I've enjoyed reading some of Frank's posts at Financial Aid Office, and in comments on a piece on setting tuition rates I said I would work on a longer piece on the question. This is the delivery.

An old professor of mine told me about his son getting admitted to Duke, where the father had also gone to school. Tuition is dear, so the professor contacts the admissions office there and speaks to the director. He says, in effect, "here's how much I am willing to pay, and we'll send the deposit if you will give aid for the remainder." The director blew him out of the office, and the son never did go to Duke. The professor said they blew it; I think the director may have been undiplomatic, but was right not to accept the offer. Here's why.

When we teach price discrimination in economic theory, we tell people that you need three things to be true in order to charge two people two different prices for identical goods.

1. have market control and be a price maker,
2. identify two or more groups that are willing to pay different prices, and
3. keep the buyers in one group from reselling the good to another group.

Market control comes from being able to distinguish yourself from others, so you need to offer "unique programs". I found this article from 1997 discussing tuition price discrimination, and of interest was the policy at Carnegie Mellon of offering deep discounts from the headline tuition rate for those student contemplating majors in the liberal arts but almost none for intended computer science majors. This is only sensible, since CMU has a high reputation in the latter area -- people wanting to get into CMU for computer science are not likely to be as price sensitive because there are fewer good substitutes available (i.e., the demand for that degree was relatively inelastic -- read here for more on elasticity.) My old professor, as an alum of Duke, revealed by his behavior that his demand was relatively inelastic, and so the admissions director called his bluff. Now in that case Duke lost, but I'm willing to bet that is the exception rather than the rule (this professor's picture can be found in your dictionary next to the word "cantankerous".)

One of the lessons we should learn from that article and that experience is that the more specific the good, the more elastic the demand -- and therefore the more difficult it is to make money by raising prices. Demand for dinner is inelastic; demand for meat as part of that dinner is more elastic; demand for beef as the meat choice for that dinner is even more so; the demand for steak, the demand for T-bone, etc. Elasticity depends first and foremost on substitutes. There will be some applicants who apply who have many good alternatives to education at institution X and others who don't, for a variety of reasons. The key to running a good admissions office is to determine what those reasons are, how to separate those with the different reasons, and then adjust the tuitions appropriately. But making your school relatively unique -- imbuing it with "market power" -- is critical too, and outside the control of admissions offices. So these schemes of price discrimination are not available for many universities.

It is worth noting that, though the word 'discrimination' has negative connotations, in this case there is a benefit to the use of price discrimination in education. It allows us to offer more higher education than we would if we offered everyone one price. (Note: I encourage readers interested in learning more economics to visit AmosWeb, which is an entertaining place to pick up glossary terms and has the funny -- to economists anyway -- Ask Mister Economy.)