Market Based Regulation: the Best Way to Regulate Community Services?

Paper to the Productivity Commission Conference,
Canberra, 26 June 2000

THE ISSUES

LIABILITY LAW AND REGULATION

Liability law and regulation are often thought of as alternatives.

Liability law is based on a notion of fairness in commercial dealings that is adapted and refined through judges deciding contested cases in commercial dealings.

Regulation often starts with the system of law based on fair exchange and, in a sense, codifies it.  Often regulation simply gives a statutory expression to what has been common practice.  But sometimes it tries to refashion the law by seeking out greater equity and it is here that distortions are created.  Regulation also suffers from having less flexibility than liability law, which is inherently organic, and adaptable to changing circumstances.

Liability law operates by penalising those who do not offer the value they promised.  Regulation often seeks to operate by preventing the unwanted from happening in the first place.

In many respects, the choice between the two approaches is a reflection of the choices we have in operating the economy.  The private enterprise system is based on people deciding for themselves how to spend their money and on producers competing for the consumer's dollar.  In order for the producers to be successful, competition forces them to bear down on costs and ensure their offerings are attractive.  The private enterprise system is based on atomised decision making.  This also allows the users to decide price/quality trade-offs without others imposing their, undoubtedly well considered, trade-offs on the rest of the community.

Intuitively, the regulatory approach has some merits:

• Its preventative rather than reactive approach appears to give bloodless benefits
• The experts, by definition appear to be better placed than the average decision maker
• There are economies in search activity where regulations bring minimum standards which allows consumers to avoid time-consuming reviews of different providers.

But, in practice, there are many deficiencies in the regulatory approach.  These include:

• its standards might not match the consumers' wishes and its uniformity might not be appropriate
• regulated supply of goods and services is susceptible to capture by producers, meaning excessive costs are introduced
• the standards often bring weak incentives to adapt to shifting demands
• the need, which is frequently the case in regulated systems, to have goods or services approved prior to being allowed to trade brings paper-burden costs and often either abuse or great inflexibilities.

Liability law performs better.  But liability law is not always the best approach.  Indeed, under the custodianship of liberal jurists in the US and elsewhere, it wandered from the traditional liability that sought to pursue efficiency by allocating responsibility to the party able to achieve it most cheaply.  Liability has been shifted onto the supplier and we have had the crazy lawsuits like the burglar who fell through a plate glass roof and successfully sued, or the motorist who inflated his tyres to several fold the pressure recommended on the rim and was able to collect after the inevitable mishap.

But this change was only partly because lawyers started to seek to impose their brand of justice rather than interpret the law.  It was also partly because modern life meant the old principles of caveat emptor could not be applied when the buyer could not easily examine goods prior to purchase.

OUTPUT VERSUS INPUT REGULATION

While liability law in principle represents the full market monty, output regulation allows a partial application of market mechanisms.  It specifies the outcomes and leaves the operators to seek out the lowest cost means of supplying these.

Like the dichotomy between liability law and regulation, the choice between output and input regulation is superficially straightforward but may be less so on reflection.

Many of us cut our teeth on some of the more egregious examples of input regulations:  laws which specified the size of fishing boats, their engine capacity, their net size and the times they might fish.  Some of us were around when building regulations specified the precise details of a door support and made it extremely difficult for anyone who developed a superior system to have it agreed to.  Having been pilloried as dreamers ideologically fastened to a free market, I think there are now very few who would deny the superiority and inherently greater flexibility of output controls.

That said, such controls are not always easy to devise.

THE COMMUNITY SERVICES TO BE ADDRESSED

While the concept of community services includes hospitals and police stations, the services I shall address are child and aged care.  These plumb the depths of the arena for market solutions because of the parties they operate with.  Children are not themselves capable of exercising informed choice, while the infirm may also have impaired faculties in these regards.

The lack of full information and capabilities on the part of the consumer does not rule out having a liability rather than a regulatory based system.  Whether we are talking car repairs, share purchase decisions, computers, or a great many other goods and services, markets work because the consumer either treats the supplier as his agent (and a poor reputation will starve the agent of business) or because an external agent is used.  This is because of the previously mentioned migration of onus for poor outcomes, under pressure of increased complexity of modern life, from buyer to seller.

In any event, these markets are generally agreed to be working efficiently with little regulatory control.

Similarly, the use of output based measurements is now generally seen to be superior in such areas as education and hospitals (with casemix).  Casemix, and the success of US HMOs, demonstrates that there is every reason to expect that health services work better under an output-based system rather than one regulated through inputs.  The HMO's demonstrate the benefits of moving still further along the true market path.

CHILDCARE

DEVELOPMENTS IN PROVISION AND COSTS

Childcare centres illustrate the deficiencies of controls, especially input controls.

Over the past dozen years, there have been three very significant directional changes in provision.

• The first of these has been a shift to have the Government pay a greater share of costs.  Commonwealth spending in dollar terms rose fourfold during the 1990's and children being cared for appear to have almost doubled.  The Commonwealth presently furnishes about 60% of centres' revenues.
• Secondly, there has been a remarkable shift from public (community) to private provision.  There are now about three times as many private as government or other non-profit places
• Thirdly we have seen an avalanche of new regulations.

As a result of the increased regulation, from 1991 to 1998 real costs increased by 37 per cent in the case of community centres, 34 per cent for private centres and 12 per cent in the case of family day care.  These costs are still increasing since the facilities are given time to have their workers trained up and some existing workers with no formal qualifications are "grandfathered".

The relatively low increase in family day care came about in spite of an administration levy being imposed for the first time in 1997.  Family day care started the decade costing almost exactly the same as the other systems but by 1998 was 26 per cent cheaper than community centres and 21 per cent cheaper than private centres.  The relatively faster increase in community centre fees is partly due to the discontinuance of centre specific subsidies and their replacement by subsidies to the parents.

These trends are tabled below.

Commonwealth funding has increased considerably over recent years and was over $1 billion in 1997/98.  About 42% of children are financed to the maximum degree by the government assistance (which provides some 70% of the costs) and about 33% receive partial support.  Hence government funding amounts to just over 60% of total revenues of the centres.

Government assistance has increased at twice the rate of the CPI but has failed to keep pace with the fee increases.  There is a growing gap in money terms between the maximum fee payable and average price for the services.  But the service is clearly competitive and there can be no suggestion of "market failure" in the observation that the fees have increased as much as they have.

In terms of provision, private centres had assumed the most important role by 1998 and have almost trebled in places;  community based centres had increased by only 31 per cent and family day care by 50%.

It might have been thought that, given the relatively stellar performance of the family day care sector, (recall that their cost increases were only one third of other centres') the authorities would wish to nurture it.  After all, the service was demonstrating consumer appeal by winning market share.

However, their increased market share can be attributed to lower costs resulting from a lesser obligation to have child-specific facilities and for training of the staff.  Hence, the regulatory authorities find themselves at odds with this class of service because it is proving itself more attractive to the market than the regulators think is good for the consumer.  As a result, the low cost of family day care, though the stats have not fully caught up with this, is largely a thing of the past.  As from mid 1999, NSW, Queensland, and WA have regulated these, and other States had also implemented some form of regulation (such as minimum standards, child-staff ratios).

A CLOSER LOOK AT COSTS

For the purposes we are discussing today, the most important of the three features I previously drew attention to is the cost increase.  The increase in fees can hardly be because of some natural increase in costs, the basic costs involve labour with skills which, since time immemorial, have come naturally.  And they involve facilities that most families have if they are bringing up children.

Impact of Credentialism

The increase in the costs that new regulations are causing must be sheeted home in large part to the credentialism that is being specified.  Rearing and caring for the young is something that requires no qualifications.  It is a natural function of all creatures.  Millions of generations have demonstrated that it requires no scholastic preparation.

But there has been a progressive extension in the requirements of having qualified staff employed in the centres.  Commonly, state regulations require a minimum of two such staff to be in attendance at all times children are present.

Some may argued that child care is part of education and that qualified staff are equally important in this service as in schools themselves.  If this is the case, the preferred approach is act directly and to lower the school attendance age.

The adverse impacts of credentialism can be crystalised under three headings:

• First, there is the needless cost of acquiring the qualifications.  If two years are taken to obtain the diploma, and the normal working period is twenty years, society incurs a front loaded cost increase of 10%.  That cost is paid for by the hapless consumer/taxpayer.
• Secondly, and related to this, the regulations will directly increase wage costs.  According to the Victorian RIS (p.31) credentialled workers are paid 29-50% more than other workers.  This must be reflected in fees.
• Thirdly, it denies some of the least-privileged members of society an opportunity to use their skills.  The qualifications will prove too onerous for many willing carers.  For others the need to obtain the credentials and forego paid employment will prove to be financially forbidding.  The impact is likely to be on people, especially women, from poor backgrounds, including indigenous Australians, and migrants.

Other Cost Increases:

Staff:Child Ratios

There have been progressive increases in required staffing in all centres.  A better approach is to abandon mandatory staffing levels and replace them by a requirement that all centres prominently display up-to-date information on the numbers of children and numbers (and qualifications) of all staff and their hours of operations.  This will give parents the opportunity to select the services that suit their situations.

Facilities

Commonly, the Regulations cover the facilities in great detail.  These specify space per child, require natural light outdoor areas, child-specific toilets and wash basins and an ability of staff to observe children at all times.  While these requirements are doubtless inspired by well-meaning considerations, a moment's reflection leads one to realize that a great many homes fall far short of these standards of appointment.

Should we not, therefore, require such facilities as a pre-condition of people having and bringing up their own children?  The logic of requiring such standards in child care centres is that they should be extended to all facilities where children are cared for.  Indeed, they are all the more necessary where the child is living in premises for 24 hours per day rather than the 40 hours per week in a centre.

The logic of current regulations could dictate:

• that children should not be brought up in tall apartment blocks, especially where there is little natural light;
• that nobody should be allowed to have children unless they have first completed the required tertiary qualification;
• that there should be at least two people present to supervise children at all times, especially where there are more than three infants in the family;
• that homes in which children reside should be remodelled to ensure the wash basins and toilets are appropriate for those of small stature and that those using the facilities can be observed at all times.

The child-care regulations represent a requirement that parents abandon to a bureaucracy their decision-taking with regard to their children.  The parents are the agents of their children.  They take decisions for them.  Interceding a government bureaucracy into this process both undermines this and has adverse cost implications.

Doubtless the increase in costs over the years has been moderated by the enlistment of the private sector into supplying an increasing share of child care.  But we can have lower costs -- reducing the burden on working families -- if we opt for a lesser role in prescriptive regulations.

DIFFERING APPROACHES TO CHILDCARE

In summary, the approaches to the provision of child care can follow one of two routes.  The first is having government specify in considerable detail:

• who may provide the service,
• the facilities in which it may be provided
• the staff who may support the provider
• the times that the facility may be open
• the age profile of each facility's group of children
• the proportion of staff to children and the nature of that proportion as between staff of different levels of credentialled expertise
• the prices at which the service should be provided.

The alternative is to insist on rigorous publication of information on the centre so that parents can choose the quality they consider appropriate to their needs, preferences and resources.

Child care is an important matter for parents.  By its nature, it is also a "repeat purchase" and dissatisfaction will lead to changing the supplier.  This places pressure on the centre to perform in order to gain and retain its customer base.  With open access to the provision of child care services, each centre must continuously strive to provide value.  This market-based approach allows needs and offerings to be matched without the intercession of a bureaucracy.

The usurping by the State of the need for the parent to exercise control may also lead to a form of "moral hazard".  Where a bureaucracy is vested with responsibility to ensure a standard is maintained, it is likely that users will be less vigilant in undertaking these tasks themselves.  Users will assume that others are undertaking the scrutiny role that they themselves would previously have performed.  This may lead to reduced resources being applied to the scrutiny.  It also may mean a less effective scrutiny where those undertaking it are focused on a rule.

The present regulatory tumescence is bringing high costs and denying capable carers without the skills or resources to pursue a university degree the possibility of offering the service.  Parents should be allowed to make choices about the class of childcare they wish to afford for their children just as they do about the nutritiousness of the food they serve or the quality of the housing they live in.

AGED CARE

While children are a relatively declining business, old folks are a growth industry.  Various estimates put the numbers of Australians with "profound or severe core activity restriction" at 800,000 in 1981, 1,210,000 in 2001 and growing to over 2 million thirty years from now.

While parents are properly the guardians and agents of their children, and the children can make their views readily known to the parents, this same link is present far less strongly with aged care.  Many older people are less articulate than children and the parental link with their own children is often weaker.  Moreover, current policy approaches mean a shortage of aged care places compared to a demand-driven number of child care places, where alternative providers need to operate on a highly competitive footing.

There are about 76,000 nursing home places and 64,000 hostel places.  The present system followed an explosive growth with the introduction of benefits in 1963 and policy since then has been designed to hold back public expenditure.  The Commonwealth subsidy to nursing homes is put at $30,000 per bed year, which accounts for roughly 80% of costs.  The Commonwealth also controls numbers of subsidised beds and requires accreditation and building code requirements.  State regulations usually specify staff ratios and other matters.

Most nursing homes are "for profit" with the remainder generally run by charitable bodies.  The proportions are reversed for hostels, which remain free to negotiate prices.

Aged Care Standards and an Accreditation Agency replaced the Outcome Standards Monitoring Program established 1987.  Inputs are, and were previously, the main controls used.  The Core Aggregated Module (CAM) determines the subsidy and homes themselves have to pay anything greater than 1.5% above this;  (they keep only the first 1% of savings below the CAM).  The inflexibilities have been subject to a number of criticisms, including by Gregory in 1994 and the PC in 1999.

Even so, the current scheme remains inflexible and perhaps inevitably so.  We have a confluence of:

• first, costs being largely picked up by the government with demand therefore well above a market-determined capacity to pay.  And, unlike child care, the government is not wedded to the idea of wishing to maximise the number of those being cared for;
• secondly, resident contributions are fixed by a series of caps, the most important being a contributions at 87.5% of the single income pension.  Some asset testing is in place but this is estimated to bring in only 2.5% of revenues even by 2007.  Some of the complexity emanated from the government's failed attempt to bring about greater user-pays in 1997.

The PC made several recommendations to increase greater flexibility.  These included sensible tidying up approaches to a system that they envisaged would remain input controlled, like:

• allowing people to pay for greater services and thereby allowing differentials and alternatives;  and
• avoiding incentives to use up all the subsidy available.

The PC saw the task as mainly continuing the focus on input controls.  There may be little option to this.  After all, we have a system where not only are the costs basically picked up by the government but inputs:  wages, facilities, treatment are also controlled.  Add to this the inability of many users to make their own decisions (or have a family member as their agent) and we are left to fall back on devising a better set of benchmarks on which the system might be managed.

One matter I don't think the PC addressed directly was the allocation system.  At present, to rein in costs, new beds are licensed according to a formula based on the needs in each region.  Applicants submit proposals and the Secretary of DHSS conducts a "beauty contest" based on these applications.  The allocation of the permits is valuable -- worth and estimated $27,000 per bed, hence a better approach from the public policy perspective would be to specify standards and allocate on price or bid.

An approach canvassed by the Victorian DHS offers a path to inject some greater efficiencies via enhancing competitive tensions in provision.  Victoria proposed a subsidy per person with the recipient able to purchase home based or institutional based care.  This approach shows some promise of allowing consumer choice and competition to have a role.

That said, as the AIHW maintains, outcome-based measures are not all that useful with chronic care.