Penny bazaar principle in bizarre setting

IT IS a long time since we had stores that charged a penny for every item. The "one price" store was never likely to make it into modern retailing because any administrative convenience it gained by charging a single amount for a variety of completely different products was vastly outweighed by the economic cost of constraining the products it could stock to those for which the chosen price was appropriate.

How interesting it is, therefore, that the "one price" concept has been embraced by the world of modern higher education. Universities do not charge anything as small or as simple as a penny - but degree courses aimed at domestic students are all priced at either Pounds 750, Pounds 1,600 or Pounds 2,800 a year. The government has imposed these rates. That is what it is willing to pay for courses and universities are to be forbidden from charging any top-up fees directly to students.

It is worth looking at the arguments for and against this peculiar form of price regulation. The pricing of university courses is important; the sector is blazing a trail in the reform of public services generally and in the redelineation of the state's role. The experience of the universities can teach us whether the state is capable of redelineating its role intelligently or not. The only other areas of public spending to have been subject to such dramatic reform in the past decade are pension provision and dental services. Every case study of public sector change provides a living laboratory test in the area of political economy.

So has the state delineated its role in higher education well? The answer appears to be "yes" with that one gaping exception: the curious "three price" rule, which effectively imposes homogeneous prices for what are manifestly heterogeneous products.

There are plenty of sectors where prices are regulated, from telephone charges to rail fares, but providers have been allowed, indeed encouraged, to let prices become more complicated. Telephone charges are now so complicated you almost need a degree to understand the bill; but they do at least reflect cost and ability to pay more accurately than they did. The regulator did not find it expedient to instruct BT to charge ten pence for all calls made on its system.

It is worth understanding why we are where we are in higher education pricing. If the state allowed universities to charge variable prices then students would have to pay variable amounts. Otherwise, all colleges would charge the maximum permitted in the knowledge that it is the government that picks up the tab. Could the government have made provision for students to pay variable amounts? Yes, in principle: it would be efficient to confront students with a price that reflects the cost of their course. No, in practice: it was a step too far, and would have aroused a good deal of opposition.

There is, though, one solid justification for restricting university prices. In the market for education people will, quite rationally, pay very high rates for the better universities, even if the price vastly exceeds the extra cost of teaching incurred by the better universities. It may be that in deciding the worth of a particular course or institution, students focus not on the absolute quality they get, but on the relative quality. They want the best, whether or not it is actually very good, or very costly to produce. As long as places at the best institutions are limited, the price of those places can be driven to extraordinary levels. The institutions concerned can make huge profits, which end up being spent on a few key faculty members whom they need to attract to persuade people they are the best.

Now, markets and price competition work much better when customers shop around for absolute quality rather than relative quality - and we are thus justified in at least restraining the right of universities to price freely. Does that mean we should limit ourselves to three prices? Of course it does not. There is no reason why we might not allow, say, five possible price bands in place of each of the three single prices now, with students bearing the extra cost of the more expensive courses they choose. Such a system would at least allow universities that wish to offer expensive faculty and teaching the possibility of doing so.

So what does the experience of the university sector tell us about public sector reform generally? It demonstrates three things: the subtlety of the arguments surrounding markets and where they work; the intricacy of design that is required to cope with the failures of markets; and the crudeness of design that the political system tends to generate. The great question is whether those crude and imperfect designs are a temporary step on the way to an ideal system or whether we are lumbered with them for good.

Evan Davies is an economics correspondent at the BBC and author of Public Spending, published next month by Penguin, price Pounds 8.99.