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Subsidizing the cost of education is one of the most common, and expensive, activities of governments. While primary and secondary schooling is available tuition-free in the United States, among post-secondary students the direct cost of schooling is quite heterogeneous. First, tuition prices vary widely across schools. During the 2000–2001 academic year, college tuitions varied from zero at some community colleges to over $27,000 at Ivy League institutions. Second, institutions heavily discount these “sticker” prices for many students, using detailed information on family finances and academic merit to engage in finely tuned price discrimination. 1 Third, the federal and state governments provide individual subsidies, such as the Pell Grant and low-interest Stafford loan, that are portable across institutions.

The standard model of human capital clearly predicts that such cost subsidies will raise the optimal level of …