14 March 2012

Education Inflation

Paul Krugman is aghast at this chart, which shows how the Pell Grant has declined in relative cost coverage:

This is pretty much how inflation works.  In the early stages, its effects are not very noticeable because an incentive has not yet taken place.  As the incentive shift takes place—marking the beginning of a bubble, the price of the bubble product begins to rise, mostly as a way to reflect the actual supply of the bubble product relative to the currency supply and actual demand.  Over time, the price of the bubble product rises to roughly match the rate of inflation (although I suspect it’s slightly lower than that in reality as inflation encourages overproduction, which increases supply relative to demand, which is then realized in larger numbers because the price declines slightly, all relative to demand elasticity, of course).  As such, subsequent rounds of inflation will never be as effective as the first round of inflation because the first-mover advantage disappears.

This is pretty much what this chart shows.  At first, the Pell Grant can cover virtually all tuition costs.  There are probably few recipients and minimal initial demand.  However, these conditions won’t remin once people learn that the government will contribute X amount of dollars to their education.  Everyone wants in on this, and so everyone applies for the Pell Grant.  An increasing number of applicants receive the grant, and then college prices rise because, fundamentally, increases in supply cannot match the pace of increases in demand.  In order to allocate the scarce resource of postsecondary inflation, an informal price floor takes effect, coincidentally hovering near the amount of the subsidy.  When all is said and done, the initial round of inflation doesn’t change a whole lot in the short- or long-run because the fundamental problem is not high nominal costs but the small amount of supply.

Thus, there is no sense in complaining about the decreasing coverage of the Pell Grant.  Inflation in the form of subsidies faces the same fundamental problem that normal inflation faces.  Quite simply, the issue is a lack of supply, no amount of currency can fix that.

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