By Herschel Grossman

The recent decision by the Justice Department to drop its antitrust case against the Ivy League colleges and MIT shows the political clout of our elite educational institutions. It also means that these colleges will be able to collude again to restrict financial aid and to deny undergraduates the benefits of merit scholarships.

First, some history. Almost 40 years ago the eight colleges in the ivy group (Brown, Columbia, Cornell, Dartmouth, Harvard, Pennsylvania, Princeton and Yale), together with MIT, formed a cartel to limit competition for desirable students. Such students are generally undergraduates who have exceptional academic, artistic or athletic talent or who are from historically underrepresented racial and ethnic groups.

The members of the cartel agreed not to award "merit" scholarships to undergraduates. Instead, they agreed to give financial aid-that Is, to discount the tuition of undergraduates-only on the basis of "need."

To enforce this agreement, the ivy colleges and MIT held an annual meeting, called Overlap, at which they decided on the dollar amounts of financial aid that they planned to offer individual students. For decades, this cartel functioned openly and without legal challenge. But in 1991, the Justice Department brought an antitrust action against the IVY colleges and MIT for colluding to fix tuition charges.

The eight IVY colleges quickly entered into a consent decree that terminated Overlap. MIT, however, decided to litigate. Last month, apparently under strong political pressure, the Justice Department capitulated.

The settlement between Justice and MIT allows colleges to participate in "cooperative financial aid arrangements." The colleges can agree to prohibit merit scholarships and exchange information to coordinate their need-based financial aid. The Justice Department is also agreeable to amending the ivy consent decree to include the terms of tile MIT settlement.

The settlement's only substantial restriction is that the participants must practice "need-blind admissions," which means that they must make admissions decisions without considering which applicants need financial aid. They must also give each admitted applicant all the financial aid that he or she needs. MIT and all the ivy colleges except Brown already claim to satisfy these conditions.

In defending their cartel. MIT and the Ivy colleges argue that they are already budgeting about the maximum amount of money for financial aid that they can afford. Hence, if competition were to force them to offer merit scholarships, they would have to decrease financial aid to needy students.

This argument is specious. The richest Ivy colleges {Harvard, Yale and Prince. ton) have substantially larger income from endowments and alumni gifts than the other Ivy colleges and MIT. But the richest colleges devote a smaller fraction of their gross revenue to financial aid for undergraduates.

This anomaly suggests that collusion enables the richer participants to give less financial aid than they would give under competition, it also suggests that the richest colleges have not been budgeting the maximum affordable amount to undergraduate financial aid. They could increase significantly the amount of financial aid that they give to undergraduates simply by devoting to undergraduate financial aid the same fraction of gross revenue as do some of the poorer colleges.

MIT and the Ivy colleges want us to believe that their "costs" of providing an undergraduate education cannot be reduced In order to free up funds for additional financial aid. But the costs of these colleges, and of other not4or-profit enterprises, are artificially inflated.

The not-for-profit designation allows colleges to keep their books in such a way that they report no profits. But this bookkeeping contrivance doesn't mean that colleges don't earn what an economist would properly call profits. Rather, it means that they include in what they call their costs some amounts that are really profits.

In fact, private colleges function similarly to producer cooperatives or partnerships. The partners-in this case the faculty and administrators-share any excess revenue over true costs in the form of generous compensation and perquisites.

One has to conclude that the Ivy colleges and MIT could continue generous need-based financial aid even if they were also offering merit scholarships. But would they do so? Not necessarily. It is possible that they would reduce need-based financial aid if competition for desirable students intensified and merit scholarships depressed net tuition revenue. But this outcome, if it were to occur, would not have been forced on the colleges. Rather it would result from their choice to reduce need-based financial aid rather than to cut costs.

What would be the social consequences of replacing need-based financial aid with merit scholarships? In defending its settlement with MIT, the Justice Department stressed the value of need-based financial' aid in enhancing equal opportunity. But need-based financial aid also has the undesirable effect of reducing the incentive for families to make their own provisions for paying college tuition. .

The larger a family's Income and savings, and the fewer children it has, the smaller the amount of need-based financial aid for which it qualifies. In this way, need-based financial aid penalizes industrious and thrifty families who have worked, saved and limited family size in order to be able to pay to send their children to college.

In short, need-based financial aid encourages sensible families to be imprudent. According to this analysis, it is not surprising that the savings of most middle-income families are inadequate for them to pay to send their children to the Ivy colleges and MIT, or that applicants from middle-income families need more and more financial aid. Responding to the incentives created by need-based financial aid, perhaps middle-income families have come to regard saving to send children to college as pointless and foolish....

Merit scholarships would help talented applicants from middle-class families who do not qualify for need-based financial aid and would also mean more generous financial aid for talented applicants from poor families. With the undergraduate financial aid based on merit, financial aid would not be a reward for being poor, as it often is now. Rather, it would be a prize available to any applicant who ranks at the top of the applicant pool.

Mr. Grossman is a professor of economics at Brown University.