How Private Colleges Are Like Cheap Sushi

In New York City's East Village, there are a number of hole-in-the-wall spots that advertise sushi at 50 percent off. But I can never bring myself to sample the goods. We're talking about a delicacy flown in from around the world. Marking it down drastically just doesn't sit right. Something — either the price, or the fish — has to be a little off.

The same uneasiness arose recently when the National Association of College and University Business Officers released a survey of tuition discounts at private, nonprofit, four-year colleges and universities. NACUBO looked at 401 schools, and the survey found two things: almost no one pays full price, and the discounts are quite steep.

They estimate 88.9 percent of first-time, full-year freshmen received some kind of discount in 2013-2014. Of those students, the average grant they received is estimated to cover 53.5 percent of tuition and fees. In other words: more than half off. These discount rates are climbing fast. They are the highest recorded since the study began in 2000.

Now, colleges aren't in the habit of calling lowered prices "discounts." They talk instead about institutional grants, or need-blind admission, or merit- and need-based financial aid, or the difference between the "sticker price" and "actual price."

This pricing strategy, in other words, is framed as an important part of the social mission of a nonprofit educational institution. "Bringing promising students to Harvard is our main objective, and we believe your financial circumstances should never stand in the way," as one prominent university says on its website.

But we wondered. What would happen if we viewed this widespread and growing practice through a more traditional economic lens, looking at higher education as though it were airline travel, or soda, or aspirin, or rugs? So we called up a couple of economists and asked them about discounting, marketing and branding. Why do companies give discounts? What are the pros and cons of discounting? And is it possible to discount your way out of business?

Weighing Anchor And Sending Signals

"If you do too high a discount, then perceptions of desperation creep in. Are they going out of business? Is this product a dud?"

Akshay Rao holds the General Mills Chair in Marketing at the Carlson School of Management, University of Minnesota. He asks a rhetorical question: "Why does anybody discount from a price? Why don't they just charge the lower price to start with and dispense with all these machinations?"

Rao adds, "Danny Kahneman won the Nobel Prize in Economics for providing the original insight on this."

The psychological principle Kahneman identifies in his book Thinking, Fast and Slow is called "anchoring."

Rao says he often illustrates this principle through an informal experiment with his students. First, he gets them to write down the last two digits of their Social Security numbers. Then, he asks them to bid a price on a coffee cup that he's holding. Here's what happens: those students whose last two digits are, say, 96, tend to bid higher than those whose Social Security numbers end in, say, 31.

It seems that students "anchor" to the number they've just written, even though it's completely unrelated to the value of the cup. The strategy can also be employed in bartering and other negotiations.

"Anchoring" is linked to a second concept that's at work here: price as a signal. Rao studies the powerful effects of price as an indicator of quality. For example, in a 2005 study, two groups of students were given bottles of SoBe Adrenaline Rush, a soda brand marketed as improving mental clarity, and then asked to solve puzzles. The students who were told that the SoBe they drank cost the full price of $1.89 solved more puzzles than those who were told that they were drinking soda marked down to $0.89. In other words, paying full price made them feel smarter.

The top end of the higher education market is driven by prestige, and a high price can be a powerful sign of a luxury good — something not available to just anyone. In fact, Rao says he has advised his own administration at the University of Minnesota to start charging more for its executive MBA program, which is currently priced at about 60 to 70 percent of private competitors like Northwestern. For two main reasons, he says: "A, we will appeal to those students who are genuinely interested in acquiring an education, vs. 'what the heck, let me get an MBA.' B, it positions us better against our true competitors." (The university has no current plans to take his advice.)

The consumer psychology of perceived value (signaling) plus perceived gain (anchoring) explains why the formula of a high advertised sticker price followed by individual, less-publicized discounts is so popular in higher education.

When the University of Chicago, say, advertises tuition of $43,581, the school is presenting its education as top-flight. Then, when an individual admitted student gets 40 percent off, she's thrilled — much happier than if she were simply charged $25,000 up front. She has "anchored" to that higher number, which she takes as a sign of the value of her education.

"People like this concept of a gain, whether it's real or illusory," Rao says.

The Minimum-Wage Pilot

"No one knows what colleges actually cost."

The discounting strategy has its drawbacks, though. If discounts are too frequent, the anchoring effect will no longer work. Rao explains that the "reference price" changes to be closer to the true price. "I've lived in Minneapolis for 30 years," Rao says. And for 30 years, every month he gets a mailer from a rug warehouse "that says they are going out of business, and I can get this rug for less than $100 that is worth $4,000." The credibility of this perpetual sale is low.

Dante Pirouz is an assistant professor at the Wharton School of Business, where she studies the brain and consumer behavior. "There are diminishing returns to constantly advertising and marketing with a discount," she says. "Consumers get a little jaded when they say, 'the deal's not special for me.' There's no reason to rush in."

Then again, if the discounts are too deep, it undermines the perception of quality — as in the cheap sushi example. Or as Rao puts it: "Do I really want to fly on a plane where the pilot is making 10 dollars an hour?"

There are some indications that many private colleges may be reaching that point of diminishing returns. They're failing to fill seats, and bringing in less money to boot.

Total undergraduate and graduate enrollment in the U.S. is down more than three percent over the last two years. In May of this year, the National Association for College Admissions Counseling listed 470 American colleges that at the time of publication had not filled their freshman classes for this fall and were searching for qualified applicants.

Sixty percent of the listed colleges were private, including well-known names like Sarah Lawrence and Wheaton College. At the same time, according to Moody's, the investment rating service, 42 percent of private colleges expected either flat or falling tuition revenue for the 2013-2014 school year.

"If you do too high a discount, then perceptions of desperation creep in," says Rao. People start to ask: "Are they going out of business? Is this product a dud?"

Mitchell Hamilton is an assistant professor of marketing at Loyola Marymount University. He says deep discounts are a short-term strategy at best. "When you're looking at discounts of half off or more, or buy one get one free, those are for businesses that need immediate results," he says. "Private universities are hoping that this is just a strategy to stay afloat until the economic situation gets better."

Coke vs. Pepsi

What's the end point of these growing discounts? Pirouz is among those who see the higher education sector in "crisis," with increased competition among privates, publics, community colleges, online programs and even the lure of joining a technology startup straight out of high school. "There are lots of ways that young people can get educated," she says. Colleges, like other brands, are struggling to differentiate themselves in a more-crowded field, she says.

Frenzied competition can push companies to squeeze their profits or even take losses in order to stay in the game. "If you get into a price war, that is a dangerous place to be," says Pirouz, citing the example of warring soda brands. "The consumer expects low prices. It's a race to the bottom. You no longer have the profit margins that enable you to create new packaging, new flavors. It drags the whole category down."

In the case of private colleges, as Moody's analysis notes, the losers are likely to be the ones with smaller endowments, weaker name recognition and a less strongly defined market niche.

John Lawlor founded the Lawlor Group, which provides consulting and marketing services to exactly this group of private colleges: as he puts it, "smaller-sized, 'no-name,' tuition-driven schools."

While he doesn't see a price war happening yet, he says that these colleges are thinking much more about their value propositions. "A key variable is the return on investment and outcomes," he says. "That's number one." Some of his clients fear that this market-driven thinking hurts their original mission of liberal arts education. "People fear that we're selling our soul and becoming more vocational."

Truth In Advertising

We've been discussing private colleges as though they were any other industry, ignoring the large role played by federal and state subsidies, among other factors, in determining pricing.

Unlike with soft drinks, the affordability and accessibility of a college degree is of great social import. That's why it's important to scrutinize the pricing strategies used in higher education and their consequences.

The large and frequent discounts indicate that colleges are less than perfectly transparent about their prices. Part of this, says Loyola Marymount's Hamilton, is about preserving the brand. Discounts take place "out of the eye of the public," to avoid diminishing the perception of luxury.

Not only are college discounts secretive, they're also complex. It's only after students are admitted and submit a long, arduous financial-aid application that they find out what they are really going to pay. Colleges give out individualized packages of grants, loans, scholarships, housing assistance and work-study.

Even if you submit multiple applications, comparing packages and bargaining for a better deal takes time and savvy. And still you don't know the full cost: the package may be good for only one year of a multiyear degree.

Pirouz says that's not unlike what happens at the supermarket. "A lot of marketers use special ploys like rebates and coupons," says Dr. Pirouz.

Studies of products including headache relievers, soft drinks and snacks have shown that these SPECIAL OFFERS!!! boost profitability more than simply marking down the price.

"The reason is that not everybody will take advantage of the discount given," Pirouz says. An especially price-sensitive consumer may be willing to jump through more hoops — clip coupons, complete a survey, mail in a rebate — to get the best price. But other buyers may not care as much, or perhaps they're just not as knowledgeable about the process.

Unfortunately, there's a real world impact here. In recent years there's been a lot of attention to the issue of undermatching. This is the finding that a majority of highest-achieving but low-income students fail to apply to a single competitive college. Even when financial need means that they would pay little or nothing to attend a school like Harvard or Stanford, these students are instead choosing non-selective schools that tend to have a lower advertised price.

Marvin Mathew is a first-generation American who grew up with a single mom in New York City. Though he was a strong student, he applied only to community colleges as a freshman. "I had this assumption that everything was too expensive, why even try?" The high sticker prices at private schools, he says, did a lot to turn him off. "Look at NYU: $50,000 a year. That's crazy! Then I see City College, $4,000. My first instinct is, it's more affordable."

Research indicates that students like Mathew from modest backgrounds may shy away from top colleges because they're misled by high prices, unfamiliar with the complicated student aid form, or are unwilling to share the financial information required by the form. In any case, it's likely that the prevalence of discounting, while a mixed bag for the universities that engage in it, harms some of the most vulnerable students as well. As Mathew puts it, "No one knows what colleges actually cost."