There are a number of decision rules government could use to allocate public funds to postsecondary education. For example, every university gets the same number of dollars, which is fair in a certain sense, but probably not a good idea. In fact, coming up with a way to divide the budget without creating bad incentives is actually quite difficult.
Suppose we instead gave a certain sum whenever a university graduated a student. This seems better in a way – similarly-sized institutions should get approximately the same coin, and it promotes the achievement of students. Except it, too, goes quite wrong.
What happens is that a university could respond to an incentive to graduate more students. Lowering their academic standards, not only to fail out less students, but to attract more entrants who are only looking for an easy ride, will hence grow their budget. Further, this cuts into the funding of other universities, who then feel pressure to follow the same path.
Lo and behold, the economic theory/common sense is correct:
The authors demonstrate that graduates from universities which give easy marks have significantly worse labour market outcomes than those who graduate from a university which maintains a tough grading policy. “We show that by funding universities according to the number of students that pass their exams, the Italian government is favouring those universities that add less value. It simply funds more those universities with lower standards.”