Rising college costs, increasing inflation, regressive effects, and moral hazards for future borrowers have been considered.

However, as an economist I noticed that one incentive has been ignored. If people expect future loan forgiveness to happen in this way, they will choose lower quality colleges, everything else constant.

Why would loan forgiveness make people choose lower quality colleges?

Let’s explain with some intermediate economics.

Relative Costs

To see why students will be more likely to choose low-quality education, let’s consider a simplified example.

Imagine there are two universities: High Quality University (HQU) and Low Quality University (LQU).

HQU offers students better classes, amenities, and connections. It is “high quality” in every sense. Let’s say HQU costs $40,000 a year. (In reality, expensive universities are more than this, but using a larger number wouldn’t change the results.)

On the other hand, LQU is a budget university. Class selections are limited, living spaces are in disrepair, and there is no promise of an expansive alumni network to offer new grads jobs. Due to this lower quality, LQU is less expensive, with a price tag of, say, $20,000.

Notice the relative cost of these two universities. HQU is double the price of LQU. Or, put differently, with the resources used to go to HQU one time, students could attend LQU two times. If these are the two options, the opportunity cost of attending HQU is two trips to LQU. Likewise, we could also say the cost of attending LQU is forgoing half a trip to HQU.

Enter loan forgiveness.

What’s important about Biden’s forgiveness plan for our example is that it offers a fixed payout for every student regardless of university quality. So let’s see what forgiveness does to the relative cost of these universities.

With $10,000 in forgiveness, the price of HQU (faced by students) falls from $40,000 to $30,000. The price of LQU falls from $20,000 to $10,000. It’s possible colleges could raise tuition in response, but we’ll hold that consideration unchanged for now (or in economist speak: ceteris paribus—“all else equal”).

Before the loan forgiveness, remember that HQU was double the price of LQU. Things have changed now. After the forgiveness, HQU is triple the price of LQU ($30,000 compared to $10,000).

In other words, going to HQU once would cost you three trips to LQU. Before forgiveness the cost was two trips. Thus, while the relative “price” of HQU has gone down, the “cost” of HQU in terms of lost opportunities has gone up. The following table summarizes the change:

	HQU	LQU	Relative Cost
Before Loan Forgiveness	$40,000	$20,000	HQU is 2x more expensive than LQU
After Loan Forgiveness	$40,000-$10,000 =$30,000	$20,000-$10,000 =$10,000	HQU is 3x more expensive than LQU

The result is that high-quality education is relatively more expensive compared to low-quality education than before the loan forgiveness. If people expect future forgiveness that takes this form, they’ll be making their education decisions with this fact in mind.

How will this impact education decisions? Well, if the cost of apples increases relative to oranges, we’d expect people would buy fewer apples and more oranges. Likewise, if the cost of high-quality college increases relative to low-quality college, we’d expect people to buy less high-quality education and more low-quality education.

The Third Law of Demand

Student loan forgiveness isn’t the only policy where a fixed price change has caused problems. In the market for illegal drugs, a similar principle operates. Laws that add fixed fines to drugs based on weight rather than quality lead to people consuming more potent drugs. Why?

Imagine two drugs: a low-quality version of a drug with low potency that you can buy for $1 per ounce and a high-quality version of the same drug with high potency that you can buy for $3 per ounce. Now imagine a cost of $1 per ounce is added to each drug to avoid law enforcement.

Since the low- and high-potency versions of the drug are equally enforced and punished, the cost of avoiding law enforcement will be the same. Consider what that does to the relative cost.

Now the low quality version is $2 per ounce and the high quality version is $4 per ounce.

Before the cost to avoid law enforcement, the high-quality drug was three times as expensive as the low-quality drug ($3/oz compared to $1/oz). After the cost to avoid law enforcement, the high-quality drug is now only two times as expensive ($4/oz compared to $2/oz). The relative cost of high-potency drugs has fallen. Thus, people buy more high-potency drugs than they otherwise would in a free market.

My former economics professor Walter Williams applied this same example in class to explain why married couples tend to go on fancier dates.

If you have to hire a babysitter at $20, it doesn’t really make sense to get a $20 meal at a fast food restaurant. A couple who chooses to do this is doubling the price of a cheap date. However, what’s $20 on top of fancy dinner and a Broadway show, for example? It’s a drop in the bucket.

This logic is called the Third Law of Demand or, sometimes, the Alchian-Allen Effect (it’s also the reasoning behind the iron law of prohibition). In summary the law goes something like this.

When you add a fixed cost to a good of varying quality, the cost of the lower-quality version will increase by a larger proportion than the cost of the higher-quality good, and this will cause people to substitute toward the higher-quality good.

Our education example is this logic in reverse. When you add a fixed subsidy (student loan forgiveness) you’ll get the opposite effect. It decreases the cost of the higher-quality good by a lower proportion than it does the lower-quality good, which means people will substitute into the lower-quality good, all else equal.

My suspicion is that Biden and advocates of student loan forgiveness would hope that the program would lead to more students having the chance to go to their dream college. However, the incentives created by the policy mean more will go to cheaper universities.

From my perspective, this effect of the policy isn’t such a bad thing. I’m a firm believer that, for many people, a cheaper university is a better option than a more expensive one. In fact, I also suspect many low-price universities provide better education than many of the top ranked colleges.

But, insofar as you believe you get what you pay for with universities, this policy will lead to students opting for lower-quality colleges.

Peter Jacobsen

Peter Jacobsen teaches economics and holds the position of Gwartney Professor of Economics. He received his graduate education George Mason University. His research interest is at the intersection of political economy, development economics, and population economics.

This article was originally published on FEE.org. Read the original article.