"So Nick, how come a free-market economist like you is acting like a central planner?"

I heard that a lot when I was an associate dean. Sometimes it was said to tease me. Sometimes out of genuine annoyance.

I had my reply ready.

"There are three ways to allocate resources. The market is best; soviet central planning is second best; and the Hobbesian State of Nature is by far the worst. And right now I'm trying to drag you miserable lot out of the Hobbesian State of Nature into soviet central planning. Maybe later I will try to get something like a market going".

The story out of Texas A&M has been doing the rounds of the blogosphere. Most seem to be against even reporting data on revenues and expenses of individual professors. God forbid actually using that data for anything.

The sarcastic response is too tempting: "You economics professors are all in favour of prices and markets for everybody else. But it would never work for economics professors, of course. Right."

But what I really want to do is switch roles and play a part I never get to play. It's now my turn to say: "You pointy-headed professors sitting in your offices don't have a clue about how resources actually get allocated in the real world of the ivory tower. I actually know something about it, because unlike you I've got the practical experience of actually doing it. You useless theoreticians don't have a clue. I see the big picture and you don't. So shut up and listen while I tell you what really happens."

That's what I'm going to do here.

Let's start with student/professor ratios. Whenever a professor (or student) opens his mouth to complain about student/prof ratios, it's almost guaranteed he will reveal he doesn't have a clue how student/prof ratios are determined. This is the first thing you need to understand about universities. Let me show you my little model.

Universities sometimes run a surplus or a deficit, but won't or can't do this forever. So let's cut to the chase, and assume total revenue = total expenditures.

Nearly all revenues come from teaching students, and are proportional to the number of students taught. It's basically a horizontal Average Revenue curve.(In my university, about 50% comes from student fees, and the other 50% comes from a government grant per student, which is effectively a voucher.) So total revenue = revenue per student x number of students.

Profs are the biggest expense. If you like, add in support staff, and classrooms and stuff, into some overall measure of teaching resources, and call it "profs". Total expenditure = expenditure per prof x number of profs.

After some very complicated mathematical economics, available on request, we can derive the equilibrium to this model as:

Students per prof = (expenditure per prof)/(revenue per student).

If the average prof teaches 4 courses and the average student takes 10, then just multiply by 10/4 to find the average class size. On average, there must be enough students sitting in the class to pay for the prof teaching them plus the classroom and all the other overheads.

A university can do almost nothing about revenue per student. It's set by the provincial government. Maybe we can lobby. Maybe if we bring in a bit more money in donations that would increase it a little. But basically it's exogenous. (OK, places like Harvard with zillion dollar endowments aside).

A university can do a little bit about expenditure per prof. Lower profs' salaries. Try to cut the electricity bill a little. But basically it's exogenous too. It's set by the market, with a bit of union power thrown in.

So, basically the student/prof ratio is exogenous to the university. The university can choose the number of students, and choose the number of profs, but it can't choose both at the same time. It can't choose the student/prof ratio.

When you hear a prof whining about the student/prof ratio, and demanding the administration hire more profs or let in fewer students, you can be fairly confident he is not demanding a cut in profs' salaries, or demanding profs teach more courses. So you can be equally confident he doesn't have a clue about how the student/prof ratio is actually determined.

OK. Now you understand the most important lesson about universities. Which is something very few profs or students understand.

Next, you have to understand that while the student/prof ratio is exogenous to the university as a whole, it is not exogenous to the individual prof, or to the individual prof's department. Here's where we enter the Hobbesian State of Nature: the war of all against all to get someone else to teach all the students that pay their salaries.

The individual prof wants a lower student/prof ratio. He can try to avoid teaching the big intro courses, and try to persuade the chair of the department to let him teach his own prissy little boutique course, preferably for graduate students, in his own little research area. Or just be strategically incompetent at teaching the large classes. So you see departments having a large number of small classes, taught by the most favoured profs, and a few very large classes taught by the less favoured or powerful. This distorts the distribution of class sizes. It's far too skewed. Plus, there's always the old standby. Too many students? Start doing some really hard stuff, and try to scare off some students to try to get the numbers down to what you think is best. Or just teach badly.

The individual department chair also wants a lower student/prof ratio. He can avoid putting on courses that attract lots of students. He can put limits on the number of seats in a class.

Each individual prof, and each individual department chair, can reduce his own student/prof ratio; but the overall student/prof ratio for the university is fixed exogenously. Their individual attempts must fail collectively. But their individual attempts nevertheless have some very undesirable consequences.

The supply of seats is determined by the individual department. But the demand for seats is determined centrally, by Admissions. Admissions is ordered to bring in as many students as are needed to pay the profs' salaries. But each individual prof and department wants to reduce the number of bums on seats in his course and his department.

The result is a classic case of chronic excess demand for seats. Just like in the old Soviet Union. Capitalist economies have chronic excess supply. Communist economies have chronic excess demand. My job as associate dean (because I made it my job) was to persuade, cajole, bribe, threaten, or bully departments into putting on enough seats for the bums that needed or wanted to sit in them. I was what the Russians used to call "the pusher".

The Chair of Department X only made enough seats available in Intro X for two-thirds the students who wanted to take Intro X. Students already majoring in X got a seat; but a lot of students wanting to take X as an option couldn't find a seat. Some had to take Intro Y instead, even though they preferred X, or would have been better at X.

The Chair of X actually had a fully worked out model which determined his choice of how many seats to create. He knew that a certain percentage of students who took Intro X would discover they liked X and were good at X, and would want to switch their major to X. But, with a given number of profs in X, any increase in students majoring in X would simply result in bigger class sizes in upper year courses. The Chair of X thought those classes were big enough already. So he restricted seats in Intro X to give him the upper year class sizes he wanted. And my job was to try to convince him to act in a way contrary to his own department's interests. I would argue that, in the long run, the number of professors he had was proportional to the number of students he taught. But I had no hard evidence to support this assumption. And he was worried about student/prof ratios right now.

The university as a whole faces a hard budget constraint. Individual departments face a soft budget constraint. Individual profs face none.

It's really strange trying to allocate resources efficiently where there's generalised excess demand.

You get gridlock, where one student has a seat in course X, wants a seat in course Y, but can't find one. And there's another student in course Y, who wants a seat in course X, and can't find one.

You get hoarding. Students grab a seat in any course that's open, even if they think they will probably not want it, just in case they do want it and can't find a seat later.

What's worse is that you get Clowerian spillovers. Walras' Law is totally false. The sum of the excess demand for seats can add up to anything whatsoever, because the student who can't get a seat in course A, will try to get a seat in course B instead, and if he can't will try for course C,…then maybe try course A again, and so on. So the central planner (that was me) trying to find out how many extra seats in which courses are really needed, hasn't got any idea. A notional excess demand for one seat in one course can create an effective excess demand for hundreds of seats all over the university. I am one of the very few economists who has actually seen the Barro Grossman supply-side multiplier at work, in real time. Create a couple more seats in one course, and seats suddenly start appearing in other courses all over the university.

The very worst case I saw was when Barney was cancelled. Barney, a very large first year course, about dinosaurs or something, was one of the most profitable courses in the university. And it was cancelled, by the department…..to save money. There was any number of prissy little boutique courses that could have been cancelled. But they cancelled Barney. We had to go all the way up to the VP Finance to get Barney a reprieve.

The problem is obvious. Barney made tons of money for the university. But the individual department saved money by cancelling Barney, since nearly all the students taking Barney came from other departments and faculties. The incentives just didn't line up.

And the solution is obvious too: make the money follow the students.

I first saw the solution in action in our Summer Incentive Plan.

Classrooms were close to capacity in Fall and Winter terms, but well below capacity in the Summer. If we taught more students in Fall and Winter, we would need to build more classrooms, which cost money. If we taught more students in Summer, we didn't. So marginal costs were lower in Summer. So the university set up a Summer Incentive Plan to give each of the four Faculties a share of the fees of any additional students they taught in the Summer.

The Dean of our Faculty was an economist. He decided that all the profits from the Summer Incentive Plan would flow through to the individual departments that succeeded in increasing Summer enrolment. What's more, he said he would underwrite any additional costs we faced in putting on extra courses to attract more students. Departments could win, but could not lose.

I was Chair of Economics at the time. I made the Dean explain it to me twice. When I was sure the Department could not lose, and could only gain money, I looked through the Calendar, and put on every single course for which I could find a qualified instructor. The Chair of Business did the same. We made a killing that Summer, and an even bigger killing the next Summer. So did Business. The other departments finally followed only after they saw that Economics and Business had spare cash to spend on all sorts of nice things, like seminars. And eventually students had lots of choice of courses to take in the Summer.

The Summer Incentive Plan worked very well in two Faculties, and failed in the other two. The problem was the Base Year Effect. The Faculty only got money for an increase in students compared to the base year. The two Faculties which failed to grow their Summer enrolments were stuck in a Poverty Trap, because they had been unlucky to have had abnormally hgh enrolment in the base year. And they got a bit confused about the distinction between average and marginal costs and revenues as well. They wouldn't hire more instructors to teach more courses unless they had the money to do so. And they never got the money to do so because they never put on more courses to attract more students. They never seemed to figure out that investing in an extra course that brought in more than 15 extra students would earn a profit.

But in my Faculty I now saw a big difference between Fall/Winter and Summer. There was never a shortage of seats in the Summer. Departments were hungry for students. They never complained that they didn't have the resources to teach extra students. They knew the resources would follow the students. The obvious thing to do was to extend the Summer Incentive Plan to Fall and Winter as well.

It eventually happened, but it took a long time to hammer out the details and implement it.

Was there to be a base year, so that only enrolments above the base would be rewarded, or should it be zero based? The former leaves existing disparities untouched, but a zero based plan would leave some parts stuck forever in a Poverty Trap, lacking the resources needed for a Big Push.

Should the money flow to Faculty Deans, or right down to Department Chairs?

How do we handle the fact that some students bring in more money than other students?

How do we allocate overheads?

Should we give less money for students enrolled in first year courses, and more for students enrolled in fourth year courses?

If an economics student takes a course in maths, how much money goes to Economics and how much to Maths?

Precisely what expenses would the Faculties and Departments be responsible for covering with their incentive money?

Our ad hoc Committee of Nerds (economists, mathematicians, statisticians, and accountants who knew how the university was run) grappled with all these questions. There were no easy answers. But we cobbled together some sort of workable compromise, and it was implemented last year.

It's far too early to say that it has worked. I'm no longer working as a central planner, or pusher. But the people doing those jobs tell me it has changed attitudes. Individual departments now want to attract students, and get more bums on seats. That's what I wanted it to do. Collectively they will still fail, of course. Because Admissions won't let in any more students. But the students we do let in will find it easier to get seats in the courses they wanted, and will have a better experience. The allocation will be determined more by demand, and less by supply. We will become an excess-supply economy, not an excess-demand economy.

Let me try to list some of the lessons I have learned:

1. An organisation that is officially a central planning economy really isn't. It's a mixture of central planning and Hobbesian State of Nature. This is really just the old Hayek story. Central planners lack the information, and lack the power, to get people to do the right thing.

2. It's hard, in fact impossible, to get prices right. You will always end up over-rewarding some activities, and under-rewarding others. The "market" will always fail.

3. That doesn't mean you should abandon prices. The prices you set will be wrong. But pricing everything at zero will be even more wrong.

4. But it does mean you can't rely wholly on prices. You will still need to order people around in some cases, and rely on their willingness to do the right thing in others. And you need to hold some money back so it can be allocated at the discretion of the central planner. (Funny, after writing this I realised it is the absolutely standard prescription for a mixed economy; you need some government spending and regulation, as well as personal ethics.)

5. Incentive plans aren't incentive plans. They are anti-disincentive plans. A department chair who doesn't give a damn still won't give a damn, because he can't put any of the incentive money in his own pocket. But a workable incentive plan will offset his strong disincentive to do what's right for the university.

6. Incentive plans aren't incentive plans. They are resource allocation methods. Central planners try to re-allocate resources to where they are most needed. So a department that gets more students gets more resources to teach them. All an incentive plan does is to formalise this resource reallocation into a clear commitment, that departments can rely on.

7. It's not enough (in some cases) to put the carrot in front of the donkey. You have to point to the carrot, tell the donkey it is a carrot, and that he can eat it. And work out marginal revenue and marginal cost for the donkey too. And repeat this several times. This is most true for departments in subjects that economists' prejudices tell us are less likely think like economists. All the usual suspects took a long time to figure out the Summer Incentive Plan and respond to it.

8. The biggest problem is the base year. Imposing a zero-based budget would mean a massive initial reallocation of resources, which you can't do; and some units would just give up, stuck in a poverty trap, if you don't give them any extra resources until they catch up with the rest. But using the current year as base means making an existing misallocation permanent.