Critics seem hell-bent to fabricate exotic reasons that college tuition is rising. “It is a market response to free-flowing federal dollars,” say some. “It is a conspiracy,” say others. “Declining productivity!” say those who are convinced that college professors are overpaid and underworked.

The 2011 annual spending report of the Delta Project on Postsecondary Education Costs, Productivity, and Accountability — the last annual report issued by Delta before it sadly closed its doors last spring — makes it clear that easy answers are likely to be wrong:

There is much public discussion and concern over rising tuition but much less attention to the intricate relationships among tuition and revenue sources–particularly state and local appropriations in the public sector — and spending.

Take the issue of lost appropriations, for example. It is true that from 1999 to 2009 tuition at public research universities rose at a much higher rate (56%) than the 32% increase at their private counterparts. These increases are almost entirely explained by the loss of state appropriates, as opposed, say, to increased spending.

All other factors are incidental. Nor does the rate of increase tell the whole story, because private universities are starting from a much higher base for their sticker prices the average dollar increase at the private institutions was three times that of the private universities. The situation is much worse at public community colleges which have seen the greatest increase in enrollment. This is because, when it comes to tuition, even small changes in enrollment headcount have a big effect on prices. And that is where capacity comes into play.

Private universities have been able to keep their increases in check because they do not accept as many students as they could otherwise afford. The increasing enrollment pressures have been absorbed by community colleges, and public masters and research universities. Students, who cannot afford to attend private institutions, flock to quality public universities. These are the very institutions that have not added capacity over the last forty years.

It is seductive but entirely false to think of higher education as a single sided market — that is, a system in which there is a supplier of goods and services to a customer who is willing to pay a price determined by the marginal cost of production. That is not higher education. Higher education is a multi-sided market, a collection of stakeholders with often competing interests and cross subsidies that make it difficult to determine fair pricing schemes.

Local newspapers were a multi-sided market, in which extremely profitable classified advertising subsidized news, subscriber fees, and print advertising.  It was a system that worked well until Craig’s List came along an undermined the whole value proposition that supported local news. The result was rapidly dropping classified ad revenue, rapidly increasing print ad rates followed by a corresponding drop in demand for print ad, and ultimately a cash crisis in which subscribers fled to other media for their local news. Newspapers were slow to recognize that they were a three-sided market. 

Higher education is taking the same path, and that is significant because it helps explain why the lack of capacity in American universities lies at the root of cost increases.

Success in a multi-sided market is determined by platform success in which a single horizontal layer allows many stakeholders to share common services at a total cost that is less than the cost of offering those same services in a vertically integrated business.

A multi-sided business without a scalable platform eventually succumbs to the nonlinear costs of growth.  Not only do the various services have to work out pairwise agreements with the other services, but individual stakeholders must also do the same. As the number of stakeholders grow the overall cost of providing services grows in proportion to the ad hoc arrangements needed to keep everyone happy.

Universities have not invested in platform scalability for at least the last fifty years. Their processes and structures are locked into a set of capacity assumptions that are falling by the wayside. And they are rewarded for growing in a market where students seeking value are fleeing lesser institutions for those that are already overcrowded.

The obvious losers are the second and third tier institutions who desperately need students. These are the schools that offer the steepest discounts. So steep that they cannot sustain them without falling into the financial danger zone I have talked about before.

The other losers are the students who are driven to higher quality by increasing prices. Which institutions are they? They are the very universities which have not added capacity but which have incentives to continue growing.

It is growth that comes at nonlinear costs. There are no easy ways for most institutions to subsidize or cross-subsidize those costs, so they are passed on to students.

Next:  Where does the money go? Visit Rich DeMillo's blog at innovate-edu.com to read more posts about innovation and change in American higher education.