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Economics and Higher Education
Coleman Patterson, Ph.D.

Read a typical definition of economics and you will see such things as "the study of allocation of scarce resources" and "marginal costs and benefits." In essence, economics is the discipline that provides us with the models, theories, and principles of how businesses and markets work and it provides us with the conceptual framework and language for describing and talking about how these things function. Because of its position as the starting point for a discussion of business and organizational topics, the economic concepts related to higher education leadership are presented first in this work. This discussion of economics is not meant to be an exhaustive review of the economics field. Rather, it is meant to introduce economic concepts that will be used in later chapters.

 

Adam Smith

One of the best places to start with an introduction of economic concepts applicable to leadership of educational institutions is with Adam Smith. Adam Smith, a Scotsman, is a key figure in the development of economic and business thinking for organizations and for nations. In 1776, Smith’s book The Wealth of Nations was published. Among the ideas he presented in that work was the concept of "division of labor." As demonstrated through his analysis of an English pin-making factory, the productive benefits of organization that arise from dividing tasks into small units helped his ideas become a core idea in organization theory.

Before describing Smith’s work on division of labor, an analysis of pre-industrial revolution life would first be beneficial. From the beginning of mankind until basically the industrial revolution in the past couple of centuries, people were predominantly farmers. They had to devote their entire life’s work to maintaining a subsistence level of survival. Before the advent of mass-produced goods and department stores, people had to make, grow, build, raise, and maintain all of the necessities of life—as well as any luxuries. In their 365-day year, people had to devote excessive amounts of time to growing food, raising livestock, and making all of the tools and things needed to survive. While a house, basic tools, and farm equipment are obvious things that would have had to be made by people, many other less obvious, yet necessary, items were also needed. Just think about all of the things that you use in the course of a day—clothing, pillows, blankets, soap, forks, spoons, cups, bowls, plates, napkins, and so forth. These are things that people would have had to make for themselves if they lived outside of a city. A wide variety of tools would also have to be crafted to make the work around the home and farm easier.

One thing that many people today would take for granted as a needed item, but one that would be necessary in days before zippers and Velcro, are pins. Pins were used to hold fabric together for sewing or perhaps to hold garments or fabric closed when over the body, windows, or other things that needed covering. In fact, it was observing work within a pin-making factory that led Adam Smith to his ideas on division of labor and his ideas about how nations become wealthy.

In his classic study, Adam Smith noted that 18 distinct tasks were involved in making pins. Some of these steps included: drawing out, straightening, and cutting the wire; grinding the top for receiving the head; making the heads (which involves two or three steps) and attaching them to the wire; whitening the pins; and wrapping the pins in paper.

As you might be able to envision in your mind, a untrained worker producing pins independently probably spent time idly standing around his workshop trying to figure out what to do and how to do it. There was probably wasted time spent locating tools, putting on gloves, positioning equipment and the partially completed pins in their proper places. And since it might have been a considerable time since the worker last performed these tasks, he might have to relearn the tasks and procedures for performing the work at each stage of production. Smith observed that a worker who was untrained in the methods of pin making and lacked specific pin making tools and equipment could, "with his utmost industry, make one pin in a day, and certainly not make twenty." For the sake of this presentation, let’s say that a super-industrious worker could make 20 pins in a day.

 

Implications for Colleges and Universities

Adam Smith’s ideas came from an analysis of a manufacturing facility. Dividing tasks to make a product are usually easy to do because products typically have some type of standardized and ordered production sequence. Colleges and universities do not produce physical/tangible products such as pins. Our institutions perform knowledge-based work. Because of this, the application of Smith’s ideas require additional analysis—which I will devote considerable attention to in later sections of this investigation.

 

Imagine being a farmer and taking one day off from farming to restock the family with pins for the year. After a day’s effort, you end up with somewhere between one and twenty pins to show for your work and time. The time spent making pins is time that is not spent attending to all of the other things needed for survival—food, shelter, tending to livestock and crops, clothing, and everything else needed each day. Workers who made only one pin as a result of their efforts ended up with very costly pins!

Smith observed a group of ten factory workers making pins. Instead of each worker performing all 18 pin-making tasks, the professional workers were each given only two or three tasks to perform. In this group for example, one worker was responsible for drawing and cutting the wire, a second ground the points, a third made the heads, another affixed the heads to the wire, and so on. Also in this group might have been a person who appeared to not be involved in working at any particular station, but rather, bounced around between the workers at the various stations relaying information about progress and pace, resupplying raw materials, aiding others when needed, reassigning help to keep the flow of work moving appropriately, and resolving problems related to personnel and the production process. Smith also might have seen something different in the workplace of this group—new tools that were custom-made for pin making. Perhaps he saw clamps that could draw out multiple wires from multiple spools simultaneously and contraptions that could straighten, cut, and grind many wires at once.

The output of this group amazed Smith. Remember, he found an untrained worker capable of making no more that 20 pins in a day. Where an untrained worker could hold his entire daily output between two fingers on one hand, the group of factory workers had to measure its output in pounds—not individual units. The factory group, Smith observed, produced upwards of twelve pounds of pins per day, where one pound of pins is comprised of about 4,000 mid-sized pins. This tremendous gain in productivity is something that even today is amazing. By dividing the work into small, specialized tasks and assigning them to workers so that each performs only a small part of the whole process, tremendous gains in productivity can arise—from 20 pins per day per worker to 4,800 pins per day per worker. In his analysis of the productivity improvements that occurred in the "organized" factory (i.e., where the workers had specific jobs to do as part of a whole), he identified three causes for those gains.

The first cause was something he called "Dexterity of the Workman." Anyone who learned to tie the shoestrings on their shoes as a small child has experienced this. When first learning to tie shoestrings, great amounts of brainpower and eye-hand coordination are needed to make a good knot. Crossing the strings, making and holding a snug first knot, creating the loop with a thumb, wrapping the other string around the loop while still holding the first knot snugly, pushing the string through the opening to make the final slip knot, and balancing the size of the loops and the remaining ends so as not to step on them, is a daunting task for the unskilled hands. However, after years of practice, tying shoestrings becomes automatic, something that you don’t even think about—you just do it. And you do it quickly. This is what Smith called dexterity of the workman.

By performing one or two tasks over and over again, the brain of the worker almost becomes disengaged from the work. The hands, arms, and body do the work with machine-like efficiency and timing. I recall spending summers working as a pricer at the warehouse for the campus bookstore at the University of Florida. When shipments of shirts, rolls of tape, or notepads would arrive on trucks to go to the bookstore, I would first have to affix adhesive price labels to each of the items individually. On big projects that would take several days of work, like 20,000 rolls of adhesive tape, I would frequently catch myself having to check opened boxes that I had placed in the completed pile to make sure that I had actually priced them. While my body quickly and efficiently went about its work, my mind and thoughts were sometimes elsewhere. To the extent that I would have to stop and convince myself that I had actually performed the task.

The second explanation for the tremendous gains in productivity he called "No Process Loss." When the untrained pin maker went about his work, there was probably some confusion as to where to start and how to complete the various tasks. These workers probably spent time looking for and setting up tools in each stage of production. There were most likely some types of metal-cutting shears and gloves had to be put on and taken off throughout the production process. Raw materials and partially completed pins were undoubtedly picked up and moved from location to location to complete the production cycle. There were certainly a host of other time-consuming, non-productive activities that went on in the process of making the pins.

Wasted time spent in non-productive activities was minimized in the factory group. The wire cutter kept the metal-cutting shears on his hand. The workers who required gloves for their tasks wore gloves—they didn’t have to share and they didn’t have to waste time taking them on and off. Raw materials and partially completed pins could be delivered to the workers throughout the factory by someone whose job it was to deliver such things. By specializing in one or two tasks, rather than making the entire pin by themselves, workers could minimize wasted time spent attending to things not involved in actually making pins.

The third explanation for the productivity gains identified by Smith was the "Invention of Machines." When doing the same thing over and over, day in and day out, one might discover a better and more efficient way to work with the invention of a new tool or machine. The workers who drew out the wire from the spools at sometime probably realized that with some type of clamping tool, they could pull out several wires from several spools at one time. The wire cutters also probably discovered that with the right type of cutting machine, the pins could be cut in batches, with more precision, and faster than they could using shears and hand strength.

A great example of this can be found in the history of automobile manufacturing. Before mass production and eventually the moving assembly line (which is a machine in itself) automobile parts were hand crafted. Body panels were banged out and shaped by the hands and hammers of skilled craftsmen. It took weeks to complete the work necessary to produce a single automobile. In the early 1900s the Ford Motor Company had factories with enormous machines that could stamp press body panels in a matter of seconds. Machines reduced not only the time to produce the parts, but also the amounts of variability and error that comes with parts produced one at a time.

By dividing the work to be completed into small and defined tasks that are given to specific workers, organizations are able to achieve tremendous amounts of efficiency and productivity. It is these tremendous gains in productivity, coupled with controlled costs that come along with efficient production, that make companies and organizations wealthy. Doing so, however, brings up at least three issues that need to be addressed to fully understand the scope and implications of such a system.

First of all, it is critically important to analyze the processes needed to complete the work in order to logically define the subdivision of tasks. Later management researchers, as will be described in subsequent chapters, suggested that tasks be divided and subdivided to their lowest components. While that type of system might bring about optimal efficiency, as suggested by Smith’s three explanations for productivity gains associated with division of labor, later research found that requiring workers to perform a job with only a few number of tasks led to workers becoming bored and unmotivated. Job satisfaction and commitment and many other desirable worker characteristics are harmed by such a system. A complete discussion of these ideas will be discussed in later chapters of this volume.

Having multiple workers performing distinct, yet interrelated, tasks requiring coordination in performance brings about the need for a coordinating mechanism—or managers. As described in the second pin-making scenario, one worker was probably seen bouncing around the workplace talking with workers, speeding up and slowing down production at different workstations, making sure that raw materials and the items needed to perform the various task were in constant supply, and reallocating and reassigning workers to duties in the production chain when needed. This individual would also be responsible for making sure that the group stayed on schedule with performance goals and for assuring quality work and a healthy and quality workplace for the employees. More on the importance of management and the various roles that managers play will be presented in later chapters.

The final issue that needs to be addressed is the realization that every job is important. While some may be more glamorous or prestigious than others, it takes every job to make the completed unit. A pin without a sharp point would not be a very good pin nor would a pin without a head on it. Every job has value and the workers who fill the jobs should understand the importance of what they do and how what they do fits into the whole. Division of labor, by breaking the jobs into smaller units, necessitates that no task be left unattended to or undone. If only the glamorous and prestigious jobs got done, there would be no completed work. Performance only occurs when ALL of the jobs are completed in relation to each other.

 

Implications for Colleges and Universities

Walk through a classroom building any time during the busy part of the day and spend a little time listening in on the lectures and discussions occurring in a variety of classrooms and you will discover division of labor in action. As faculty members, we are trained in a very narrow area of expertise, but as a whole, the faculty possesses expertise across a wide variety of subject matter. From literature to history to mathematics to religion and a countless array of other disciplines and sub-disciplines, the university faculty embodies the ideals of specialization, expertise, and division of labor.

Division of labor also exists in the staff ranks of a university. Our institutions are dependent on staff members to market the institution and recruit students for enrollment, conduct alumni affairs efforts and development, and everything in between. Financial aid counselors must review and package aid awards, custodial and maintenance workers must keep the facilities clean and operational, grades must be recorded and processed by workers in the registrar’s office, and computer and information systems professionals must maintain and keep IT equipment and software up-to-date to optimally handle the information processing needs of our schools. All of these jobs are necessary for a healthy and effective organization. A slow down or inefficiency in one area will have ripple effects throughout the institution—ultimately including an impact in relationships and interactions between faculty and students. Without workers in all parts of the organization performing their specified tasks, the organization won’t function effectively. College administrators, at all ranks and across all areas of the university, are the ones specifically designated with establishing and communicating organizational goals and coordinating the work and performance of the faculty and staff.

Through specialization of duties, individual organizational members can develop expertise in their particular areas of responsibility and perform their tasks in the most efficient ways possible for the organization. Directors, department chairs, deans, vice presidents, and presidents must set the direction of work through communication and interaction with their constituencies and properly ensure that the parts of the organization work together to bring about optimal performance. Effective educational leaders also must realize the value and importance of every role within the institution—from the most glamorous and prestigious to the least.

 

So how do these ideas make nations wealthy—as the title of Smith’s book suggests? Extending the ideas of division of labor within a firm to division of labor within a nation is relatively easy to do. The worker in the individual firm devotes his/her entire work career to one or two tasks in one particular organization making one particular thing. He/she performs these tasks to the exclusion of everything else needed in life—no growing crops, raising livestock, building houses, making clothes, etc. By specializing in one particular thing to the exclusion of everything else, the worker becomes so proficient in the particular task such that he can produce much more than he could ever possibly need.

The organized pin-makers, for example, produced 4,800 pins on average per day per worker. An average person would probably not need 4,800 pins in a lifetime; and these workers produce 4,800 pins each everyday. The secret to the wealth of individuals, firms, and nations comes from the excess produced. If everyone in society specializes in a particular task and becomes proficient enough to produce tremendous surpluses above what is personally needed, the excess can be traded in a common market with everyone else in the society who produces excess.

From a societal perspective, one can think of businesses and organizations within societies as the equivalent of individuals within firms. As long as there are businesses and organizations to supply the goods and services needed and wanted by people in a society, the same advantages of division of labor can arise. Specialization by firms in the production of goods and services will lead to efficiency and excess production which can be traded in a common marketplace. Rather than barter systems, which involve trading one good for another, we typically conduct trade using currency and credit.

 

Implications for Colleges and Universities

Colleges and universities must produce things that are desired in the marketplace. For any institution to remain in business, it must attract the money (i.e., the "excess") earned by people outside the organization for the expertise of their work. If not, a school will be unable to attract students, supporters, donors, and agencies willing to hire its students or admit them to advanced study. In the common marketplace, our institutions compete with other colleges and universities and with other "things" for peoples’ excess (i.e., family income and deferred family income willing to be devoted to higher education). In the common marketplace schools must have a way of signaling value to potential customers in order to draw them to their products.

In some instances, it might be more efficient for a school to hire expertise by entering into contracts with organizations that can perform tasks more efficiently, and hence cheaper, than what can be done internally. Bookstores, maintenance, food service, security forces, and others services are already being contracted out. Information technology and alumni development and fundraising duties might also become areas that become hired out to professionals. Concentrate on what you are good at (i.e., those things in which you are an expert) and consider hiring expertise from other organizations if you are unable to develop it internally.

 

Products and Services

What are products? Technically, products are things that are manufactured—where raw materials are combined to produce a "thing." Take a look around and you will see an almost countless number of things that have been produced. The book that you are reading, the chair or couch you are sitting on, the light bulbs and light fixtures that are giving off the light that you use to read, the building that you are sitting in, and many other things in your present environment.

So what are the characteristics of a product? Let’s use this book as an example again. When was it produced (look at the copyright date)? Where was it produced (look at the location of the publisher)? If you picked out this book at a bookstore, were there other copies available? Did those copies have the same number of pages and the same words on each page?

Products are tangible and can be produced at different times and stored until they are needed. They can be produced in locations different from where they are consumed—that is, they can be shipped from the point of production to the place of consumption. Products can be mass-produced, resulting in standardized and nearly identical outputs.

Do colleges and universities produce products? According to the characteristics of manufactured products, probably not. Higher education is mostly in the service business. Services differ on the dimensions that define products. Services are typically intangible and are produced and consumed simultaneously and in the same location. A lecture or classroom discussion is consumed as the ideas are presented. For teachers and students to interact and exchange ideas, they must be in the presence of each other (web-based and distance education instructional methods confuse this dimension a little). Student-teacher dialogues and discussions cannot occur in one place and be delivered to another—once they occur, they are gone forever.

Finally, educational experiences cannot be standardized like mass-produced items. Teachers must understand and address the learning needs of their students to be successful. Ways of teaching and delivering ideas must differ for different groups of students and for students individually. When students come to my office for help, I customize my responses specifically to their needs. My answers and recommendations are neither standardized nor identical—they are specific for each particular student.

Before leaving this subject, it is worth noting that some things are both products and services. A meal from a restaurant is an example of this. When you pay your bill, you pay for the food that you consumed (i.e., the product) and for service you received through the preparation of the food and for the service received at your table—having food brought to your table, having your dining needs attended to, and having your table cleaned after you leave. Because colleges and universities provide such a broad range of things that students, faculty, staff, and school supporters demand, some are bound to be services, others products, and still others product/service hybrids.

Labor is easier to divide when working with a standardized and invariable output—such as a mass-produced product. Production processes can occur in a single location and for a set amount of time—because the products can be shipped to off-site locations for individual consumption and inventoried and stored until consumption is demanded. Services, because they are customized to the consumer, and provided in the presence of the consumer, both in terms of location and time, are more difficult to divide into specialized and well-defined tasks. The nature of services confuses the notions of division of labor.

Luxuries and Necessities. Products and services can further be classified into luxuries and necessities. Necessities are things that are required in life. Food, clothing, housing, and transportation are some basic necessity goods. There are also necessity services—medical services, legal consultation, and home and automobile maintenance/repair are some examples.

Luxury products and services are those things that are not necessities or those things that are consumed for reasons other than a necessity. An automobile may be considered a necessity in certain circumstances, however, when a consumer purchases a new, high-end $40,000 automobile decked out with all the features instead of a stripped-down, basic, economy model, the consumer is purchasing the automobile for reasons beyond what is really needed—they are buying prestige, image, comfort, safety, ego gratification and a host of other non-necessity things.

Elastic and Inelastic Demand. The way that economists distinguish between necessity and luxury goods and services is by their elasticity. Elasticity is a measure of the change in quantity demanded of a product or service when the price of that product or service changes. For example, have you wondered why politicians are able to continually raise the prices of cigarettes and other tobacco products through taxes and surcharges without the demand for tobacco products dropping? Or when gasoline prices rise, consumers continue to purchase nearly as much gasoline as when prices were lower? The reason is because these products tend to have "inelastic" demand. This means that the demand for the items stays about the same regardless of the price.

Typically, as the price of a product or service increases, consumers will purchase less (or demand less) and when prices drop, consumers will purchase more. When demand is inelastic, changes in price do not affect the quantity demanded or consumed. Necessity products and services have relatively stable, or inelastic, demand. When things are absolutely needed, consumers will pay whatever the price charged. Cigarette smokers, who in many ways need their product because of an addiction, pay whatever is charged to get their product. Gasoline, many types of groceries, and a variety of other products follow this pattern—stable demand under different prices. Necessity services have a similar relationship between prices and quantity demand—plumbers, physicians, dentists, lawyers, mechanics, hairdressers, and barbers provide necessity services and can typically raise prices without tremendous decreases in consumer demand.

"Elastic" demand is a characteristic of luxury products and services. When prices on luxury products and services (i.e., things that we consume that are above-and-beyond what we really need) change, the quantity consumed is affected to a greater degree than for necessities. When the price of a manicure doubles or the newest model tennis racquet is unveiled with a significantly higher price tag, consumers might decide to do other things with their money and no longer partake of the luxury. However, when prices on a product or service that seemed almost wasteful and extravagant at a normal price drop to a level that makes them "affordable," consumers will demand considerably more of the item at the lower price. Luxury products and services are things that people could easily "live without" but are appealing because they help fill other needs—prestige, image, comfort, ego gratification, etc.

Substitutes and Complements. When the price of a product or service rises to the point that it is no longer valued, consumers may search for products or services that could take its place. When the price of a hamburger rises to a point considered unreasonable by the consumer, the consumer might seek out chicken sandwiches or deli sandwiches. In economics, similar or related products that can replace ones that become less desirable for price and other reasons are known as substitutes.

Organizations must not only be aware of the perceptions of value in the marketplace for their own products and services, but also for products and services that might substitute for their offerings. Attentive monitoring of your offerings as well as those of organizations providing substitutes might help prevent you from losing consumers to other organizations and give you the opportunity to steal away consumers from others by promoting your products and services as viable substitutes to those of other firms.

Until the last couple of years, I had never owned a hands-free headset to attach to my phone. Neither had I owned an adaptor to plug my phone into my automobile. These two purchases came about when I bought my first cell phone. The headset and car adaptor are products that I purchased because they expanded the capabilities and utility of my cell phone. These are known as complementary products—or complements. Substitute products replace the demand for a product or service; complements build on the demand of another product or service. Add-on features and accessories are examples of complements. I would never have bought the car adaptor for my cell phone if I had not first purchased the phone. Likewise, I would never have taken advantage of "get the carpet in the second room cleaned at half price" without first having purchased the cleaning service for the first room.

 

Implications for Colleges and Universities

Nations and organizations become wealthy when they throw their offerings into the common marketplace for consumption and trade. In higher education, the offerings put into the common market for consumption by students, supporters, governments, and businesses are mainly services—and sometimes products or product/service hybrids. The offerings thrown into the marketplace have to be attractive enough to "shoppers" that they attract attention and a desire to purchase, or trade the hard-earned excess that they have accumulated through their work, for the offerings of the institution. In some cases, the excess to be traded for a higher education from a particular school will come after they graduate—through the forms of student loans that will be repaid after graduation.

As will be discussed in subsequent chapters of this book, schools can compete for attention, students, and supporters through a variety of strategies. They can elect to compete on low price, services, program offerings, or on a particular distinguishing characteristic or set of characteristics. Community colleges typically market themselves as being open-door and low cost. Small schools often emphasize small class sizes and personalized attention. Schools with unique programs or degree options often promote those features when trying to attract students and supporters. Church-related institutions and large comprehensive universities also emphasize the particular benefits offered on their campuses.

Understanding the differences between products and services, necessities and luxuries, and substitutes and complements will give organizational decision makers the tools needed to make informed decisions to best position their schools for success in the future.

Can increases in tuition and other college costs keep increasing without a decrease in demand? In today’s society, a college education has become, in many ways, a necessity. Earnings and job opportunities are greater for people with college degrees than for those without. Because of higher education’s "necessity" perception, schools have been able to raise tuition and other costs without corresponding decreases in enrollment—as would be suggested by necessity, or inelastic, goods. However, economic theory suggests that when the educational experiences of colleges and universities come to be viewed as luxuries, rather than necessities, we should expect to see a decrease in demand. Colleges and universities, when raising tuition and fees or undertaking new expense-heavy projects, must be sure to give off the impression that the increases in cost are associated with providing the necessary environment and conditions needed for a higher education.

Many private colleges and universities charge substantially higher tuition than state-support institutions. Because of this, they have to create a sense of value in the minds of students and potential students that warrants the expenses incurred above and beyond what would be charged at a lower cost institution. As with an expensive car, a consumer chooses it over a basic model because it satisfies other important needs beyond basic transportation. If schools are unable to convince consumers that the premiums paid to attend their institutions are warranted, they will seek out other value-priced institutions.

Some schools are able to charge high tuition and not be as concerned. These schools cater to the people who have the money to spend on luxury items or people who might not really be able to afford it, but want the benefits that come with such an investment. Other schools can charge high prices simply because the programs they offer are worth the price in the marketplace. Fine gems are expensive because people attribute to them a sense of rareness and great worth. The demand by consumers for the gems increases the price of the gems in the marketplace. Institutions that offer things that can’t be earned easily elsewhere will cost more because people want it—in other words, demand exceeds supply and prices rise.

Complements can be necessities or luxuries and can be services or products. Complements are those add-on expenses associated with a college education—products (books, spirit wear, supplies), services (room/rent), and hybrids (meal plans).

What substitutes to traditional higher education are there? Perhaps today’s substitutes are simply new versions of traditional higher education. In recent years, we have seen a trend toward more on-line courses and programs, the emergence of more adult education and degree completion programs, and the birth and explosion of for-profit higher education.

 

Competitive Advantage

How do organizations compete and win in the common marketplace for consumers? Find something that you can do better than your competitors and use it to your advantage. In businesses this "competitive advantage" might come from unique inventions that make work processes more efficient, technology and superior ways of transforming raw ingredients into completed units, exceptional methods for processing and disseminating information, superior logistics and the ability to move things from place to place most efficiently, awareness of consumer needs and outstanding customer service, or the characteristics of the workers that make the whole organization function most effectively.

For a sports team, a competitive advantage could be gained from having exceptional players at key positions, a coach’s superior understanding of the game, or a home field advantage due to unique characteristics of the playing arena or ultra-supportive fans. Coaches and team managers should use the knowledge of their competitive advantages when formulating game plans for how to compete with opponents. The ability to continually use and benefit from its "winning edge" to ultimately become better than opponents is what economists refer to as a competitive advantage—something that a firm does on a sustained basis to make it more effective, and/or profitable, than its competitors.

 

Implications for Colleges and Universities

Ideally, schools can create competitive advantages that will allow them a way to compete against and defeat competitors on a sustained basis. Most schools will not be able to outperform all competitors in an absolute sense, so it is better to focus on beating a smaller group of direct competitors. A few possible dimensions on which schools can create a competitive advantage include: specialized programs, outstanding faculty, supportive alumni, state-of-the-art classrooms and instructional technology, a distinct culture, scholarship assistance, having a more persistent and attentive recruitment effort, having nicer dormitory rooms, or a more caring an accessible faculty and staff.

 

Economies of Scale

If you were to open you own pin making factory, you would incur a lot up up-front costs even before you manufacture your first pin. A building would need to be secured through purchase or lease, tools, equipment, supplies, raw materials, insurance, pre-opening payroll, prepaid taxes, and a host of countless other things would need to be acquired. If you planned to package your pins and sell them for $1.00 per package, you would have to sell a lot of packages to make a profit.

The goal of the business it to sell pins at a price that not only covers the costs of production but also brings in additional money above the costs of production—that is, profit. Costs can be broken into two types; fixed costs and variable costs. Fixed costs are those that remain the same whether you produce one or 1 million items. Lease or mortgage payments on buildings and equipment, insurance premiums, and salaries are typically fixed over the course of year. Variable costs change with the quantity produced. The more products that a firm manufactures, the greater its raw material costs, shipping costs, and the labor costs paid to hourly workers (because greater production requires more help).

Breakeven analysis, which is used by managers in many different areas of business, provides a method to calculate the number of units that would have to be produced to begin making a profit. The breakeven point for any product can be calculated with the following equation.

Break Even Point = Fixed Costs / (Price of Item – Variable Costs)

So for example, if you paid $100,000 in your pin-making factory for your fixed costs (i.e., building, equipment, insurance, pre-paid taxes, salaries, etc.) and each package of pins that you sell for $1.00 costs $.50 to produce (raw materials, labor, utilities, packaging, shipping, etc.), you would have to sell 200,000 packages before you would begin making a profit.

200,000 units = $100,000 / ($1.00 - $.50)

After the breakeven point is reached, you could begin pocketing $.50 per package of pins sold. The $.50 per package profit could be used in many different ways—as determined by the goals and mission of the company.

The important lesson to take from this example involves an understanding of the relationship between costs, products sold, and profit. Organizations become more profitable as they become bigger—in terms of production. Small production batches will not cover the fixed costs of the business and result in a loss for the company—sustained losses for a company will lead to its failure. At the breakeven point, businesses will make just enough to cover their costs. After the breakeven point is reached, the business becomes a worthwhile investment for its owners.

An interesting thing to note about production past the breakeven point is that, with fixed costs covered, the only costs to be covered by the sales price of the item, are the variable costs. "Bigness" leads to profitability—for your pin-making factory and for the companies that supply your raw materials. If you doubled your production output of pins you would have to purchase twice the amount of raw materials. Your suppliers, who then sell double the amount of their particular outputs, should also be able to better meet their fixed costs as well and be able to offer your company a lower price on raw materials with the bigger orders—thus reducing your variable costs!

When you double your production output, your variable costs for raw materials will double and other costs might increase as well. After a certain point of production capacity, additional equipment and factory space might have to be acquired and additional workers will be needed. Before making decisions to expand, new breakeven analysis procedures will have to be performed on the new cost, sales, and price estimates.

The concepts of profitability through largeness and the ability to meet fixed costs through "big" production are known in economics as "Economies of Scale." As organizations become bigger, they can become more efficient and profitable in their operations primarily by meeting their fixed costs and operating considerably above the breakeven point. Organizations must be cognizant of their cost structures and seek to position themselves so that fixed costs are minimized and variable costs can be reduced through large numbers—and profit can be maximized.

As will be noted in the management section of this work, "bigness" brings about a variety of other organizational issues, both good and bad, that must be monitored by organizational leaders.

 

Implications for Colleges and Universities

Colleges and universities love to construct and open new buildings. To many, it is seen as a sign of growth and prosperity. However, if the reason for building new structures is something other than to handle an "expansion in productive capacity," the new facilities may actually be harming the organization’s effectiveness. Buildings and the costs of maintaining them are fixed costs. Fixed costs will have to be covered by tuition, gifts, and other means. The money spent on buildings is money that is not spent on other things.

Almost every college and university requires certain activities to function. Recruitment, admissions, registrar, financial aid, maintenance, and information technology are staff functions required for every higher education institution. All schools also require a faculty. These functions are fixed to an extent—whether the school has one student or 1,000 students, professionals filling these positions will have to be on payroll. Likewise, a core group of faculty members is needed to provide the required courses for a degree plan. Economies of scale apply to these positions. As schools become bigger, the amount of work that these positions will increase until their production capacity is reached. At that point, another faculty or staff member will be needed to help complete the work (just as another building will eventually be needed by a growing pin-making company). When schools become bigger in terms of enrollment, the amount spent per student on fixed costs will drop and the school will see more real income. Schools with small enrollments must devote a greater percentage of every tuition dollar to fixed costs than those with large enrollments that carefully monitor and control their fixed costs.

 

Opportunity Costs

Another type of cost that economists analyze is called "opportunity cost." An opportunity cost is one associated with giving something up. If you invested $100,000 into a pin-making factory, you give up the "opportunity" to do something else with that money—whether it is investing in stocks and bonds, buying a luxury car, endowing scholarships, saving for retirement, giving to charitable organizations, or adding on to your house. Every decision that you make has an opportunity cost associated with it. When a choice is made as to how to use scarce resources (i.e., time and money), other potential choices are passed up. Before making a decision, all of the possible alternative solutions, and their associated opportunity costs, should be assessed and the relative merits of all choices considered.

 

Implications for Colleges and Universities

A new building or construction project might be a wonderful addition to a campus, but money spent on those things might be at the cost of salaries, benefits, and scholarships. Likewise, dedicating funds to salaries at the expense of maintenance and repairs of the physical plant are also decisions that should be carefully analyzed.

Students, in addition to their costs of attendance (i.e., tuition, fees, books, room, and board), also incur opportunity costs while earning their college degrees. The time spent in school could be time spent earning income and building experience in the workplace. Students must perceive that their college experiences are worth the time, money, and foregone opportunities that they invest in their educations. Colleges and universities must make a concerted effort to communicate their value to students, parents, and supporters to ensure that they will perceive a maximum payoff for their investments.

 

Marginal Costs and Benefits

The E-commerce revolution ushered in what many believed to be a new way of conducting business. Having consumers able to purchase products from their homes rather than traveling to a physical location, allowed businesses to free themselves from the traditional requirements of needing to be near their consumers. Changes in commerce brought about by the Internet were really more evolutionary than revolutionary. Being able to purchase items from a company from a distance is not too different from sales through a catalog. Sears and Roebuck mastered this concept a century before the e-commerce explosion.

The evolution of the catalog sales model through the Internet occurred through the ability of companies to instantly update their inventories and prices, the ability for customers to pay for their items as quickly as in a store, and worldwide reach with 24-hour availability. Businesses engaging in e-commerce sales, in place of catalog sales, saw immediate cost savings using the e-commerce model because printing and mailing costs were eliminated. In the virtual marketplace, electronic catalogs can be created and displayed for anyone with an Internet connection and browser software. With paper catalogs, the costs of adding one more customer included paper, ink, printing, and mailing expenses. With virtual catalogs, the cost of adding one more customer is nothing. In economics terms, the marginal cost of having one more person view an on-line, electronic catalog is zero.

Marginal changes are economic concepts that involve small incremental adjustments to a course of action—for business applications, marginal changes can take the form of costs or benefits. The marginal cost of adding one, ten, or 100 people to the total number of people who view an electronic catalog is zero. For the print publication, the costs of adding the same number of people to the printed catalog customer base is the paper, printing, and mailing costs associated with one, ten, or 100 people.

Benefits can also be analyzed as marginal changes. I have been asked on several occasions to help move pianos. The marginal benefit of adding one more person to the task is usually a welcome relief. With every new able-bodied person invited to the task, the load that the rest of the lifters must carry, individually, drops. There is a limit, however, to the marginal benefits of adding new people. At some point, the addition of another worker is actually a net cost to the group. When too many people try to help lift and move a piano, people get in the way of each other, they don’t communicate effectively with each other, and the chances of getting someone injured might actually increase. Economic theory suggests that the point at which workers should stop being added to the task is when the marginal benefit of adding the worker is less than the marginal cost. In other words, when the next worker ends up being more of a liability than an asset, it is time to stop bringing on workers.

The idea that each new worker adds to the total work produced, but at a lesser rate than the previous worker is known as diminishing marginal productivity. Each new person brings in more help to the problem, but less help than the worker before. When a single piano mover gains a helper, the workload of the first worker drops substantially—50 percent less effort is required from the first mover to complete the task. When a third worker is added, the workloads of the first two movers drop from 50 percent to 33 percent (a 17 percent reduction). The addition of a fourth worker brings with it a 12 percent savings in work. One can follow this line of thinking to see that at some point, the benefit of adding another worker won’t be worth the benefit received. If you have nine buddies in your driveway waiting for the tenth buddy to arrive before moving the piano, you might just want to go ahead and move it and let your friends go home. The opportunity costs associated with nine friends taking more time out of their schedules would probably outweigh the marginal benefit that your tenth friend would add to the task.

Another concept of diminishing marginal returns is known as diminishing marginal utility. Utility, as an economic concept, is a measure of "goodness." If you’ve ever had "eyes bigger than your stomach," you have probably experienced diminishing marginal utility. The first spoonful of a craved-after hot fudge sundae always tastes tremendous. The second bite is still pretty good, but not a good as the first one. Each bite provides a little less utility than the bite before. After the 49th bite, you may be wishing that you would never see another hot fudge sundae again, and by the 50th, you may throw the remaining sundae in the trash with all of its utility depleted.

Making decisions with an understanding of marginal cost can help lead to better solutions. If a bus is about ready to roll out of the depot on a trip with five empty seats and a last-minute customer appears with money enough for only one-half of the normal ticket fare, should the bus line accept the passenger? From a marginal cost and benefit perspective, as long as the last-minute customer pays more than his marginal cost, the bus company will profit by taking the half-price passenger. The marginal cost associated with the new passenger would most likely only include a minor amount of additional fuel to transport his additional weight and the weight of his luggage. Without an understanding and analysis of marginal costs and benefits, the last-minute customer would probably be left at the depot—with his cash in his pocket and the bus with five empty seats.

 

Implications for Colleges and Universities

The e-commerce revolution has hit higher education in the form of web technology. Prospective students can discover vast amounts of information about colleges and universities by browsing their websites. Virtual tours, on-line catalogs, frequently asked questions sections, program and faculty information, community and student life information, and a wide variety of other issues relevant to prospective students can be displayed on a school’s website—all available to visitors at a zero marginal cost.

The notions of diminishing marginal productivity are also extremely relevant to colleges and universities. How does a college or university know when to hire another person? The ideas of division of labor and fixed/variable costs suggest that a new worker be added when the productive capacity of the existing workers is maximized. Only after all of the workers have enough work to occupy all of their time and abilities, should a new person be hired. From a marginal cost perspective, new workers should be added to the task until the benefit added by the last worker is no less than the cost of hiring and keeping the worker. Adding additional workers to the alumni magazine or more clerks to the registrar’s office should be done with strict consideration paid to the added benefits and costs associated with such decisions.

In a related manner, if an employee costs the college or university $60,000 in compensation, that employee should add at least $60,000 of benefit to the school. If the contribution to the school is less than the amount paid to retain the worker, the worker should be given more to do, be compensated less, or released from the organization. As long as the benefits of a decision outweigh its costs, the decision will profit the institution.

Several tasks within a university seem almost impervious to the laws of diminishing marginal productivity. Admissions recruiters and development officers, for example, perform different types of tasks than "moving pianos." Recruiters and fundraisers work independently to tap new resources in a seemingly limitless pool of opportunities and possibilities. If schools only target a limited market for students and donors, adding more staff would only cannibalize efforts and provide no benefit to the school. However, if adding new recruiters and fundraisers permit an institution to expand its ability to reach new and untapped markets, the investments in those positions could be very worthwhile. Recruiters and fundraisers would simply need to attract more resources than the school pays them in compensation to make the efforts worthwhile—and anything that they bring in above their compensation would be added benefit to their schools with very little marginal cost.

The notions of marginal costs and benefits also have direct application to tuition, financial aid, and discount rates. The primary reason that automobile dealers don’t typically sell cars at a set price is because they want to maximize the price that every customer pays. A wealthy car buyer might willingly pay the sticker price for an automobile and return a maximum payoff for the dealer. Another buyer of more modest means might only be able to pay 80 percent of the sticker price. By negotiating a price through the salesman and the sales manager, the maximum price that this second buyer is willing to pay will be found—and it will be that price at which the deal occurs. Colleges and universities are, in many ways, like car dealerships. For students who have the resources to pay the "sticker price" tuition, colleges and universities will "sell" it to them at that price. For students who can’t afford the advertised price but are seen as desirable customers, special discounts might be available to make the "product more attractive."

Federal and state financial aid, institutional scholarships, tuition waivers, and a host of other techniques exist to reduce the sticker price of a college education to a level deemed acceptable. Colleges and universities must carefully determine the relative merits of reducing tuition and college costs through discounting in order to attract students who would otherwise be passed up or go to rival institutions. A discounting policy makes sense as long as institutions thoroughly understand their fixed and variable costs and are careful not to spend more on new students than they receive in marginal benefits.

Lastly, another place that an analysis of marginal costs and benefits should be performed is in academic programs with empty seats in their classrooms. Business schools, for example, are traditionally upper-level programs with mostly junior- and senior-level classes. New students could be added to fill empty seats in these programs with very little marginal costs—because faculty, building expenses, and utilities are being paid for with or without empty seats. Community college and upper-division transfer students brought in to finish their final two years in a business program could be added with minimal marginal costs and tremendous potential benefits. While some institutions have to restrict enrollment in business and other upper-division programs, many schools would enjoy and need the additional students. While many four-year schools desire to attract students for a four-year stay, the benefits of attracting junior- and senior-level students, from a marginal cost and benefit perspective should not be ignored.

 

Conclusion

Division of labor, products and services, costs and profitability, and marginal change are all concepts directly applicable to higher education. An understanding of these concepts as they relate to higher education will give administrators in both the faculty and staff ranks a better and more complete set of tools to draw upon when making business and managerial decisions.

Many of the concepts described in this chapter will reappear in other sections of this work. Because economics provides us with the language, tools, philosophies, and models for describing markets and the ways firms work within those markets, it shouldn’t surprise you to see these concepts come up again in their direct forms and sometimes masked with other names in the different sub-fields of business. Each sub-field of business uses these principles to give meaning and direction to their specific disciplines—to help frame, ask, and answer questions particular to their areas.

 

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2006, 2007, 2008  Coleman Patterson, All Rights Reserved