Subsidizing heterogeneous higher education systems

• Published date: 01 April 2021
• Author: Limor Hatsor,Itzhak Zilcha
• Date: 01 April 2021
• DOI: http://doi.org/10.1111/jpet.12487

J Public Econ Theory. 2021;23:318–344.wileyonlinelibrary.com/journal/jpet318

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© 2020 Wiley Periodicals LLC

Received: 28 November 2019

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Accepted: 20 September 2020

DOI: 10.1111/jpet.12487

ORIGINAL ARTICLE

Subsidizing heterogeneous higher education

systems

Limor Hatsor

1

|Itzhak Zilcha

2

1

Department of Business, Jerusalem

College of Technology, Jerusalem, Israel

2

The Eitan Berglas School of Economics,

Tel Aviv University, Ramat Aviv, Tel Aviv,

Israel

Correspondence

Itzhak Zilcha, The Eitan Berglas

School of Economics,

Tel Aviv University, Ramat Aviv,

Tel Aviv 6997801, Israel.

Email: izil@tauex.tau.ac.il

Abstract

In many countries, there is an ongoing debate on the

public funding of the higher education (HE) system.

Our goal is to examine the theoretical justification for

the establishment of HE institutions and analyze the

self‐selection of students under different policies of

student subsidies. We study nonstationary equilibria

of an overlapping‐generation economy in a hier-

archical education system. Given the capacity con-

straints of Universities, we explore the impact of

adding new institutions, to be called Colleges, to the

HE system, focusing on three issues. Given that

Colleges are less productive and less selective than

Universities: (a) Should the government establish

Colleges? (b) Should the government divert funds

from Universities to Colleges? On the basis of long‐

run economic growth considerations, we obtain po-

sitive answers to both questions. (c) Then, we com-

pare several policies of student subsidies across the

board. Our results suggest that much caution is

needed in the implementation of student subsidies.

Specifically, targeting subsidies to the highly‐ranked

students in each institution may distort their self‐

selection across institutions and downgrade the hu-

man capital accumulation in the economy. To offset

this distortion in the demand for HE it may be useful

to target subsidies to the low‐ranked students in each

institution. Our model also accounts for several sty-

lized facts over time: (1) the increase in the number

of institutions and students, (2) the decline in College

admission standards, and (3) the decline in public

budget per student and the corresponding increase in

out‐of‐pocket student payments.

1|INTRODUCTION

In higher education (HE) systems, subsidies for highly‐ranked students are quite popular and

their growth‐enhancing effect is considered unquestionable. The argument in favor of these

subsidies, however, typically ignores some features of the evolution of HE systems in Western

countries during the 20th century. Particularly, the emergence of more and more heterogeneity

in the HE system calls for an analysis of the effect of targeted subsidies on the self‐selection of

students across HE institutions. To fill this gap, we introduce a theoretical framework that

considers the changing structure of the HE system over time. Using this framework, we uncover

a potential distortion in the self‐selection of students caused by targeted subsidies. Specifically,

our results suggest that subsidies targeted to the highly‐ranked students in each institution may

induce students to downgrade their level of human capital. The solution we suggest in this

paper is to mix these subsidies with subsidies targeted to low‐ranked students (no need for extra

budget). On the basis of our results, we argue that the design of student subsidy policies should

take into account their effect on the self‐selection of students. This additional consideration

may enhance the accumulation of human capital in the economy.

Many European countries have experienced an expansion of their HE systems over time, in

terms of both number of institutions and number of students. For example, Figure 1documents

the evolution of the HE system in Israel in the last 50 years. On the left axis, the number of

institutions is marked in blue, and on the right axis, the number of students is marked in red.

Figure 1shows that since 1965 (seven Universities and about 15,000 students in Israel) the

number of institutions has increased by about 10 times and the number of students has in-

creased by about 17 times. Similarly, Cottini et al. (2017) document an increase in the number

of Universities in the years 1859–2009 in France, Germany, UK, and Italy.

To analyze the expansion in HE systems over time, we consider a hierarchical education

system. Young individuals attain compulsory (or basic) education and then optionally pursue

HE to achieve supplementary skills. The demand for HE is endogenously determined by three

heterogeneous factors of individual returns: the initial endowment of each student, the pro-

ductivity (technology of human capital formation) of HE institutions, and the cost of HE

(the tuition fee determined by the policy of student subsidies). On the basis of these con-

siderations, individuals form the HE demand period by period. We characterize their choices

and capture 'hidden' distortions in the self‐selection of students across HE institutions under

common student subsidy policies.

The two main messages of this article are the following. On the one hand, Colleges play a

key role in the accumulation of human capital (or earning potential) in the economy. This

argument challenges a common criticism on the allocation of public funds to HE systems, given

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