The New Economics of Online Education

Let’s stipulate up front that there is an old model of online for-profit education that has completely failed. The old model is this: take everything that used to be done in person, put it online, charge for it. There are some programs along these lines that are still kicking, and some traditional universities have online programs, but it seems clear now that the future of online education does not lie here.

A large problem with this model is incentive-compatibility. The incentives of the online provider are to enroll as many students as possible, especially since students are often subsidized, and then to let standards slip so that the students pass. If most students fail, they will be angry, and the commitment to keeping standards high is not credible. High standards are not a subgame perfect equilibrium.

The reason most universities are not for profit is that the profit motive strengthens the incentive to let standards slip, although it should be noted that standard-slippage has happened, albeit more slowly, even at non-profit universities. The great success stories in for-profit education are those that generate easily verifiable skills. For instance, if you want to learn German, you are probably better off going to Berlitz than to Harvard. When you finish at Berlitz, you know whether you got your money’s worth because you know whether you know German; this solves much of the incentive-compatibility problem. If Berlitz taught English literature (to English speakers), I don’t think it would be as successful as Harvard.

Enter Udacity. Unlike many other online education providers, Udacity has not tried to simply replicate the old in-person education experience online. Rather, they are adopting an entirely new business model. First, they have a radically different cost structure than traditional providers. Udacity does its grading by AI, so the marginal cost of another student is basically zero. It has a much higher fixed cost per course, because it needs to train the AI to grade homework and exams.

Since Udacity’s marginal cost of a student is zero, it can give away the courses for free if it can find another way to cover its fixed cost. I perked up when I read this:

All classes are currently free, and the goal is to keep it that way. When asked how it will make money, [Udacity co-founder] Sebastian [Thrun] pointed out that recruiting good technical talent is something that companies pay for. Udacity knows who the best students are and could pass them along to companies looking for new hires.

In Silicon Valley, finding talent is so difficult that recruitment bounties are often as high as 20 percent of the new hire’s first-year salary. This provides an opportunity for a new revenue structure for online education: vertical integration into job placement.

Udacity can sell its database of high-performing students to recruiters from tech firms. They can survey these students to see if they are interested in a job before they do so to ensure that the database is high quality in the interest dimension as well. This database is a very valuable asset, one that seems likely to cover Udacity’s fixed costs.

I think the Udacity model can succeed in subject areas where:

  1. Skills command a large premium in the labor market.
  2. Employers can verify skills in the medium run, so that they can decide whether to continue to pay for Udacity-educated recruits.
  3. It is possible to evaluate coursework using artificial intelligence (we’re not there for writing yet).

Udacity has started out with classes on computer programming, because that is what its founders know, but they seem eager to expand to new subject areas. I wonder if economics will be one of them.

Socially, there are some advantages to the Udacity model versus the traditional university system. Perhaps most obviously, we can avoid a lot of the student debt crisis. Since classes are free, there is no tuition expense, and since revenue is constrained by the labor market, the skills taught will need to correspond to those that are valuable. We can also save a lot of money on government subsidies for higher education; indeed, cutting off these funds now would hasten the adoption of new education business models.

Speaking generally, new contexts allow for new business models. People are often slow to recognize these new opportunities. We need to make sure as a society that we are not locking in old business models and preventing change. This means giving up control and being willing to be surprised by the outcome.

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