The characteristics of aged-care services make it difficult to rely solely on market forces to meet demand. First, given community expectations about the level of care, and also the potential problems of privately insuring against the risk of requiring high-cost aged-care services in the future — which can be economically comparable to private insurance against unpredictable and catastrophic events (Productivity Commission 2008) — there is a need for an effective safety net for those with little ability to pay. Second, as consumers in this industry may be poorly placed to exercise either ‘voice’ or ‘exit’, there may be a case for a relatively high degree of service-quality regulation. However, subject to the constraints imposed by such regulation, competition between providers could ensure that the industry adjusted to changing needs, including in terms of the balance between different types and levels of care. Set within a framework of sensible quality regulation, and of provision of a safety net for low-income consumers, market forces could therefore be harnessed to provide individuals with care choices that matched their needs.

Unfortunately, existing regulations of the sector go well beyond what is necessary to achieve social equity, and undermine the ability of market forces to ensure supply effectively meets the needs of consumers. The consequences of the current approach to regulating aged-care services have been extensively discussed in Professor Hogan’s Review of Pricing Arrangements in Residential Aged Care (Hogan 2004) and the situation has not altered materially since that time. The most recent development has been the handing down by the Commonwealth Government’s consultative body, the National Health and Hospitals Reform Commission (NHHRC), of its Interim Report recommendations, some of which relate to reforms to increase choice in aged care. Nonetheless, existing regulations remain in place.^[22]

More specifically, the rationing of places, while it does manage fiscal risk, creates an artificial scarcity that limits the scope for competition, blunts pressures for efficiency and innovation, and deprives consumers of choice.

Thus, since the turn of this century, occupancy levels in residential-care facilities have been in excess of 90 per cent for low care and of 95 per cent for high care, and though they have recently declined slightly, they are likely to stay high for so long as the current planning controls persist. This means that there are usually very few places open in any particular locality. In 2005–2006, for example, in a third of the 71 aged-care planning regions there were (on average) fewer than three vacant places each day for every 1000 people aged 70 or over.

The shortage of places has obvious implications for potential residents and their families. Consumers seeking a place, especially in high care, are often doing so as a result of either a sharp deterioration in the ability to perform essential daily activities or the death of their spouse or carer. There is therefore an element of urgency in their search for a place. Moreover, potential residents (and their families) usually have strong preferences over the location of the facility, and incur a significant element of discomfort should they need to move from one facility to another. Given the urgency of finding a place, and of doing so within a confined geography, persistently high occupancy levels mean that consumers often have very few options open to them.

This, in turn, means that suppliers face little threat of displacement and have limited incentive to be efficient. The result is an industry structure that does not make the best use of scarce resources, leading to losses of allocative, productive and dynamic efficiency.

As at 30 June 2006, some 1276 businesses/organisations (‘approved providers’) were engaged in the provision of subsidised residential aged care through 2929 outlets (‘aged-care homes’). The residential aged-care industry continues to be highly disaggregated, with the average approved provider operating 2.3 aged-care homes and 128.1 operational places in June 2006. Some 65 per cent of providers operate only one home and 71 per cent of providers operate fewer than 100 places.

Many current providers seem too small to achieve economies of scale and scope. However, the restrictions on the number of places make it difficult for entrants to secure a sufficient number of beds in any locality to themselves achieve scale and scope economies and displace less-efficient incumbents. While it is possible that further gains in productive efficiency could be achieved by consolidation among existing providers, with some consolidation having already occurred,^[23] additional efficiency gains might be more readily achieved by making it easier for entrants to grow by establishing new centres, as this would allow them to secure a higher level of standardization and hence reduce costs.

The overall consequence of these restrictions on displacement of existing providers is persistent productive inefficiency. Hogan estimated that in 2001–02, the average technical inefficiency of the residential aged-care industry, measured in terms of the difference between average practice and the technical efficiency frontier, was 17 per cent. It is questionable whether that gap has diminished significantly since then. Thus, industry returns continue to be highly variable. In 2004–05, for example, the average net profit/loss per bed-day varied from a loss of $7.31 (or a profit margin of –4.6 per cent of revenue) in the lowest quartile of performance to a profit of $25.42 (or a profit margin of +15.9 per cent of revenue) in the highest quartile of performance. While some of these industry returns can be affected by factors unrelated to efficiency, the large gap estimated by Hogan suggests that technical inefficiency is a factor contributing to the inability of a fairly large group of suppliers to achieve cost coverage.

As well as blunting the incentives for technical or productive efficiency, the limited choice most consumers face means that some form of price control is needed to prevent the abuse of localised market power. Reflecting this, most of the prices that can be charged by care providers are set by the Government.^[24] However this in turn leads to further distortions, including allocative inefficiency, as the limited number of places may not be allocated to those who value them most highly. Dynamic efficiency is also reduced because the incentives of operators to make long-term investments in their businesses is blunted by quantity restrictions and hence by uncertainty as to the ability to expand. Additionally, because of price restrictions, there is a longer-term risk that prices will not be allowed to reach levels that cover efficient costs, further compromising the incentives to invest, at least in those locations with high costs of service. The inefficiency created by the rationing of places may then be accentuated by distortions to the pattern of investment, with places ultimately not being available when and where they are needed. The fact that the regulated prices are largely geographically uniform, despite substantial variations in costs, makes these risks of inefficiencies all the greater.^[25]

Most recently, the government’s own consultative body, the NHHRC (which had access to an earlier form of this article), has commented on and summarised the adverse consequences of quantity restrictions on the various forms of efficiency as follows:

The complex structure of the current arrangements has partially disguised these distortions. While there are price controls over all forms of Government-assisted care, the controls over prices for ‘low care’ residential care are not especially effective, as suppliers are allowed to charge accommodation bonds (upfront payments for admission) that are virtually uncapped. The level of bonds charged has increased substantially over the years (with the average bond increasing by a factor of five in nominal terms over the period 1996–2006), and the value of many bonds now appears to materially exceed the replacement cost of a residential place.^[26] In the last three years, the total value of the accommodation bonds held by the residential-care industry has almost doubled, from $2.7 billion to $5.3 billion. At the same time, the Government’s ‘Ageing in Place’ policy largely assures residents who enter low-level care of being able to secure a high-level care place as and when their condition deteriorates. Suppliers of low-level care residential care have therefore been pre-selling high-level care and securing what amounts to a largely uncapped pre-payment for high-level care from low-level care bonds. With some 30 per cent of current non-concessional high-level care residents having paid low-level care bonds, there has been a cross-subsidy, or at least a financial transfer, from low-level care to high-level care, mitigating the impacts of the price controls.^[27]

Above and beyond the efficiency issues, it is questionable whether the current arrangements are fully sustainable. Through the mechanisms set out above, these arrangements make the financing of high-level care depend, at least in part, on the flow of admissions into (and hence bond payments for) low-level care. However, demographic trends are likely to reduce demand for low-level care relative to high-level care, compromising this source of funding just as the need for high-level care places increases.

Already, recent reforms have rebalanced the supply of subsidised services more towards the provision of community rather than residential care, and (within residential care) towards high-level rather than low-level residential care.^[28] As the trend away from low-level residential care proceeds, the financing of high-level residential care will become increasingly problematic.

Some degree of market response to these pressures is already occurring. More specifically, there appears to be a strong expansion under way in the ‘Extra Service’ segment of high-level residential care, where prices are less regulated.^[29] These Extra Service homes are allowed to charge bonds, unlike other high-care providers, so that the aggregate charge they impose on residents is less effectively capped.^[30] While Extra Service places have accounted for less than 1 per cent of places in residential aged care, they now account for a substantial share of the recent growth in claim-days. Thus, the number of claim-days in Extra Service increased from around 650 000 in the six months to June 2004 to close to 1 000 000 in the six months to December 2006. The vast bulk of this growth has been accounted for by for-profit providers. Nonetheless, for the six months to December 2006, these providers accounted for 85 per cent of Extra Service claims, while Extra Service claims accounted for 10 per cent of all claims by for-profit providers.

This expansion in Extra Service is all the more remarkable given the fact that the means-testing arrangements for aged-care subsidies tend to penalise residents in Extra Service homes.^[31] Undoubtedly, income and wealth effects are primarily at work, as a more affluent elderly population seeks care better attuned to the amenities it is used to enjoying. As access to these amenities increases the net benefit residents obtain from care (since they value the Extra Service at more than its additional cost), it enhances the efficiency of the aged-care sector as a whole. However, it would be less obviously efficient, and more likely undesirable, were Extra Service to expand simply because it was less constrained than other types of provision — that is, if Extra Service homes could use their relative pricing freedom (in a situation where restrictions on the number of places limit entry and competition) to charge prices durably above costs, while the more effectively price-regulated sector shrank as a result of unduly onerous price controls.

The expansion in Extra Service places cannot, in other words, make up for the lack of competition on the merits between providers and forms of care.

A better arrangement would have three elements.

First, it would reduce, and ultimately remove, controls over the number of places, which would provide more scope for competition and choice.

Second, it would alter the structure of the assistance provided so as to make it more neutral between the venues in which care was provided — that is, so that care in the community (be it domiciliary care or care in congregated living arrangements) could compete on an equal footing with care provided in conventional residential facilities.

Third, as those changes came into effect, and competition became a real factor shaping market outcomes, controls over prices could be eased and eventually eliminated, ensuring efficient providers of aged care could fully recover their costs.^[32]

While a number of approaches could be adopted to make such a change, there are two reasons why a sensible place to start in terms of significantly expanding capacity (and ultimately removing any restrictions on entry) would be high-level care. This is for two reasons.

First, demand for high-level care is likely to increase over time in response to the demographic changes noted above. Liberalising the supply of high-level care places would therefore be consistent with the patterns that would be observed in an effectively competitive market and would facilitate the transition to such a market.

Second, fiscal risk and, more generally, moral hazard^[33] are less of a concern in high-level care than in other forms of long-term care. High-level care residential care is not desirable for its own sake, and few individuals would choose to consume high-level care merely because it was available at a subsidised charge.^[34] Moreover, to the extent to which there is a concern about fiscal risk, that risk can be managed through the ACAT assessment process (which determines eligibility for care places on the basis of health condition), noting that that process appears to be most effective at the higher levels of impairment.

That said, until significant supply expansion has occurred, localized market power is likely to persist. For this reason, it would be preferable to only gradually ease price controls, contingent upon the development of competition in the industry as other restrictions are removed. This approach is in accord with the recent thinking of the NHHRC which recently stated that:

Ultimately, reform should not be limited to high-level care, at least over the longer term. In particular, community care is the area where the growth in demand is likely to be greatest and it is also an area where there are substantial opportunities to increase efficiency. Moreover, increased availability of community care would, albeit indirectly, place increased competitive pressure on residential-care providers.

Relaxing controls over the number of community-care places is, however, more complicated, as the risks of moral hazard are greater for community care than for other forms of assistance. Experience in the United States and Europe points to a ‘woodwork’ effect in community care, whereby increased availability of financial support brings carers ‘out of the woodwork’, increasing budgetary costs without a corresponding increase in the volume of services provided.^[35] Further policy development, aimed at better managing fiscal risk, is therefore needed before a substantial liberalisation of community care can be undertaken across the board.^[36]

That risk, however, need not prevent an expansion in the number of community-care places at the upper end of the care spectrum; that is, at the levels of disability corresponding to the current Extended Aged Care at Home (EACH) packages, which provide high-level care nursing services in the home. In effect, the danger of an expansion in the number of places merely displacing care in the home that would have been provided in any event is significantly lower at these high levels of disability.

Such an expansion in EACH packages (and ultimately in community care more generally) would have wider implications for residential-care providers. Specifically, increases in community care create a need for additional access to respite care; that is, for short-duration stays in residential care that serve either to deal with periods where acute care is required or to provide a rest period to carers. Respite care tends to be costlier than longer-duration residential care (inter alia because admission and discharge costs are incurred more frequently), so provision would need to be made for these costs. Moreover, so as to meet this need, providers of residential care would need greater flexibility to use places for respite-care purposes than they currently have. Indeed, an increased emphasis on respite care is one direction current ‘low care’ providers could take in a more competitive environment.

Over the longer term, care in the community and residential care should be allowed to compete as alternative venues for care provision. For this to occur, the ‘care’ component of any subsidy provided to residents would need to be effectively separated from the ‘accommodation’ component, with each of these ultimately becoming portable (so that they can be used for distinct service providers). While reforms in recent years have taken steps in that direction, there remains a considerable distance to go before the subsidies provided come to resemble fully portable and separable vouchers.^[37]

This is not to say the current distortions all favour residential care: that is not the case. For example, under current arrangements, means-testing applies to residential services, but not to domiciliary care. A move to a more neutral system would involve not merely a transferable voucher, but one that was subject to the same means-testing (and hopefully to substantially simpler and more transparent means-testing than currently applies) wherever that voucher was ultimately applied. Moreover, it is important that, in contrast to the situation as it stands, the means-testing be the same as between residential and non-residential care options.

There are precedents for use of voucher-like mechanisms in other countries.^[38] Of course, the devil is in the details, and on what terms such vouchers should be made available is a matter of legitimate debate. For instance, in recommending the removal of restrictions on the quantity of aged-care places, the NHHRC has also advised that providers of aged care would still need to meet existing criteria in order for the care they provide to be eligible for government support, including being an approved provider under the Aged Care Act and having their facilities accredited (NHHRC 2009: 172). Such criteria could be made readily applicable to a voucher scheme.

In short, the current arrangements, while likely relatively effective in providing for equitable access to aged-care services, achieve that goal at what appears to be an unnecessarily high cost. There is a complex tangle of quantitative restrictions that impedes supply flexibility and limits competition. The lack of competition and the desire to limit the Commonwealth’s fiscal exposure then give rise to price controls which, though extensive, are of very differing degrees of effectiveness. Consumers face restricted (and distorted) choices in terms of the range of care available, and charges that are often difficult to understand as a result of the interaction of complex prices with even more complex income and assets tests. Recent changes to policy do move broadly in the right direction in addressing these issues; but there remains a need for more comprehensive reform, which by its nature will take some years to devise and effect.