Challenges and Responses to Business School Legitimacy: An Economics Perspective

Lynne Pepall and Dan Richards Department of Economics

Tufts University

lynne.pepall@tufts.edu dan.richards@tufts.edu

Abstract

Business school legitimacy has been increasingly questioned over the last decade. This challenge has at least two dimensions. One concerns the relevancy and legitimacy of business school research. The other concerns the relevancy and legitimacy of business school professional training. We develop a vertically differentiated model of the business school market that permits separate consideration of these challenges. While either challenge cuts into the bottom line of both elite and second-tier business schools, they can nonetheless lead to an expansion in business school enrollments. More generally, the model permits identification of which kinds of schools are likely to be most affected by which type of legitimacy challenge. Keywords: legitimacy, vertical differentiation, peer effects We thank Andrew Pettigrew, Donald Lessard, Morris McInnes, Bhaskar Chakravorty and participants at the 2015 EFMD Conference on the Legitimacy and Impact of Business Schools and Universities (Oxford) for helpful comments.

Challenges and Responses to Business School Legitimacy: An Economics Perspective

1. Introduction

What is the role of business schools today? What gives these schools “legitimacy” as

educational institutions? What value do they bring that makes their training worthy of its

considerable cost to their students? Such questions have been raised with an escalated

vociferousness in recent years. Scholars such as Pfeffer and Fong (2002), Bennis and

O’Toole (2005), Starkey and Tempest (2008), Podolny (2009), and Thomas and Wilson

[(2011) and (2012)], among others have energetically questioned the research and

teaching agendas and, indeed, the basic business model of business schools. In these

critiques, business school faculty are typically accused of either researching the wrong

things or teaching the wrong things or both.

This charge implicitly recognizes that the “legitimacy” question has more than one

dimension. As Thomas and Wilson (2011, 2012) among others have observed, business

schools may acquire legitimacy as an academic enterprise that produces knowledge via

recognized scholarship. They may also gain legitimacy as highly skilled educators in

which faculty teaching is professionally focused and emphasizes skills and techniques

directly linked and valued in business applications.

There may be some irony in proposing an economic model to address issues of

business school legitimacy given that a number of those questioning that legitimacy, e.g.,

Bennis and O’Toole (2005) and Starkey and Tempest (2008) claim that an economics-

and-finance driven research agenda together with viewing students as “consumers” is in

fact a large part of the “legitimacy” problem. We believe however that to have a thorough

1

discussion of the “business” of business schools, an understanding of the market place in

which that “business” is conducted is extremely helpful if not absolutely necessary.

While any economic model has its limitations, working through the logic of such a

model also has many benefits. First, it forces us to recognize critical features of the

business school environment such as the differentiation among programs as well as

among the students that they serve. This is important because it means that challenge to

business school legitimacy will not have the same impact on all schools. Second, an

economic model allows one to consider explicitly that educational legitimacy is measured

in more than one dimension as well as to understand how those dimensions are

interrelated. Finally, and critically, a formal model allows us to investigate the strategic

response of business schools to legitimacy challenges. Working through those responses

in the strategic environment of the business school market—even in our simple model—

can lead to surprising results. For example we show that the strategic response of

business schools can, in some case, result in MBA programs actually enrolling more

students at precisely that moment that their legitimacy comes into doubt.

We describe our economic model of business school competition intuitively here, and

present the formal model in a brief appendix. The next section outlines the model’s basic

features while Section 3 describes the equilibrium or market outcome these features

imply. The impact of different challenges to legitimacy and the consequent strategic

responses are discussed in Section 4. Some brief concluding remarks follow in Section 5.

2. A Model of Business School Competition and the Quest for Legitimacy

2.1 A School Needs Students But Not all Students are the Same

There is considerable debate about whether business schools are academic institutions

2

producing new knowledge, or instead, are business organizations seeking to maximize

profit. One fact is common to either view however, namely, that each business school must

attract students willing to pay the tuition fee that the school has set. No institution can call

itself a school that does not enroll students. Few institutions can survive unless students

contribute to the cost of their education.

Yet while students are a necessary constituency for any business school, not all

students are the same. Some students are well prepared to succeed in a degree program

because of their innate talent, prior training, motivation or a combination of these and

other factors. Others are less able and hence less likely to reap the full benefits that a

school’s degree program offers. We recognize this feature in our model by assuming a

uniform distribution of students, differentiated in terms of their abilities to benefit from a

school’s degree program. We index this skill level by the parameter θ. At the top of the

distribution, the very best students (θ = 1) have a probability equal to 1 to benefit from

everything the school has to offer by way of an educational experience. At the bottom (θ =

0), are those students who really can get very little—essentially nothing—from a school’s

business degree program. All others lie between these two extremes.0F

1

2.2 Some Measure of Ranking Matters—to Schools as well as to Students

Generally speaking, those who get more out of a product are willing to pay more for it.

Moreover, such differentiation among consumers’ values will typically lead to a

differentiation in the products offered in the market place , [Shaked and Sutton (1982)].

The reasoning is straightforward. Take the business school market. If two schools offer

1Interestingly, simulations of our model calibrated to roughly coincide with market outcomes yield an average θ value across all management students of about 0.63. This implies that about 37 percent of the educational value schools offer is not realized by students. This is tantalizingly reminiscent of the finding cited by Alvesson (2015) that 40 percent of US students do not improve intellectually during their education.

3

the identical management training, any difference in price will sway all students to prefer

the cheaper program leaving the higher-priced school out in the cold. This will then

induce that school to cut its tuition price below its rival but now, for exactly the same

reason, its rival will be the outsider. Now the rival will cut tuition and so on. In short,

when two schools or any two firms compete in a market with identical products, price

competition is greatly intensified. To avoid this outcome, firms or schools in this case

have a strong incentive to soften the competition and segment the market by offering

different products—different kinds or different qualities of degree programs.

For simplicity, we use a duopoly model and so have two business schools offering two

different degree programs. One school offers a higher quality of program than its rival. We

denote the quality of a school’s degree program by the parameter vi, i = 1,2 and assume

that v1 > v2. We refer to the former, higher quality program as the elite school and to the

latter as its less-selective rival. The less selective school corresponds to what Bennis and

O’Toole (2005) among others call the “second tier”. The difference in quality of degree

programs is perceived or known to potential students.

What a student gains from the school’s degree will depend on the program quality as

well as on the skills and talents that the student brings to the program. Matching student

type to school we denote by θvi the benefit that a student of skill level θ will obtain from

attending a business program with quality vi. Thus, any given student (any given θ) will

gain more from attending a higher-quality school—a school with a higher v.

Of course, it is difficult to give an absolute quantifiable measure of v to any school. For

our purposes however, all that is needed is a relative measure so that students are able to

rank one school above the other. Whether this ranking is provided by the Financial Times,

4

US News, or some other source is less critical than the fact that some such ranking exists, at

least in the eyes of potential students. A relative comparison of degree quality is all that our

model requires. Note though that focusing on a ranking or relative measure has the further

advantage of allowing us to consider the quality of the less-selective school v2 relative to

that of the elite school v1, by normalizing the latter to 1. In other words, v2 = 0.8 would

imply that second tier schools offer a management program that is 80 percent as good as

that of an elite institution.

All students gain more from attending an elite school rather than a second-tier one.

However, the best or high θ students gain more from attending the elite program than do

less talented students. Thus, if the elite school charges a higher tuition, it will attract

those who can best afford that expense, namely, the highly-skilled (high θ) students who

get the most from its offerings.

2.3 Peer Effects are Real, Especially for “Elite” Schools

It has been increasingly recognized in the education literature that the ability of a

student’s peers (the θ’s in our model) is an important determinant of the student’s own

success. Since the pioneering work of Hoxby and Weingarth (2005), it has also been

increasingly recognized that this impact is especially strong for high-ability students. Lavy,

Paserman, and Schlosser (2007) find that high ability students in Israeli schools benefit

from the presence of other high-ability students but that this effect does not translate to

less capable students. More recently, Imberman, Kugler, and Sacerdote (2009) use the

natural experiment provided of student transfers induced by Hurricane Katrina to show

that high-achieving students are the ones that benefit the most significantly from the

arrival of other high-achieving students.

5

We incorporate peer effects at the elite institution and assume that their value or

importance of peer effects in the value of the degree declines as that school expands

enrollment to include less talented students. This gives the elite school a strong reason to

be selective in admissions. The importance of peer effects to the elite school mitigates the

incentive of the elite school to cut tuition and “steal” students from its lower quality rival.

Enrolling these students –who are less prepared or able to benefit from the elite school’s

curriculum—decreases the value of peer effects and therefore lowers the overall value of

the elite school’s degree program.1F

2

2.4 Scholarship and Transforming Student Lives Yield their Own Reward

Competition in the business school marketplace leads to differentiation among

programs. This is of course not unique to management education. Law schools,

seminaries, and undergraduate institutions differ notably in the academic package they

provide. An important point, emphasized by Hoxby (2014), is that elite educational

institutions are distinctive because they not only teach and transmit knowledge but they

are as well leaders in research and producing new knowledge. While scholarship has had

growing importance at all management schools, the dichotomy between research-

intensive and teaching-intensive schools still remains. Even as late as 2008, the AASCB

Report on Research Impact noted that less than half of the business schools surveyed

valued research as much as teaching, and so business school programs are differentiated

in terms of the research intensity of their faculty.

2In the canonical vertical differentiation models of Mussa and Rosen (1978) and Gabsewicz and Thisse (1979) if marginal cost is constant and independent of quality, the firm with the highest-quality product also has the largest market share. The peer effects mechanism can reverse that result. [See also, Shaked and Sutton (1982).]

6

To be sure, the value of business school research is itself part of the legitimacy

question. Yet there is good evidence that faculty scholarship can transform students’

educational experiences for the better. Research-active faculty are able to generate value by

transferring to students new knowledge or findings directly acquired from their own research or

from the latest developments in the field that may only be known and understood by such

faculty. In addition, faculty engaged in research can engage their students in the research

process, adding a research dimension to their educational experience. That engagement can

give students a “competitive edge” [Morgeson and Nahrgang (2008)]. Studies such as

O’Brien et al (2008, 2010) and Rindova et al (2005) are just some of those finding that

business faculty scholarship has a positive impact on subsequent MBA salaries.

Financial rewards to the research agenda of business schools may come through

various avenues. First, the scholarship may generate outside funds via grants and other

awards. Few achievements better establish a school’s scholarly standing than research that

wins competitive funding from prestigious peer-reviewed organizations such as the US

National Science Foundation. Second, and perhaps of more importance for management

programs is the fact that financial support from private foundations and companies serves

as a testament to the relevance and “cutting edge” quality of a school’s scholarship.2F

3 Third,

the research-based educational experience offered can transform student experiences and

lead to future alumni donations. This is consistent with empirical evidence in Becker et al

(2003) that students value faculty research when making their enrollment decisions and

3We are not saying that all research that receives funding passes the double hurdle of rigor and relevancy first emphasized (among other hurdles) by Pettigrew (1997, 2001). We are simply saying that research that meets these standards can generate funding. We are also saying that student involvement in such research activity can itself be valuable as an educational experience that, when looked back upon, can prompt donations.

7

that higher quality students value research more than less talented students.3F

4

Alumni donations can, in fact, be viewed as part of a “trust” game in which research-

active faculty first provide an exceptional experience beyond basic education and later

receive a “payment” by way of a donation—after alums have realized the value of that

training. That is, the education-first donation-later game can be viewed as a quality

assurance mechanism in which alumni only make the later donation if the educational

experience is validated by their experience after graduation. Indeed, John Byrne, editor of

the Poets & Quants website devoted to business school topics, has written that alumni

donations are perhaps the single most “telling number to judge the strength of a school’s

alumni network” as well as student satisfaction with their education. (Byrne, 2011).

Scholarly achievement is one dimension of the quest for academic legitimacy, earning a

business school an equal place in the academy with more established scholarly disciplines.

While many schools may seek this validation, we believe it is a particularly distinguishing

feature of elite schools for two reasons. First, the pressure on the business school to match

the scholarly prestige of faculty in other disciplines—Arts, Sciences, Law, Engineering, and

Medicine—is likely strongest at institutions such as Harvard, Oxford, Yale, and Chicago.

Second, both the ability to translate cutting edge research into students’ classroom

experiences and to engage students in the research experience depends on the quality of

the students themselves and this is greatest at the elite institutions.4F

5

To put it another way, because better students get more from their educational

4As Becker et al (2003) note this sets up a positive feedback loop. Elite schools attract the best students who are best able to support research-active faculty. In turn, this research generates the grant and donation income that enables elite schools to continue to attract the best students (and faculty). 5Our model incorporates the quality (θ value) of the students as one of the inputs into the research process. By this means and also via the peer effects term, the model envisions students as education producers as well as consumers.

8

program and therefore go on to better jobs, and because higher-quality students are better

research participants, it is likely that the value of both alumni donations and research

grants will be positively associated with the overall quality (the average θ) of a school’s

student body. When these factors are combined with the pressure for scholarship at the

best universities, it makes sense that the quest for scholarly legitimacy is most pronounced

at the elite business schools. In fact we observe the elite school, such as Harvard, Oxford,

Tuck and Yale not only enroll the top students, but also lead the way in terms of both

alumni donations and research rankings. [Byrne (2011) and Financial Times (2015)].

The donation and grant revenue at the elite business school then influence competition

in the business school market in two, mutually reinforcing ways. First, it provides another

compelling reason for elite schools to enroll the top quality (high θ) students in addition to

the “peer effects” factor mentioned previously. Second, by providing an additional source

of income, it makes elite schools less directly reliant on tuition income. Together, both

these factors soften price or tuition competition in the business school market. Elite

schools do not seek to expand aggressively their enrollments by cutting tuition because this

would ultimately lead to admitting less qualified students, which in turn would lower the

quality of its alumni network and reduce the school’s scholarly reputation.

3. Putting It All Together: Equilibrium in the Business School Market

The basic features characterizing the market for business school degrees underpin how

business schools compete for students. In our model, we investigate this competition in a

simple duopoly model in which there is one elite institution competing with one less

selective one. The elite school earns revenue from tuition and alumni or external

donations, whereas the non-selective school only earns tuition revenue. On the cost side,

9

the majority of each school’s costs are basically fixed (tenured faculty and facilities).

Admittedly, the elite school is likely to have greater overall fixed costs (more expensive

faculty and facilities). Yet each school plausibly has the same variable cost of admitting one

more student. This is assumed to be constant and for simplicity set equal to zero.

Each school chooses its tuition rate (t1 for the elite school and t2 for its less selective

rival) to maximize revenue in order to cover its fixed costs. We then solve for a Nash

equilibrium in tuition prices. We examine the features of a market equilibrium as well as

explore how that equilibrium changes with changes in the environment including, most

especially, threats to business school “legitimacy.”5F

6

Three key parameters determine the nature of the outcome. These are: 1) the relative

educational value v2 of the less-selective school; 2) the intensity of peer effects at the elite

institution; and 3) the strength of the connection between student quality and

grants/donations at the elite school. For roughly 90 percent of the feasible values for

these parameters, the outcome is a selective equilibrium. By this we mean that the elite

school enrolls fewer students6F

7, charges a higher tuition, and provides educational training

that provides a gross or pre-tuition value (considering peer effects) for any students it

enrolls that exceeds what that student could obtain at the second-tier school.7F

8 Of course,

6This behavioral assumption seems consistent with the assumption of many critics, e.g., Pfeffer and Fong, (2002), Starkey and Tempest (2008), and Pfeffer (2015) that management programs are viewed as “cash cow” by universities. It is not to say that business schools should act as revenue maximizers. In principle, we can model schools as having a richer set of objectives as implied by a Balanced Scorecard approach [see Thomas (2007)]. However, as Ferlie et al (2008) recognize, even business schools with broad public interest objectives will need to meet the funding challenge of somehow generating sufficient funding to cover costs 7 While this may be a sensible result, it is worth noting that in the economics literature on vertical differentiation, a standard result of models in which rivals have the same marginal cost as here, is that the elite or high-quality firm wins the lion’s share of the market. It is the peer effects and outside donation and grant income factors that reverse that result here. 8 According to US News, the top 10 highest tuition Business Schools are: Stanford, Harvard, Wharton, Chicago, MIT, Northwestern, Berkeley, Columbia, Dartmouth and Virginia.

10

in all such equilibria the top quality (high θ students) attend the elite institution. In short,

the selective equilibrium in our model captures the broad dimensions of what we observe

in the actual marketplace. Additional insights follow immediately.

First, as noted above, outside income by way of alumni donations and grants works to

soften tuition competition between the elite and its less-selective rival. In other words,

better grantsmanship or just greater giving by elite alumni to their former school leads to

higher tuition prices overall, a result also found in Peña (2010) for a related but somewhat

different reason.8 F

9 Greater access to alternative grant and donation income gives the elite

school a greater incentive to maintain the quality of its research environment, creating

“peer effects” or an educational experience that its students feel is transformative and that

could not be achieved without the institution. In turn, this makes the elite school less

willing to pursue additional tuition revenue by cutting its tuition fee to attract more but

less capable students. Yet the higher the elite school sets its tuition t1 the higher the tuition

t2 the less selective rival sets as well.9F

10

Second, any increase in the value of peer effects will make it more important for the

elite institution to focus on enrolling only very high-quality students. This has a similar

impact. It reduces the intensity of tuition competition between the two schools. If the

value of having a high average-quality (high θ) student body rises, the elite school will

raise its tuition even higher to insure that only those students with a high expected

benefit from obtaining a degree will be willing to pay the higher tuition. Yet once again,

9In Peña’s model, the donated (or possibly grant) funds are spent on any items—classrooms, IT, meal services, recreational facilities, etc.—that raise the value of the educational product to students and thereby makes them willing to pay more. 10 Tuition prices t1 and t2 are strategic complements meaning that the best response or reaction curves of each school slope upward. Thus, school 1’s best response to a rise in t2 is to raise t1, and likewise for school 2’s best response or reaction to a rise in t1..

11

when the elite school raises its tuition, its less selective rival will do the same as price

competition in the market has been softened.

Finally, it is important to note there is a segment of potential business school students

who choose not to enroll at either institution. These are students with less ability i.e., the

lower θ students. It is not the case that such students would not benefit from

management training. It is instead that in this market, they would not benefit sufficiently

to justify paying the tuition that either the elite or less-selective school is charging.

4. Challenges to Business School Legitimacy

We can use our model to work out the implications of two distinct challenges to

academic legitimacy in the business school market. We first consider what happens when

the research mission comes into question. We then consider what happens when the

value of the basic skills training offered by both the elite and the less-selective school fall

relative to some other business training alternative, e.g., in-house business training or

perhaps new alternative competency-based management programs.

4.1 Doubts About the Legitimacy of Business School Scholarly Status

When the elite school’s claim to legitimacy as a producer of rigorous and relevant new

ideas falls, its ability to convince external organizations to fund its research mission and to

persuade students that their education is professionally transformative falls as well. This

loss of grant and donation income then has consequences for the competition for students

and tuition revenue between the elite school and its less-selective rival. In particular, it

induces the elite school to pursue tuition revenue more aggressively by cutting its price.

The reaction of the less-selective rival is to cut its tuition as well. In general, the less-

selective schools’ reduction will be smaller but the strategic complementarity of tuition

12

fees means that both fall. For example, a ten percent decline in grant and donation funding

typically leads to a five percent decline in the elite tuition and a three percent decline in the

less-selective tuition. Both schools expand enrollment, but the elite school expands slightly

more so that its share of the enrolled student population rises a bit.

The most interesting result though is that, with both tuition prices falling, more

potential students are induced to incur the expense of a business school education. The

expansion in percentage of the student population enrolled is on the order of three

percent. This is not to say that the loss of research legitimacy does not hurt. Both schools

see a revenue decline of say six (less-selective) to eight (elite) percent.10F

11 Yet the general

expansion in enrollment across all schools is perhaps even more important. It means that

business school enrollment expands even as the business school claim or value as a

legitimate scholarly enterprise declines.

4.2 A Fall in the Relative Value of Business School Training

In our initial market equilibrium, there is no alternative to the two types of business

schools. This is a simplification but a useful one in that it captures a setting in which, at

least in the eyes of potential students, a business school has a legitimacy that say in-house

corporate and other programs lack. In practice, that legitimacy may come from being part

of an actual university. This gives the school the same organization—faculty,

administrators, classes, grading, and diploma ceremony—as the larger university of which

it is part. In turn, this tends to validate the business school as a true educational enterprise.

Further, as a state or non-profit institution, the business school has some built in “quality

assurance” owing to the need to protect the reputation of the entire academic enterprise.

11If the schools were just breaking-even before the decline, this would clearly require retrenchment in the long-run. Our impression however, is that most business schools currently earn a surplus.

13

Relative to say a for-profit institution, it will be less likely to “rip off” consumers by

providing worthless training that leads to few if any job opportunities.

However, saying that there is no management-training alternative to the standard

business schools is not the same as saying that no such alternatives exist at all. In fact, in-

house management training programs have been around for some time. Other

alternatives, such as private, for-profit schools are also available. What our initial model

implicitly assumes then is not that these other programs do not exist but that the training

they provide has no marketable value relative to that of the MBA degree. The alternative

yields no credentialed diploma or certificate that can credibly signal a graduate’s learning,

skills, and value to potential employers. This kind of training is not a competitive

alternative for potential business school students.

Yet the situation can change, and we consider an innovation that catalyzes such a

change. In particular, we examine the impact of a decline in the value of the traditional

university-affiliated business degree relative to that of some alternative business training.

Working in relative value terms means that we can introduce this change either by

lowering the intrinsic value (the v’s) of our two initial schools or, by raising the value of a

third alternative above its implicitly assumed value of zero. We choose the latter

approach, as it is analytically a easier to work with.

Specifically, we introduce a third business training program that offers a certificate with

intrinsic value v3 > 0 such that a student with skill level θ receives a benefit of attending

this new type of training equal to θv3. The certificate does not have the same status as the

diplomas of either of the established schools; that is, v1 = 1 > v2 > v3. Ignoring tuition, any

student will gain more from attending either the elite or even the less-selective business

14

school than s/he will from attending this new alternative.

However, what motivates a student to attend any program is the net benefit—the

benefit less the tuition fee. When v3 was initially set equal to zero, this third alternative was

not viable because it could never provide a positive net benefit even if it charged zero

tuition. Once the credential has positive value (or once the relative values of the traditional

schools falls), the third alternative is able to market its program at a low but positive price.

The alternative program can begin to compete for students with the more established

institutional rivals.

The immediate impact of this decline in the legitimacy and value of the standard

business school training is quite surprising because it depends critically on the pricing

strategy of the non-management school alternative. If we assume that the alternative

institution prices optimally to maximize revenue, it will charge a tuition price higher than

marginal cost (which like the elite and the nonselective schools is assumed to be zero)

and this sets in motion a complicated set of reactions. To understand these, it helps to

recognize that in the initial market outcome v3 = t3 = 0 and so, the non-business school

tuition t3 = 0 was in fact equal to marginal cost. Now relative values have changed and

value v3 > 0 leading to a tuition t3 > 0, i.e. greater than marginal cost.

Because the business training alternative sets a tuition price t3 that is now higher

relative to its marginal cost than it was previously, it further softens the pressure on price

relative to cost for the two initial institutions, and both raise their tuition fees a bit

further. Because of both peer effects and its research mission, the elite school tuition rise

allows it to cut back on enrollments and raise student quality, thereby increasing its grant

and donation income slightly. Again, this induces a similarly small tuition increase by the

15

less-selective school. The effects are not large relatively speaking—on the order of two to

five percent. Moreover, while the overall revenue of the elite school is relatively

unchanged by the arrival of the non-business school alternative (it loses some tuition but

gains some donation and grants), the revenue of the less-selective school that competes

more directly with the new alternative falls by nearly ten percent. Its enrollments shrink

by nearly 20 percent. So, this new competition does hurt. That pain though is

concentrated at the second-tier level.

However, the foregoing scenario may not be what those who fear a loss in the

legitimacy of traditional management schools have in mind. Critics such as Mintzberg

(2004), Pfeffer and Fong (2002), Starkey and Tempest (2008), Podolny (2009), and Thomas and

Wilson (2011) appear, in part at least, to fear a more general collapse in the perceived relative

usefulness of such training. One way to capture such a more general collapse is to imagine

instead that the third alternative, valued at v3 > 0, is provided competitively—by lots of firms

doing in-house training or many for-profit schools. If so, that competition will drive the price of

the valued alternative back to marginal cost (= 0). If this happens then the outcome will likely be

very large for both schools but the impact will still reflect an important differential between elite

and non-selective schools.

The immediate neighbor—so to speak—of the new training alternative is the less-selective

management program that now faces severe price competition. As a result, it must cut its tuition

quite dramatically. The elite business school will now feel this new price competition from its

less-selective rival and respond with a tuition price cut, as well. However, it is inhibited from

responding aggressively because again, it is reluctant to lower the average quality of its student

body owing to peer effects and research funding. This reluctance to cut price means that the

16

tuition gap between the elite school and its second-tier rival widens, leading more students to

abandon the former and switch to the latter. The elite program is left with a small but highly

talented cohort while the enrollment in the less-selective program actually expands. Overall, the

elite business program loses more students but as this raises its average student quality and thus

the educational value that it offers, its revenue loss is relatively small. By contrast, the less-

selective program’s steeper price reduction allows it to keep its enrollments fairly close to their

original level. It loses students to the new rival but gains some from the elite school. The steep

tuition price cut though necessary to achieve this means that its revenue falls. In the typical case,

it falls by close to 20 percent.

It is in this context that we can perhaps understand a further strategic response to this

loss of legitimacy as providers of professional training at traditional business schools,

namely, the move to online education. Education delivered at a distance via the medium of

the Internet may not have the same value or legitimacy in the eyes of potential students as

the standard brick-and-mortar programs. Yet it may be seen as at least equivalent to or

better than alternative, non-business school training if offered at the right price.

To be sure, once either the elite or less-selective standard schools start offering online

degrees, they begin to compete with their brick-and-mortar selves as well. Yet the only

option may be to lose many of these students either to alternative, non-MBA business

training or to one’s traditional rival who is cutting prices to compete with these non-school

alternatives. In short, the recent growth of online MBA programs, including those at highly

ranked schools such as Illinois-Champaign Urbana, may be seen as a strategic response to

the loss of legitimacy or relative value of traditional business education. This response may

also expand the overall number of MBA students once online programs are included.

17

5. Summary and Concluding Remarks

Questions regarding the legitimacy of the business school business have been raised for

some time but have taken on increased intensity and urgency in recent years. Such

challenges have at least two dimensions. One is the legitimacy of the business school as a

scholarly enterprise producing as well as disseminating knowledge on an equal footing

with the research mission of other academic institutions such as STEM programs, laws

schools, and medical schools. A second concern queries the value of the basic business

school training. Independent of any new knowledge that business faculty may produce, is

the existing knowledge that they transfer to students in MBA programs truly worthwhile?

We have approached these issues in an economics framework. Specifically, we have

built a formal model that captures the important dimensions of the business school

market. These include: 1) product differentiation among schools; 2) differences among

students in their ability to realize the benefits that a business school education offers; 3)

peer effects in learning; and 4) the potential for grant and donation income to augment

tuition revenue significantly at top institutions. For the most part, we work with a simple

duopoly model with one elite and one second-tier school. However, we later consider the

entry of a third alternative to an MBA program.

Our model suggests that the impact of challenges to business school legitimacy

depends, inter alia, on whether the challenge is focused on business school research or,

instead, on the transmission of professional management skills and competencies. In the

former case, the loss of legitimacy affects mainly the elite schools where large

investments in research activity have been made. Yet, in this case it is noteworthy that

the market response is for both schools to cut tuition and thereby expand business school

18

enrollments overall. In the second case, there is a fall in the perceived relative value of

the MBA professional training. Business school enrollments can shrink overall but it is the

second-tier programs that are now at risk in terms of revenue shortages.

This second challenge to legitimacy also raises the possibility that the longer-run

strategic response of business schools may include an expansion of online education

offered at a greatly reduced tuition price. In the absence of a challenge to their

pedagogical legitimacy, offering less expensive, online education would not be a wise

strategic choice as it largely steals students from existing brick-and-mortar programs.

However, when the value net of tuition cost for traditional programs falls relative to that

of non-business school alternatives, the strategic calculus changes. The online education

option can soften the blow because while potential students may not value the online

experience that highly, they will still find it attractive at a sufficiently low tuition rate, and

it is better to collect that revenue than to lose these students altogether.

Our model is a simplified version of the business school market and alternative

models may yield different insights. We certainly do not claim that our model is the

fundamental truth. We do claim however that the practice of modeling the economic

forces underlying business school competition is itself a valid and important exercise. It

permits one to identify the different challenges to legitimacy as well as to investigate the

strategic responses that these induce. Business schools and indeed law and other

professional schools may well be facing a legitimacy challenge. Precisely what kind of

challenge though and which schools are most threatened can only be understood by

establishing an analytical framework that permits explicit consideration of these issues.

19

6. References

Alvesson, Mats (2015). “Logics of Higher Education: Qualification, Customer-Satisfaction, or

Looking Good.” Presented at EFMD Conference on “The Legitimacy and Impact of

Business Schools and Universities.” Oxford, UK, 3-4, June.

Becker, E., C. M. Lindsay, C.M., and G. Grizzle, G. (2003). “The Derived Demand For Faculty

Research.” Managerial and Decision Economics, 24(8), 549.

Bennis, W. and J. O’Toole. (2005). “How Business Schools Lost their Way.” Harvard Business

Review, 83 (May) 96-104.

Byrne, J. (2011). “The Best B-School Alumni Networks in the U.S.” Poets & Quants.

http://poetsandquants.com/2011/05/30/best-b-school-alumni-networks/

Ferlie, E., G. McGivern and A. De Moraes. 2010. “Developing a Public Interest School of

Management.” British Journal of Management ,21: S60-S70.

Gabsewicz and Thisse (1979). “Price Competition, Quality, and Income Disparities.” Journal

of Economic Theory, 20 (June) 340-59.

Grilo, I, O. Shy, and J-F. Thisse (200). “Price Competition When Consumer Behavior Is

Characterized By Conformity Or Vanity.” Journal of Public Economics 80, (September), 385-

408.

Hoxby, C. and G. Weingarth (2005). “Taking Race Out of the Equation: School Reassignment

and the Structure of Peer Effects.” Mimeograph.

Imberman, S., A. Kugler, and B. Sacerdote (2009). “Katrina’s Children: Evidence on the

Structure of Peer Effects from Hurricane Evacuees.” American Economic Review, 102

(August), 2048-82.

Lavy, V., M. D. Paserman, and A. Schlosser (2007). “Inside the Black Box of Ability Peer

Effects: Evidence from Variation in the Proportion of Low Achievers in the Classroom.”

The Economic Journal, 122 (March), 208-37.

20

Mintzberg, H. (2004). Managers not MBAs: A Hard Look At The Soft Practice Of Managing

And Management Development. San Francisco: Berrett Koehler

Morgeson, F. and J. D. Nahrgang (2008). “Same As It Ever Was: Recognizing Stability In The

Business Week Rankings.” Academy of Management Learning & Education, 7: 26-41.

Mussa and Rosen (1978). “Monopoly and Product Quality.” Journal of Economic Theory, 18

(September), 301-17.

O’Brien, J.P., P. Drnevich, and T. Crook (2008). Does Business School Research Add

Economic Value For Students? Proceedings of the Academy of Management, Anaheim, CA.

_______, _______, _______, and C. Armstrong (2010). “Does Business School Research Add

Value for Students? Academy of Management Learning & Education, 9 (December), 638-51.

Peña, P., 2010. “Pricing in the Not-for-Profit Sector: Can Wealth Growth at American Colleges

Explain Chronic Tuition Increases? Journal of Human Capital, 4(3), 242-73.

Pettigrew, A. M. (1997a). ‘The Double Hurdles for Management Research’. In: T. Clarke (ed.),

Advancement in Organizational Behaviour: Essays in Honour of D. S. Pugh, Dartmouth

Press, London, 277-96. Pettigrew, A. (2001). “Management Research After Modernism.” British Journal of

Management, 12: 61–70.

Pfeffer, J. (2015). “Business School Legitimacy: How the Naked Emperor Perseveres.”

Presented at EFMD Conference on “The Legitimacy and Impact of Business Schools

and Universities.” Oxford, UK, 3-4, June.

Pfeffer, J. and C. Fong (2002). “The End of Business Schools? Less Success than Meets the

Eye.” Academy of Management Learning and Education, 1 (September), 78-95.

Podolny, J. M. (2009). “The Buck Stops (and Starts) at Business School” Harvard Business

Review, 87 (June), 62-70.

21

Rindova, V. P., Williamson, I. O., Petkova, A. P., & Sever, J. M. 2005. Being good or being

known: An empirical examination of the dimensions, antecedents, and consequences of

organizational reputation. Academy of Management Journal, 48(6): 1033-1049.

Shaked, A. and J. Sutton. (1982). “Price Competition Through Product Differentiation.”

Review of Economic Studies, 49 (January), 3-13.

Starkey, K. and S. Tempest (2008). “ A Clear Sense of Purpose? The Evolving Role of the

Business School.” Journal of Management Development , 27 (July), 379-90.

_________, and A. Pettigrew. (2015). “The Legitimacy and Impact of Business Schools.”

Academy of Management Learning and Education, Special Issue, forthcoming.

Thomas, Howard (2007). “Business School Strategy and Metrics for Success.” Journal of

Management Development. 26 (January), 33-42.

_________ and A. Wilson (2011). “Physics Envy,” British Journal of Management, 22

(September), 443-56.

________, and _______ (2012) "The Legitimacy of the Business of Business Schools: What's

the Future?", Journal of Management Development, 31 (July), 368 - 76

7. Appendix: A Formal Model of the Business School Market

We consider a simple duopoly model with vertically differentiated business programs.

There is a mass of N students, each indexed by the parameter θ i indicating student i's

ability to reap the benefits of a particular institution’s business program. θi is assumed to

be uniformly distributed between 0 and 1. For further simplicity, N is normalized to unity

so that market demands at each school are equivalent to the percentage of students

served.

The two business degree programs are vertically differentiated. The elite school offers

an educational product of intrinsic value v1. It’s less selective rival offers a lower ranked

22

product of intrinsic value v2 with v1 > v2 > 0. We normalize and set v1 = 1, so that v2

measures the intrinsic value of the less-selective school relative to that of its elite rival.

The expected utility of a student i attending the elite institution and incurring tuition cost t1

net of any scholarship funding is:

𝑈𝑈𝑖𝑖 = 𝜃𝜃𝑖𝑖𝑉𝑉1 − 𝛼𝛼𝑋𝑋�1− 𝑡𝑡1 (A1)

Here 𝑋𝑋�1 is the expected number of credentials or degrees conferred at the elite institution. The

greater is 𝑋𝑋�1, the less selective the elite school is and the lower is its average student quality.

This in turn, lowers the value of the education each student receives because of “peer effects”

and the parameter α is a measure of the importance of these effects.

There are no peer effects at the non-selective institution. Hence, a student’s expected

utility of attending the less selective business program at tuition cost t2 is:

𝑈𝑈𝑖𝑖 = 𝜃𝜃𝑖𝑖𝑉𝑉2− 𝑡𝑡2 (A2)

These utility functions imply the existence two marginal students for any set of tuition

prices t1 and t2. The first marginal student denoted by is such that the student is indifferent

between attending the elite school and its less selective rival. The second marginal student

denoted by is such that the student is indifferent between attending the less selective rival

and not attending a business school at all. These marginal θ values are defined by the

following three conditions:

(A3)

23

Given the assumptions of a uniform distribution of θ and N = 1 the demand functions facing the

high quality and low quality institutions are given by:

𝑋𝑋1(𝑡𝑡1, 𝑡𝑡2) = [1 − 𝜃𝜃�1(𝑡𝑡1, 𝑡𝑡2)] (A4) 𝑋𝑋2(𝑡𝑡1, 𝑡𝑡2) = [𝜃𝜃�1(𝑡𝑡1, 𝑡𝑡2) − 𝜃𝜃�2(𝑡𝑡2)]

We assume that students have rational expectations about the enrollment of institutions, which

as in Grilo, Shy and Thisse (2001), is equivalent to assuming that the institutions announce and

commit to their net tuition charges, 𝑡𝑡1 and 𝑡𝑡2 before students enroll.

We treat the total costs at each school as essentially fixed (capital facilities and

tenured faculty) and denote these as F1 and F2. Each school earns tuition revenue equal to

its tuition fee times the number of students, either X1(t1, t2) or X2(t1,t2) it enrolls. In

addition, the elite school earns research grant and alumni donation income that depends

positively on the overall skill level of its students, , which increases monotonically

with the last or marginal student admitted to the elite school. For simplicity, we assume

= , where D is a positive parameter. Consistent with our earlier normalizations, we

restrict the parameters α and D to satisfy: 0 < α < 1; and 0 < D < 1.

Each school seeks maximizes revenue net of costs or solves:

Elite School: max𝑡𝑡1 𝑡𝑡1�1 − 𝜃𝜃�1(𝑡𝑡1, 𝑡𝑡2)� + 𝜃𝜃�1(𝑡𝑡1, 𝑡𝑡2)𝐷𝐷 − 𝐹𝐹1 (A5)

Less Selective School: max𝑡𝑡2 𝑡𝑡2�𝜃𝜃�1(𝑡𝑡1, 𝑡𝑡2) − 𝜃𝜃�2(𝑡𝑡1, 𝑡𝑡2)� − 𝐹𝐹2 (A6)

Equations (A.5) and (A.6) imply the following best response functions:

𝑡𝑡1∗ =(1 + 𝐷𝐷 − 𝑣𝑣2 + 𝑡𝑡2)

2

(A7)

𝑡𝑡2∗ =(𝛼𝛼 + 𝑡𝑡1)𝑣𝑣22(1 + 𝛼𝛼)

24

Simultaneous solution of equations (A.7) yields the Nash equilibrium in tuition prices. We

restrict ourselves to selective outcomes defined as those equilibria in which relative to its less-

selective rival: 1) the elite school serves fewer (but a positive number of) students; 2) provides

greater perceived educational value; and 3) charges a higher tuition.11F

12 For this purpose, it is

useful to define three critical values of v2, the relative intrinsic value of the less-selective

school’s program.

For any relative quality of the less-selective school, 0 < v2 < 1, it is straightforward to show

that the less-selective school has a positive market share. However, if v2 is too high—if the less-

selective school’s business program is perceived to be close in quality to the elite institution’s—

the latter is unable to attract any students. In order to have a positive enrollment for the elite

program, there is an upward limit on v2. This limit is given by: =

2(1+𝛼𝛼)(1−𝐷𝐷)2−𝐷𝐷+𝛼𝛼

. Note that for any case in which this critical > 1, implying that

this constraint is always satisfied for all values of the parametersα,D in this range.

In addition the relative quality of the less-selective business program cannot be too large

otherwise those attending the elite school may not get added value.. In other words, we must

have for the marginal student at the elite institution: . We denote the critical

value of v2 satisfying this constraint as: .

12Those familiar with the canonical papers in vertical integration, Mussa and Rosen (1978), Gabszewicz, and Thisse (1979); and Shaked and Sutton (1982), will recognize that this result is distinctly different from that of these pioneering papers in which the highest quality firm also wins the largest market share. The difference here is due to the incorporation of peer effects and the non-tuition or grant and donation income for the elite school. In our framework, this corresponds to 𝛼𝛼 = 𝐷𝐷 = 0.

25

D

Finally, while v2 < is required to ensure that the elite school has positive enrollment a

further restriction on v2 is needed to ensure that the elite school enrolls fewer students than its

less-selective rival. This restriction is: 1 > v2 > ..

The regions of the parameter space 𝛼𝛼,𝐷𝐷 in Figure A1 below help identify the conditions for a

selective equilibrium. The downward-sloping red curve that delineates Region A indicates the

values for which = 0. For all values of α and D to the right and above this line, Hence,

the requirement that v2 be sufficiently large to ensure that the elite business program serves fewer

students is automatically satisfied for all α,D combinations outside of Region A.

Figure A1

The upward-sloping (left-to-right) curve separating Regions B and C reflects those

combinations such that = 1, defined by . Below and to the right of this curve,

> 1. Since v2 cannot exceed 1, this means that for all α, D combinations in Region B,

the condition that the elite institution has positive market share is satisfied. Conveniently,

however, it turns out that above this curve where , the requirement that v2 < is

α

A B

C

26

C

B AA

0.0 0.2 0.4 0.6 0.8 1.00.0

0.2

0.4

0.6

0.8

1.0

automatically met as well. Moreover, it is straightforward to show that whenever the elite

business program enrolls fewer students who each perceive that it offers higher educational value,

then it follows that in equilibrium t1 > t2.

The equilibrium in either Region B or Region C is always selective. In the former, the elite

school has a positive but smaller market share while The binding constraint on v ensures that it

offers higher educational value. In Region C, by contrast, the elite school is the elite school

offers a greater educational value and enrolls a smaller market share. The binding constraint on v

is to ensure that given these α,D combinations it enrolls a positive number of students.

The initial equilibrium implicitly assumes that there is no real alternative with positive

intrinsic value relative to that of either the elite or less-selective school. Hence, to the extent that

doubts in legitimacy reflect a fall in the relative value of business school programs, we can

capture the impact of such a challenge by introducing a third alternative that, while its intrinsic

value v3 is still less than that of either school, is now positive.

With the emergence of a third alternative with intrinsic value v3 > 0, the assumption that

each institution tries to maximize revenue given its fixed costs results in the tuition best

response functions below.

Elite (v1 = 1):

Less-Selective (0 < v3 < v2 < 1): (A8)

Non-Business School Alternative (0 < v3 < v2 < 1):

It is easy to see that equations (A8) resolve to the two-school case (A4) when v3 = t3 = 0.

The implied Nash equilibrium in tuition fees is:

27

(A9)

Enrollments and other equilibrium features then follow from equations (A9).

28