The Silent Revolution

by: Shareholders Unite

The race is on to improve the public sector.

With deflation in Japan, deleveraging in the US, and the unfolding euro suicide on the old continent continuing, what we can expect, at best, is moderate economic growth. This poses all sorts of problems. With moderate growth in tax receipts and the public sector automatically growing, the race is on to find efficiency improvements in the public sector.

Why is the public sector automatically growing? Well, here are a few reasons:

  • 'Baumol's disease': much of the public sector is (at least so far), not amenable to anywhere near the same productivity growth as much of (private) industry. This causes the relative price of the public sector to increase.
  • Increasing wealth tilts preferences slowly towards more publicly provisioned things: safer food, safer neighborhoods, better education, cleaner environment, better healthcare, stuff like that.
  • Increasing complexity is a problem for markets, requiring better regulation to deal with information asymmetries.

Now, two sectors that will become more expensive automatically are healthcare and education. The old industrial classroom model of teaching has been around forever. Schools still need one teacher per, say, 25 students to impart knowledge like it took a century ago (or three centuries ago). There is little or no productivity growth here.

Healthcare is considerably worse, as apart from the same doctor/patient ratio issues as education, there is also a growing elderly (and hence more disease prone) population, and all kinds of new and expensive interventions arriving all the time.

However, new ICT and software has opened up a host of different possibilities of increasing, sometimes even dramatically increasing productivity in sectors that until now, were stubbornly resisting any increases in productivity, wedded as they were to the industrial model.

For profit online-education
Perhaps the biggest opportunities lie in education. The internet opens up vast possibilities here. Where previously professors had an audience of 1000 at best, now size doesn't matter anymore. In the words of Wuster and Evans (who wrote a book about the consequences of the internet called "Blown to Bits"), the internet does away with the trade-off between 'richness' (the amount of information that can be exchanged) and 'reach' (the number of people participating).

For instance, while the books are browsable ('richness'), traditional bookshops can only stack so many books (limited 'reach'). Amazon busted this trade-off and offers both richness (browsable books) and reach (millions in catalog), and even some nifty new tools to navigate this bewildering world, like recommendation software.

Lectures of star professors previously had a limited 'reach' but they can now be made available online and have an infinite audience and be seen when it's convenient for the student, even though some of the 'richness' is lost (no direct interaction with the professor or fellow students).

They can also be endlessly repeated and watched from the comfort of the student's home, saving on commuting time and cost. Against these advantages there are a couple of disadvantages. The whole experience might be more convenient and it considerably alters the student's experience. Student 'life,' with all social aspects of joining clubs, making friends, living in dorms, studying together, stuff like that will disappear if education moves on-line.

There are two aspects of this, the cultural (that is, 'student life') and educational aspects. Let's focus on the latter first. Education is imparting a host of skills, social, disciplinary, verbally, stuff that's difficult to impart with an on-line video of a lecture or interactive wizardry via the internet, no matter how good.

Much knowledge that students acquire in a traditional school or university is tacit, rather than the more explicit information imparted through lectures. Much of this can be reproduced on-line by how-to video tutorials, practicing routines, and exercises, or the institution could make people available on-line for answering questions.

With the advent of Web 2.0 technologies, students can form virtual study groups, or even real ones based on location. But while all of this helps, none of it reproduces the full immersion of a real university, let alone the student life. Which is why it's probably good to mix features by having a real 'bricks and mortar' school with a host of online resources available that increase productivity and efficiency of education.

For profit education is plagued by some fundamental incentive problems though. It's difficult to assess the quality of the school or university in question from the start, providing the institution with an informational advantage to exaggerate its quality. There is also a rather clear incentive to minimize the cost per student, which has led to huge scandals in the Netherlands where some schools provided a sort of extensive education with few 'contact' hours between teachers and students on the basis of some really dubious educational reform theories.

Similar trouble has erupted in the US, with the Federal government tightening regulations and financial assistence which has grown from $1B to $7B in a decade. Since relatively easy to get government backed education loans provides up to 90% of their revenue, the temptation is there to swell the numbers by dubious marketing practices or even paying recruiters by the number (which isn't legal).

According to the US Department of Education, "students at for-profit institutions represent 12% of all higher-education students, 26% of all student loans, and 46% of all student-loan dollars in default."

There are other problems with standards:

Seven of 12 for-profit colleges attended online by undercover U.S. investigators violated school policies on cheating, grading standards and loan counseling, a report by the Government Accountability Office found.

Another curious sign is executive pay, which looks to be rather high in certain cases:

Representative Elijah Cummings, the top Democrat on the House Oversight and Government Reform Committee, sent letters asking to see pay agreements from 13 companies, including Apollo Group Inc. (NASDAQ:APOL), Strayer Education Inc. (NASDAQ:STRA) and Washington Post Co. (WPO)'s Kaplan unit. Cummings cited a 2010 Bloomberg article that showed executives at the 15 U.S. publicly traded colleges received compensation that exceeded traditional colleges and collected $2 billion from selling stock over the previous seven years. Congress and the U.S. Education Department are scrutinizing for-profit colleges, which received almost $32 billion in federal grants and loans in the 2009-2010 school year. Students at those schools are defaulting on government loans at higher rates than those who attend nonprofit and public institutions.

There is a rather depressing Wikipedia article that seems to provide an overview of the main problems. It has to be said though that these problems do not affect for-profit schools exclusively. Dutch universities have seen a proliferation of courses, often of dubious quality as a result of finance being linked to student 'throughput.' Some argue that this has affected quality as well.

Instead of lobbying Washington, the industry could do a lot to restore trust in these institutions. Reputation is one of the most important assets of companies offering stuff that is difficult to evaluate at the point of buying. Reputation clearly helps in the decision making, as can be witnessed from the rankings of MBA's. The top schools command premium prices although we really wonder whether the education is that much better than in the second tier schools.

There is no question that there is demand for their services. A proliferation of business models is good for overall industry evolution, but students need protection against opportunistic behavior and wasting their time and money on an education that isn't helpful.

There are two main ways to protect students and restore confidence in the sector:

  • Transparency
  • Regulation

Since it's very difficult to assess the quality of the education before actually experiencing it, the industry should do everything to be as transparent as possible. Figures about loan delinquency (one of the main issues in the US), rigorous student evaluation of programs and teaching methods, jobs they land after completion, contact hours, and a host of other metrics should be made available for applicants to compare.

Just like airlines and mobile telecom providers don't like their prices being compared at the click of a mouse, many schools won't like this either, but it is in the interest of the industry as a whole and, more interesting, it's in the interest of the good institutions. How can good institutions command premium prices if potential students cannot evaluate its superior quality?

Regulation could offer rigorous quality standards and public visitations to check whether these standards are adhered to. This seems a pretty good start:

the administration plans to issue financial aid rules this month that among other things would require more disclosure of graduation and job-placement rates and reinforce a federal law that prohibits schools from paying recruiters solely on how many students they enroll [Washington Post]

What we expect is if the industry continues to fight sensible rules like this one they will do themselves more damage than good and they could open themselves up for competition from established non-profit organizations with a sound reputation.

This is already happening. From a recent Pew Research Center study:

More and more colleges are offering online classes. More than 75% of college presidents reported that their institutions are now offering online classes. Nearly half of adults who have attended college in the past 10 years reported that they had taken a class online.

However, for profit education still has an advantage though:

Two-year and for-profit colleges are more likely to offer online classes. 91% of two-year colleges and 71% of for-profit schools offer online classes. The presidents of these types of institutions are also more likely to state that online learning is just as valuable as in-person courses.

However, most efforts to restore the reputation of the for-profit education sector might be in vain, as new fronts have just been opened.

Meantime, at MIT
In the higher learning sector MIT is just offering free online course platform MITx with a certificate of attendance (obviously not, or not yet, carrying the weight of the real thing, but we have to see how this develops). The new platform builds upon the MIT OpenCourseWare platform which has offered courses for free for quite some time. The new platform also offers a considerable degree of interaction and training routines.

The MIT initiative is really the kind of stuff we're expecting. This is the kind of institution with the reputation and the cloud and resources to do this. This week, it launched its first full course:

6.002x: Circuits and Electronics, based on the campus-based course of the same name. This is not a "watered down" version of the campus course or "any less intense", says a university spokesman.

If I was running a for profit university or school, the likes of Strayer Education Inc. (STRA), University of Phoenix (APOL), Capella (NASDAQ:CPLA), or American Public Education (NASDAQ:APEI), this would scare the living daylights out of me. Yes, these schools offer real-world and face to face contact, but they also charge upwards of $10,000, not to mention that the reputation of many has been somewhat impaired, the last years. And it's difficult to beat the reputation of MIT.

Enter Apple
And MIT is not the only one at it. Apple (NASDAQ:AAPL) has just come up with a business model that Evans and Wuster would have called disintermediation. Apple cuts the university out and enables a direct relation between the teacher and the student via its technology platform that works on the iPad.

We're not so sure about this. It might work, but there are potential problems in accreditation and reputation. For starters, how do students show what they've learned? Is Apple going to proceed with mass exams via the iPad? And who establishes any coherency in the myriad of individual courses?

While we won't exclude some (as of yet) unforeseen evolution here, what's missing is an institution that vets and accredits. For now, future employers won't be too impressed with receiving CV's full of iPad courses. But, like we said, evolution is possible here, and it's an interesting start.

It's early days, but these are dangerous developments for for-profit educational institutions. It's also enormously interesting from a public policy perspective. Education is both labor intensive (and thereby costly) and very important for the economy. New technologies and new business models have the potential to dramatically reduce cost. They have advantages, but also disadvantages.

Although it's interesting to speculate how this will all play out, it is way too early for that. We're fairly sure of one thing though. Should the MITx program catch on, and we don't see any reason why it shouldn't, the for-profit educational sector is in deep trouble. This isn't going to happen overnight. Much depends how employers will react to the course credentials, for instance. But a business model that has served and been essentially unaltered for centuries is now under siege. About time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.