What's really driving skyrocketing prices

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By Penelope Wang, Money Magazine senior writer

If colleges were spending most of their money on initiatives that improve the quality of education for students, you might regard price hikes running at two to four times the rate of inflation as a necessary evil. But spending on palatial dorms, state-of-the-art fitness centers and a panoply of gourmet dining options? Maybe not.

Yet that's precisely what many schools are doing to attract students - engaging in a luxury arms race, fueled by the wealth of such elite institutions as Harvard and Yale.

Sure, they're also putting funds into cutting class sizes and hiring top professors. But they're spending even more on building Hogwarts-style dorms with mahogany casement windows of leaded glass (Princeton's newest $136 million student residence); installing 35-foot climbing walls and hot tubs big enough for 15 people (Boston University); providing multiple eateries with varied cuisines and massive fitness and recreation centers (too many schools to name).

"There's a lot of competition from other colleges," says Steven Knapp, president of George Washington University. "In today's consumer culture, parents and students expect a certain level of comfort - and they compare the amenities."

The goal of all this collegiate bling is to entice more people to apply. Not just because the school gets a bigger pool of qualified students to choose from but also because the more students who apply, the more it can ultimately reject. That lowers its acceptance rate and makes it appear more selective in the critical U.S. News & World Report college ranking system.

"The rankings are a measure of wealth, exclusivity and fame, not quality," says Kevin Carey, research manager at the nonprofit Education Sector. "Still, they've become a de facto standard for parents, students and the colleges themselves."

The rankings generate a lot of criticism, and nearly 70 colleges refuse to participate. Many more try to work the system to their advantage by spending in ways that will boost their standing - say, offering more merit aid to attract top students.

Here's the rub: More merit aid means less money for need-based aid - which means many families end up paying more, unless their child is one of the lucky few to earn a scholarship.

The appearance of misguided spending by colleges has prompted some lawmakers to question whether wealthy schools still deserve their tax-exempt status. After all, they argue, the colleges are spending only a small fraction of their endowments on the public good - often less than 5%, which is the mandatory payout for private foundations.

The implied threat caused a minor panic attack in academe and prompted many wealthy colleges to announce plans to raise their spending on financial aid. Harvard, the nation's richest university with a $35 billion endowment, now guarantees that families earning up to $60,000 will pay nothing and those earning $180,000 or less will pay no more than 10% of their income.

Yale ($23 billion) promises that families earning $120,000 or less will pay no more than 10% of their income. Many other highly selective colleges, including Wesleyan, have followed the Ivy League leaders. Says Sen. Chuck Grassley (R-Iowa), a leading voice on the issue of college affordability: "The quick response by the schools is admitting that something's not right."

The improved aid for the fortunate few, however - less than 1% of students attend Ivy League schools - may result in higher costs for everyone else. Public colleges and less wealthy private ones are now under intense pressure to compete, yet few can afford to match the largesse of the rich schools.

At the University of California-Berkeley, for example, a family earning more than $90,000 would get little or no aid, so they'd have to pay the total cost of nearly $25,000. At Harvard they'd now pay less than $9,000.

"That puts middle-class families at a huge disadvantage in our system," says Berkeley chancellor Robert Birgeneau. "Many colleges may have to raise fees to funnel more money into financial aid or risk losing many of the best middle-class students."

The high sticker price is actually part of many colleges' marketing strategy. For as counterintuitive as it seems, schools have often found that raising tuition attracts more applicants because families tend to equate high price with quality. Marketers call it the Chivas Regal effect.

In 2000, for example, Ursinus College in Collegeville, Pa. boosted tuition and fees by 17.6%. The following year the school received nearly 200 more applications than the year before, and within eight years the freshman class had grown 56%.

Hendrix College in Conway, Ark. had a similar experience in 2005 when it hiked its tuition rate by 29% to $22,000. The college in effect gave back much of the increase as financial aid or merit scholarships to 99% of the students; still, it seemed that tuition was as high as at places like the University of Richmond. Since then the number of incoming freshmen has increased by nearly 40%.

Says Hendrix College president Timothy Cloyd: "We are competing with schools that charge more, so it was hard to convince people that we were as good as our rivals when we charged so much less."

The outlet for students who can't play this game has always been public colleges, which 80% of undergraduates attend. But as states struggle to meet the growing cost of Medicaid and federal requirements for elementary and high school education, less money is available for colleges.

Twenty years ago, nearly 75% of state university general funds came from state appropriations vs. 63% today. And in the current economic downturn, which is reducing tax revenue in many states, college officials worry, rightly, about additional cutbacks.

Public colleges have been making up the shortfall by raising tuition at an even faster clip than private schools -31% compared with 14% over the past five years. Last year alone, Illinois public colleges raised rates 12%, while in Colorado costs jumped 16%.

And prices at some flagship public universities are starting to look more like what you'd pay at a private institution. At the University of Michigan, for instance, in-state freshmen now pay nearly $20,000, and out-of-state first-year students pay almost $42,000 - $10,000 more than the $32,000 cost of the average private institution, although still less than the $50,000 or so charged by top private schools.

Colleges could help ease the pressure by adopting cost-containment practices that are standard in private business. But most schools are nonprofits. And without the pressure to produce earnings, they have little incentive to slash expenses or improve productivity.

Says Ron Ehrenberg, an economics professor at Cornell University and author of "Tuition Rising": "For nonprofits the goal is to raise all the money you can, then spend it."

Then too, teaching is an inherently labor-intensive process that isn't conducive to economies of scale. "It's not like automating a factory - one professor can only grade so many papers and teach so many classes," says Vassar College president Catharine Hill. "If you were to double the class size, the quality would go down."

Classroom instruction is just one part of a college's budget, however, and not even the biggest part. In a study of spending at nearly 2,000 public and private schools over 18 years, researchers for the Delta Cost Project found that the percentage of operating expenses going to classroom instruction (mainly professor salaries and benefits) accounted for 34% to 44% of spending - and those percentages actually fell over the period reviewed.

By contrast, an increasing amount was being spent on such items as faculty research and recruiting. "We see indications that institutions are spending more money in areas that may not fit in with the public priority of preparing more graduates," says Jane Wellman, the project's executive director.

That ought to leave plenty of room to cut costs without sacrificing quality. Brit Kirwan, chancellor of the University System of Maryland, has kept tuition level for three years with moves such as centralizing purchasing and increasing faculty teaching hours. Meanwhile, 20 private colleges and universities in Wisconsin have banded together to consolidate administrative functions, saving $16 million over the past three years.

These schools are largely the exception, though. Most colleges don't approach cost-cutting in a systematic way. The American Association of State Colleges and Universities has found that more than three-quarters of schools fail to devote significant resources to identifying and carrying out cost-containment measures and 60% do not regularly quantify results.

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