Can care homes survive with privately funded residents cross-subsidising those who are state funded?

(by Morten Hviid) Care homes often take a mix of privately funded and state funded residents. Recent research by a leading provider of market information about the care home sector, LaingBuisson, assesses that the average fee per resident with a local authority (LA) assisted place fell short of what it costs care homes to provide the care by £104 p.w.. They also argue that the shortfall is picked up by private fee payers who are thereby providing a cross-subsidy. They refer to this as a hidden “care tax”.  The existence of this cross-subsidy is nothing new. The predecessor of the Competition and Markets Authority, the OFT, found the same in a report from 2005.  However, the size of the cross-subsidy is notable.  Even without assessing the strength of the new research, which is not publicly available, several aspects of this news story are worth pondering further.  Should LAs use any buyer power they might have when negotiating prices?  What are the consequences for the care market from the cross-subsidy?  Why are care homes willing to accept below cost prices?  These questions have added current importance because the CMA is undertaking a Market Study into the care home market.

Assuming that LAs have buyer power which they could use to negotiate low prices, should they use this buyer power? An “Efficiency Review” undertaken in 2010 by Sir Philip Green for the Prime Minister’s Office suggests that this would be desirable.  The summary from the Prime Minister’s Office of the report dated 11 October 2010, states: “Sir Philip Green has published his review into Government efficiency. The review found that the Government has consistently failed to make the most of its scale, buying power and credit rating.”  The then Prime Minister David Cameron welcomed the report, stating that “I think it’s a good report, it will save a lot of money and it’s important we do it.”  This use of buyer power may be more important in a period where public resources are especially scarce.  However, using this power may distort markets in a way which is not desirable from a public policy perspective.

The current government appears more explicitly concerned with distributional effects of policy, compared the immediate predecessors. Using buyer power typically create both winners and losers. The current Prime Minister, Theresa May, has placed emphasis on the “just about managing” families.  Who then are affected by a cross-subsidy from the private payers for a care home place to those with a LA assisted place?  At a first blush, the cross subsidy would appear to be from the financially relatively better off to the financially less well-off and as such could be seen as a progressive tax, which some may welcome.  Work undertaken with Professor Ruth Hancock and published as a CCP working paper in 2010 attempted to understand the consequence of this use of buyer power by LAs for both consumers and the care home sector.[1]  We identified a squeezed middle arising from this cross-subsidy, the persons who did not qualify for the LA assisted low price, but who were not able or willing to afford the private rate.  The alternative would be for family or friends to provide the necessary support, with the associated stresses and costs of doing so.  The bigger the gap between the two prices, the larger the group squeezed out of the market is likely to be.  Are there more JAMs in the group which benefits from the cross subsidy than the group that is squeezed out?  From the simulations we did then which allowed for an even bigger difference between costs and LA assisted price, the size of the squeezed middle appeared rather small under the existing funding rules.  To the extent that this analysis is still valid and that one can reasonably assume that JAMs are predominantly in the group with access to LA assisted places, the use of LA buyer power may simply be moving some of the costs of care over to wealthier families.  However, this fails to take account of the supply response by care home owners.

The care home market has in the past been characterised as fairly competitive with a large number of suppliers. This both explains why the cross subsidy is feasible and also why any outcome with substantial cross subsidies may be very unstable.  Competition is normally very effective at weeding out cross subsidies by enough firms only serving the part of the market which pay high prices.[2]  The local authority must be able to make (almost) all care homes accept supplying local authority assisted places to avoid large scale free-riding or cherry picking by either existing care homes or new entrants who decide to focus on the private market.  If the LA can control the mix of private and LA assisted places in each care home and they manage to do so in the appropriate proportion, then the price for private place which ensures that the care home will just breakeven will be the same across care homes and we could have an equilibrium with differential pricing.  Self-evidently, such an equilibrium is very unstable.  How many periods with below capacity numbers of private payers can the care home sustain before having to exit?  The incidence and reasons for exit by care homes is the focus for current research.  A question which our research was never able to answer satisfactorily was: what is the source of LA buyer power which enable them not just to demand a low price but also that the care homes provide the “right” number of places so ensure that the residual market for private places is well-behaved?  We hope the current CMA investigation as well as our on-going research will shed some light on this.

[1] Hancock, R. & Hviid, M. (2010) ‘Buyer Power and Price Discrimination: The Case of the UK Care Homes Market’, CCP Working Paper 10-17

[2] Often referred to as cherry picking by those who are balancing their books by charging both prices.

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