Price regulation & university failure🍋
Domestic student revenue has collapsed at NZ universities, yet regulatory rigidities constrain their ability to adapt
Universities are in the news, but not for good reasons. Recent headlines include Victoria University proposes up to 260 job cuts as financial deficit rises, Several hundred jobs to go at University of Otago as student numbers plunge, When downsizing means destroying our universities, and What’s ailing our universities?
Falling demand means lower revenue
NZ universities operate two main business lines, domestic education (for NZ students), and export education (for overseas students).1
The export education market is only slowly recovering from a Covid-induced shutdown. And, more recently, the combination of deferred overseas travel and a buoyant labour market has reduced domestic student intakes. A perfect storm!
Lower student numbers have led to a substantial fall in revenue. In this post we argue that because universities operate in a tightly regulated market, they are unable to respond to market changes as a business normally would.2 If universities had been allowed more flexibility, then they would currently be in a better position — one more able to adapt to the market conditions of the past few years.
When revenue falls, businesses respond (to the extent they can)
Demand shocks are normal. No industry is immune. When demand for their products (and thus revenue) falls, producers normally respond with some combination of:
reducing costs;
reducing prices (expecting that increased sales will more than offset lower prices in net-revenue terms);
increasing prices (expecting that the price boost will more than offset lost sales in net-revenue terms); and
product innovation.
The ability of universities to respond to falling domestic student demand by changing prices and product innovation is severely constrained, as we describe below. That leaves cost reductions, which, for institutions whose largest cost is academic staff, typically means layoffs.
Pervasive government control of the domestic education market
The market for domestic tertiary education was comprehensively analysed and described by the NZ Productivity Commission (NZPC) in 2017:
“The tertiary education system is controlled by a series of prescriptive regulatory and funding rules that dictate the nature, price, quality, volume and location of much delivery. These controls … limit the flexibility and responsiveness of the system as a whole.
“Tuition subsidies allocated to tertiary providers come with tight specifications on the nature and volume of delivery … Government purchases a limited range of products: it will only subsidise study towards a full qualification, and the equivalent full-time student (EFTS) funding mechanism bundles teaching, assessment, credentialing and often pastoral care. Government also tightly regulates the fees that providers can charge.
“The total number of domestic student places in the tertiary education system is capped, and the proportion of total government funding that shifts between providers year to year is very small.”
Funding rules, generally formulated by the Ministry of Education and implemented by the Tertiary Education Commission (TEC), dictate the price, quality and other attributes of product offerings by universities. These controls have been extended over time to cover the financial, quality and political risks faced by government. Acting in concert, they discourage innovation.
The Committee on University Academic Programmes (CUAP), for example, controls which new courses can be added, and the amendment of existing courses. Further, TEC rules mean that new courses have to be priced at the same level as similar programmes, driving uniformity in pricing and dampening market innovation.
Price controls on domestic student fees
For domestic students, the Minister for Education administers the annual maximum fee movement (AMFM) policy. This policy limits the annual increases providers can make to student fees. The AMFM has tracked well below consumer price inflation (CPI) for the past three years.
Universities have also had to deal with falling real income per student, as 2023 fees are around 11.5% lower in real terms than 2020 fees. This, on top of lower student numbers, makes for an even more perfect storm!
Constraining price increases to (at most) the CPI is consistent with a specific form of price regulation called incentive regulation or price-cap regulation.
Price-cap regulation misapplied to universities?
Market regulators, such as the NZ Commerce Commission, use price-cap regulation to constrain the market power of monopolies.
Price-cap regulation is based on the idea that monopolies over-charge their customers, and therefore lack proper incentives to contain costs and innovate. An externally imposed price cap pushes consumer prices down, forcing the monopolist to look elsewhere to maintain their profitability.
Price-cap regulation is typically applied in response to a significant historic period of price gouging, and/or minimal evidence of cost reduction and product innovation.
Price-cap regulation is effected using a formula RPI-x where RPI is the inflation-indexed price and x is the percentage of real price reduction the firm is expected to impose. The rationale is that if revenue decreases in real terms, the firm must focus on cost reductions for existing products, or develop new products costing less that offer the same benefits to consumers. To take just one example, this form of price control was used in NZ on Telecom prior to 2003, with x being 0.
When x is greater than 0, as it has been for universities in the past 3 years, there is a real risk that the regulator imposes harsher cost controls than is feasible with available technology. If regulated firms cannot reduce costs to the extent required, they face a threat to their ongoing financial sustainability.
Effective RPI-x regulation is time-limited, ring-fencing the extent of the overcharging that is expected to be corrected, and to limit the effects of imperfect knowledge leading to over-harsh x factors. Transparent and accountable negotiation and renegotiation is expected as part of the process, with all objectives clearly articulated, and justification given for the terms imposed.
Do universities have market power?
The standard test for market power comes down to one question: can the seller raise their prices without losing market share? This question is moot in the domestic education market, as the government both sets prices and allocates market share!
A further test is whether the market is concentrated or prices are coordinated. Is there evidence of a monopoly, duopoly, oligopoly or cartel?
Compared to other industries in NZ, university education is one of the least concentrated, especially if including the competition in basic degrees from the polytechs, and the ability for students to study online from overseas universities.
That said, prices are coordinated, and supply of places in specific course types (e.g., dentistry) is constrained. Market entry is tightly restricted. So, this market has elements in common with a cartel. But arguably those elements arise more by (government) design than (producer) intent.
Do universities compete for students?
Within overall market share limits set by government, universities do compete at the margin for students.
When demand exceeds (government-fixed) supply, universities need not compete to fill their courses. They may, however, compete for better quality students, on the basis that these are less costly to teach.
By contrast, when aggregate student demand is lower than the permitted supply, we might expect intense competition for the marginal student. But such competition mostly reallocates students between universities, which does nothing for their collective financial health.
Do universities price gouge?
There is limited evidence of price gouging historically. Price controls are best understood as a government budget control mechanism. It is the government, rather than students, that ultimately pays around 82% of student fees.3 Accordingly, student demand is relatively inelastic to fee price changes. While price gouging is a real risk in an unregulated market, it is impossible under the AMFM policy.
Does price regulation encourage innovation?
Programme innovation, to the extent permitted, takes a long time to implement. It is not well-suited to the forms of rapid adjustment usually expected in RPI-x regulated systems.
Why has this regulatory design persisted?
The tightly regulated market for domestic students has some advantages, at least for the government and for universities. It allows government, which bears the majority of the cost of student fees, to keep its expenditure within annual budgets. And the inflexible allocation of students to universities reduces the intensity of competition between universities, protecting the weaker-performing universities. These features also makes it easy for universities to plan and budget.
These advantages, however, are contingent on demand from students exceeding supply, and student fees that reflect the cost of providing education. Those contingencies have broken down, revealing the fragility of the regulatory system.
Regulatory design error has set up NZ universities for financial failure
Tight price-cap regulation, applied within already overly restrictive regulatory system, is a major contribution to the current parlous situation.
A government bail-out may assist in the short term, but does not address the underlying issues. These are to be considered in a complete review of the tertiary education funding system, to be conducted over the next two years.
A predictable downside of this delay is the likely loss of much human capital, as the financial positions of AUT, Massey, Otago, Victoria, and the new merged polytechnic, continue with staff redundancies as their least-unattractive cost-control option.
The reform proposals in the Productivity Commission’s 2017 report would, if they had been implemented, made the tertiary education system more flexible, and thus more robust. They are worthy of reconsideration.
By Bronwyn Howell & Dave Heatley
Universities are also in the research and real estate businesses. In New Zealand, however, the primary source of research funding (specifically academic staff time) is the surplus from the education business. We won’t consider the real estate business here, except to say that lower student numbers also puts financial pressure on universities’ student accommodation offerings.
New Zealand’s tertiary education sector also includes polytechnics and wānaga, the latter being three publicly owned tertiary institutions that provide education in a Māori cultural context. The discussion here applies, to at least some extent, to non-university tertiary education organisations. The ownership structure of Te Pūkenga, the recently merged polytechnics, appear to allow it to continue functioning despite huge losses being incurred.
This figure — 82% of student fees are ultimately covered by government — is from page 300 of the Productivity Commission’s 2017 report New Models of Tertiary Education. That report predated the first-year fees-free policy, introduced in 2018. The 82% figure is probably still applicable for second and subsequent years of study.