Seto: The Law School Pricing Problem

Theodore Seto (Loyola-L.A.) responds to Friday's post by Brian Z. Tamanaha (Washington U.), The Crunch Is Coming for Law Schools:

Brian, my prior post addressed the NY Times study and your elaboration on it, not the question of tuition. I agree that the pricing structure of legal education is becoming increasingly problematic. The two basic points made in my prior post were that (1) there is no evidence that there are fewer jobs per law graduate now than in the past, and (2) there is no evidence that increased faculty hiring is, by itself, creating structural problems for law schools.

The issues raised by pricing structure are more difficult. An Econ 101 instructor would tell us that the "correct" price for legal education, as for any other commodity, is where supply intersects demand. Ultimately, we discover this point by trial and error. When law school seats are left empty, we know the price is too high. The inability of lower-ranked schools to attract students who ultimately can pass the bar is the equivalent of law school seats being left empty. In the long run, the ABA will deny accreditation to such schools and the resulting seats will be removed from the market (see, e.g., LaVerne). It is also possible, alternatively, that such schools will cut price and thereby attract students of high enough quality to stay in business, forcing price competition up the chain.

One thing that makes the pricing problem particularly difficult is that law school seats are not fungible. A seat at Loyola-LA is not identical to a seat at UCLA or Vanderbilt. At least two factors contribute to product differentiation in legal education: reputation and geography. Reputation is now driven in large part by US News rankings, which in turn depend significantly on expenditures per student. This means that the more a school spends, the higher it is ranked and the more it can charge. In other words, a school facing inadequate demand (typically evidenced by lower incoming stats) has two inconsistent solutions open to it: (1) cut price to attract buyers, or (2) increase price and spending and thereby reputation to attract buyers. Geography also contributes to market fragmentation. No rational applicant whose ambition is to become a big firm partner in Los Angeles, for example, would ever choose Vanderbilt over Loyola-LA, regardless of price or reputation.

Worse, pricing varies from student to student. The effective price to each student equals published tuition less the scholarship awarded to that student. As a result, schools now routinely charge different students different prices for the same education. Since scholarships vary from student to student, the effect is to make each student his own market for supply and demand purposes.

There is also what might charitably be called an information asymmetry problem. The average straight-through student is not aware in any sophisticated way of the relationship between the "cost of attendance" that appears on a school's website and the likely return on the resulting degree after he graduates. If so, we would predict that demand from straight-through students should respond more slowly to price than demand from more sophisticated students. This may account for the nationwide decline in demand for evening programs in recent years. (But note that evening students have greater opportunity costs and fewer years over which to amortize their investment, so the price point for evening programs may be lower than for day programs.) To my knowledge, there has not been a similar decline in demand for Tax LLM programs, which have more sophisticated consumers and charge prices similar to those of JD programs.

Looking at pricing by attempting to measure return on investment is sound theoretically, but fraught with practical problems. First, many of the most important returns to a law degree are noneconomic. Many parents would prefer to be able to say "my child is a lawyer" rather than "my child is a plumber" even if plumbers, on average, make significantly more than lawyers. With legal education comes power as well -- power to change the world, as we often tell our students.

Even focusing solely on economic returns is hard. The NY Times approach is just plain silly; no economist would give it the time of day. Attempting to estimate how much more a student makes with a law degree than without (e.g., Herwig Schlunk) makes sense, but presents major practical problems, the most obvious of which is determining opportunity cost.

Having said this, between 1973, when I started law school, and 2011, Harvard Law School's nominal tuition rose at an annual compound rate of 7.71%. Between 1976, when I graduated, and 2007, Cravath's starting associate salary rose at an annual compound rate of 6.04%. Between 1999 and 2007, the Bureau of Labor Statistics reports that the mean annual wage of lawyers inflated at an annual compound rate of 3.38%; between 1999 and 2010, at an annual compound rate of 3.29%. There are problems with assuming that associate or employee inflation rates are representative of law graduate compensation generally. Among other things, the BLS data do not include anyone treated as self-employed (e.g., partners). Nevertheless, law school tuition does appear to have been inflating at a rate hard to justify by reference to purely economic returns, even by New York top-dollar standards.

This suggests that one or both of two things is true: (1) law school tuition was once a bargain and has since been catching up to market, or (2) law school tuition has shot past equilibrium and is due for a correction. The first is certainly true; my total 3-year tuition at Harvard (ignoring scholarships) was less than half my starting salary as a law clerk. Whether the second is also true is the big question. Since we are still in the midst of the Great Recession, current market behavior gives us very little in the way of a reliable answer. You seem to assume that the second is true when you claim that: "Schools would be prudent to anticipate a cumulative drop in applications of perhaps a third from their high." Perhaps. Perhaps not.

I myself do not expect any long-term drop in applications that will materially affect the operations of schools in the top half of the pecking order. The new ABA bar passage requirement will create problems for schools servicing students with lower paper credentials, but the result will likely be to reduce supply, not demand -- thereby increasing upward price pressure (or reducing downward price pressure).

It does seem safe to assume, however, that 7.7% compound annual tuition increases are not sustainable indefinitely. For most schools, the 3.38% mean annual wage inflation rate for lawyers experienced prior to the Great Recession may be a reasonable benchmark for tuition increases until we have further data. Although schools further up the pecking order will be able to charge more because of product differentiation, they already do. It is therefore not clear that they will be able to sustain higher rates of tuition increase merely by reason of their position in the food chain.

Even if tuition increases average 3.38% from now on, schools will face structural financial strains nevertheless -- not because they are spending too much on instruction, but because over recent years professor salaries have not kept up with the mean annual wage inflation rate for lawyers. At 3.38% compounded annually, if the starting salary at your law school in 1990 was $80,000, then today (2011) it should be $160,932. Based on what I've seen, this has not generally been the case. Schools appear to have been using their tuition increases to expand the portion of their budgets consumed by non-instructional spending -- my guess is technology in particular. If average tuition increases drop to 3.38%, this will no longer be possible unless they substantially reduce the rate of instructional salary increases. If they do, they may begin to have problems attracting and retaining faculty. This is one of the problems that makes me skeptical of non-scalable distance learning; the economics just don't make sense.

The foregoing is a very preliminary cut at a very difficult issue. I expect to continue studying the pricing problem for some time to come.

Update: Larry Ribstein (Illinois), More on the Value of Legal Education