Infant Formula Crisis Explained
How the unintended consequence of a cost shifting gimmick in the 1996 Welfare Reform Act led to empty shelves
When military planes have to deliver bulk shipments of European infant formula to America, it’s clear something is very wrong with our system. The public’s voice on this has emotions running high, but it’s short on facts. The fact is America’s supply system for formula is based on a federal budget gimmick enacted in the Welfare Reform Act of 1996. The ‘gimmick’ strengthened market concentration by three firms, but made the U.S. infant formula sector fragile—as the empty store shelves attest. High U.S. tariffs on imported infant formula has made the problem worse by further limiting competition.
Explaining The Gimmick
First, the U.S. Department of Agriculture’s Women, Children and Infants (WIC) food assistance is a discretionary grant, funded by an annual appropriation. It is not an entitlement program (funded via automatic Federal payments).
Eligibility for WIC is means-tested; family income must be at or below 185 percent of Federal poverty guidelines. Its impact on the infant formula sector is huge, as over half of all U.S. infants receive WIC benefits.
Because WIC is not an entitlement, it’s possible funds will run short. Thus, USDA has a priority system whereby people most at risk receive benefits first. Policy makers sought a way to grant access to all eligible people. While a noble concept, it came at a price, and ultimately resulted in empty store shelves for infant formula.
The Gimmick was the WIC ‘cost containment’ scheme: shifting program costs from the Federal government to the infant formula manufacturer, and, eventually, the retail customer.
The 1996 Welfare Reform Act (a Republican initiative, signed by President Bill Clinton) codified the WIC cost containment process. Here’s how it works:
1. Each state, tribal government, and U.S. territory has a WIC agency. They each receive an annual grant from USDA. No state matching funds are involved.
2. Each state WIC agency makes an announcement for infant formula manufacturers to submit sealed bids to provide formula for WIC beneficiaries.
3. A bidder must specify the ‘rebate’ it will pay the state for infant formula sold by a retailer and purchased by a WIC beneficiary, typically with an Electronic Benefit Transfer (EBT) card.
4. The state WIC agency unseals the bids in public. The bidder with the largest rebate wins the sole-source contract from the agency.
5. The state’s EBT cards are programmed to limit WIC-funded purchases of formula to the products of the sole-source manufacturer.
6. When a person uses their EBT card to purchase formula from a retailer, the retailer submits its record of WIC sales of formula to its bank.
7. The retailer’s bank sends an invoice to the bank that processes payments for the state WIC agency. Next, the state WIC agency reimburses the retailer for the full retail price of the formula.
8. The state WIC agency then bills the infant formula manufacturer, per the terms of their contract. The manufacturer pays the state WIC agency a cash ‘rebate’, based on the discount specified in the contract.
9. The state WIC agency adds the value of the rebates to its WIC funds.
Bottom line: it’s about ‘cost shifting’ —instead of relying only on appropriated funds, the formula manufacturers, via rebates to state governments, also fund WIC. This expands the funding pool so that all or nearly all eligible people receive WIC benefits. But there’s a price: rock-solid market concentration and ordinary purchasers paying a higher price for formula.
When a typical winning rebate bid is 80+ percent off the retail price, it’s clear that only very large manufacturers can afford to compete. Other firms that could produce infant formula are shut out. And, as we’ve seen, formula shortages arise when one manufacturer’s production line is closed, while all manufacturers face supply chain issues.
For decades, there have been only three major manufacturers of infant formula: Abbott Laboratories, Mead Johnson (now owned by Reckitt), and Nestlé. The Federal government viewed these firms as being able to offer sizable rebates because (they believed) the firms had included high markups in their retail prices. Keep in mind that about 60 percent of all U.S. infants are covered under WIC.
A firm that wins a WIC contract receives benefits that translate into more (non-WIC) retail sales, such as:
1. Retailers devote increased shelf space to the WIC contract products. Non-WIC formula products get less space, and possibly less attractive space (bottom shelf).
2. Pediatricians are likely to treat the WIC contract product as the default for infant formula, and recommend the formula to non-WIC clients.
3. Hospitals, birthing centers, etc., are more likely to choose one formula product (the WIC product) for their ‘Welcome Baby’ packages for new mothers.
4. The WIC contract manufacturer can take advantage of its market power within the state and recoup lost revenue by increasing the retail price paid by non-WIC customers.
5. Due to market concentration, the other two formula manufacturers have little incentive to compete for non-WIC customers by lowering their prices—as they have WIC contracts in other states and likewise need to recoup their losses from the rebates.
What About Imports?
Most infant formula is based upon powdered cow milk. Since the 1950s, U.S. dairy farmers have functioned behind a high wall against imports of milk and milk-containing products. Although 21st century dairy farming has evolved into large entities, involving hundreds or thousands of cows per farm, resistance to imports has remained strong.
Thus (with some small exceptions) all U.S. imports of infant formula are subject to a 17.5 percent duty. Unsurprisingly, U.S. imports are virtually nil.
Clearly, trade negotiations on infant formula have not taken into account the WIC program’s restrictions and its impact on the U.S. formula market. Add in market capture (the ‘Welcome Baby’ packages), and we have non-WIC buyers who aren’t price sensitive. If Baby likes the formula that Mama got in her package, Mama will continue to buy that brand, even if a generic equivalent or another (equally nutritious) brand is available.
Naturally, these purchasing habits went out the window when Abbott closed down its Michigan production line and all types/brands of infant formula disappeared from store shelves. But it’s unclear if the current change in habits will last when infant formula becomes readily available.
What’s the Solution?
It’s time to scrap the The Gimmick—the cost containment, sole-source contract system. The WIC statute needs to be changed to allow buyers to purchase any formula they want, and allow formula makers to compete on price. This will encourage generic and efficient foreign manufacturers to enter the market. It also would give a break to non-WIC buyers who have to pay higher prices for formula so the manufacturer can pay a rebate to the state government. Maternity clinics and pediatricians should offer discount coupons (not samples) for various branded and unbranded formula products. Lastly, WIC families should be able to use discount coupons when buying infant formula; manufacturers could offer special coupons targeted at low-income households.
Conclusion
Airlifting infant formula into the U.S. is not a solution to the shortage; it’s a bandage, not a cure. Blaming the FDA is wrongheaded; only the most radical libertarians would be indifferent to putting an infant’s life at risk from ingesting contaminated formula. And those nasty memes from the right that somehow U.S. aid to Ukraine is the reason for our shortage of formula—that’s very wrong.
The fragility in our infant formula supply system is stark. Continuing the practice of sole-source WIC rebate contracts will not fix the problem. The answer is opening the American market to give access to more formula suppliers. It’s the only way to ensure that the actions of just one supplier results in parents facing empty shelves instead of packages of infant formula.