For the first several months of life, breast milk or infant formula is the primary item in a baby’s diet. The content and quality of infant formula is strictly regulated by the Food and Drug Administration for all brands. Therefore, milk-based or soy-based infant formula is nutritionally identical among brands. Three major manufacturers currently supply most of the infant formula sold in the U.S. market. Two of these three companies are subsidiaries of pharmaceutical companies and primarily market their infant formula through endorsements from the medical establishment—physicians and hospitals—rather than through direct advertisement to consumers. This marketing process is referred to as medical detailing. Carnation, which effectively entered the infant formula market in the United States in 1990, markets infant formula directly to consumers through mass advertising. Currently, Carnation has the smallest market share of any major producer. To qualify for participation in WIC, applicants must be at nutritional risk and have an income of no more than 185 percent of the poverty level. The supplemental foods that WIC provides include infant formula, milk, cheese, fruit and vegetable juices, iron-fortified adult and infant cereals, dried beans or peas, peanut butter, and eggs, as well as carrots and tuna fish for breast-feeding participants. Typically, participants receive their food benefits in the form of a check or a voucher that is used to purchase the specific foods at authorized retail vendors. Each state designates the types and amounts of foods that local WIC agencies can prescribe to meet participants’ nutritional needs. WIC operates in the 50 states (as well as on 33 Indian reservations), the District of Columbia, Guam, the U.S. Virgin Islands, American Samoa, and the Commonwealth of Puerto Rico. The program is primarily funded by federal appropriations, but some states supplement the federal grant with their own funds. In fiscal year 1996, WIC’s estimated expenditures for food were $2.7 billion, of which $578 million (net expenditures after rebates) was spent for infant formula. The rebates for infant formula totaled about $1.2 billion, lowering WIC food costs so that WIC agencies could provide benefits to approximately 1.7 million additional WIC participants monthly. Wholesale infant formula prices rose steadily from 1982 to 1996. Prices increased at a faster rate, however, at about the time the federal requirement for infant formula rebates first took effect in 1989—rising 9 percentage points above the general rate of inflation in the economy in this period compared with increases of about 3 percentage points above inflation, on average, at other times. Since little data are available on the factors that could have affected the price of infant formula, we could not analyze the extent to which, if at all, the accelerated price rise in infant formula was due to the rebate requirement. For WIC agencies, which had previously paid the same price as non-WIC purchasers, the net prices paid for infant formula decreased significantly after rebates went into effect. WIC agencies, for example, paid 85 percent less, on average, than the wholesale price for infant formula after accounting for rebates in 1996. Average wholesale prices for infant formula increased every year from 1982 through 1996. They increased fastest, however, at about the time the rebate requirement first came into effect—peaking at 9 percentage points above the general rate of inflation in the economy, as shown in figure 1. Because little data are available on the factors that could have affected the price of infant formula, we could not analyze the extent to which, if at all, the accelerated price rise in infant formula was due to the rebate requirement. Nevertheless, using available information, we analyzed whether the WIC rebate requirement for infant formula could have caused the acceleration in infant formula prices for non-WIC purchasers. These wholesale prices could have risen as a result of the WIC rebate requirement if, for example, the demand for a particular infant formula increased in the non-WIC market simply because the manufacturer of that formula won the WIC contract. We asked experts on the infant formula market whether any such “spillover” effect occurred. According to these experts, this spillover effect could have happened if (1) a WIC contract enabled a firm to obtain increased shelf space at grocery stores and hence increased sales to non-WIC purchasers and/or (2) physicians were more likely to recommend the contract-winning formula to their non-WIC patients. While such occurrences cannot be ruled out, the rapid price increase for infant formula that occurred at the time the rebate requirement went into effect could also be due to a host of other unmeasurable market factors. Such factors could include, for example, an increase in the cost of producing infant formula or changes in the demand for the product. The prices WIC agencies paid for infant formula decreased significantly after the rebate requirement went into effect in 1989. Before 1989, most WIC agencies generally paid the same prices as non-WIC purchasers for infant formula. With the rebate requirement, the price WIC agencies paid was basically the wholesale price of the formula minus the rebate offered by the contract-winning manufacturer. Figure 2 shows the national average wholesale price, average WIC rebate, and resulting average WIC net price from 1989 through 1996. As indicated by the figure, the average wholesale price in 1996, for example, was $2.48 per can. Manufacturers sold infant formula to WIC agencies, however, for about $0.38 per can. As the figure also shows, these rebates have been substantial and have been increasing over time. USDA estimated that, in 1996, over $1.2 billion in savings to WIC resulted from rebates for infant formula. These savings enabled the states to enroll 1.7 million more participants in WIC. Key characteristics of the infant formula market are the likely reason that manufacturers are able to offer WIC agencies significant rebates. In particular, the wholesale prices of infant formula appear to be high in relation to the cost of production—indicating the likelihood of high profit margins and the associated possibility of significant rebates. However, the nature of the market is changing because a new firm has entered the market—Carnation—that is offering infant formula at significantly lower wholesale prices. Our analysis indicates that manufacturers are able to offer WIC agencies significant rebates because a number of key characteristics of the infant formula market may lead to high prices relative to the costs of production. First, consumers of infant formula are probably not very responsive to changes in prices for infant formula. In particular, because many parents rely on a physician’s recommendation for a specific brand of infant formula, they are likely to be reluctant to change brands, even though infant formula is nutritionally identical across brands and the price of an alternate brand may be significantly lower. This strong brand loyalty, based on physician’s referrals, would typically enable firms to charge higher prices relative to costs than is the case in other markets in which consumers make purchasing decisions by comparing prices. Second, the practice of marketing infant formula through the medical profession is costly and may make it difficult for new companies, particularly those that are not in the pharmaceutical industry, to enter the infant formula market. When new firms are unable to enter a market easily, existing firms are usually able to charge higher prices relative to the cost of producing a product. Finally, the U.S. infant formula market is made up of only three major firms—possibly because of the costs of entering the market. When only a few firms sell in a market, the market is considered “concentrated.” Many studies have shown that more concentrated markets tend to be characterized by higher prices, relative to the cost of producing the product, than is the case in less concentrated markets. While the structure of the infant formula market may have resulted in prices that are high in relation to the cost of production, the structure may have changed in recent years with the entry of Carnation, a division of the Nestlé Corporation. Carnation effectively entered the infant formula market in 1990 and won its first WIC contract in 1992. Carnation changed the infant formula market by (1) marketing infant formula directly to consumers rather than by relying on the endorsements from the medical profession and (2) offering infant formula at wholesale prices that are significantly lower than the other manufacturers’. (See fig. 3.) Similarly, USDA officials told us that the sale of generic or store brands of infant formula is a growing trend in the industry, offering another lower-priced alternative to the major brands. While experts on the infant formula market told us that Carnation has had difficulty increasing its market share because it does not market its product through medical channels, the existence of a lower-priced competitor would generally tend to put competitive pressures on the industry. In fact, price increases by other manufacturers were relatively low in the year that Carnation entered the U.S. market and have since risen more slowly then they did prior to 1989. Although we did not have access to price and cost data that could help us determine definitively whether non-WIC consumers subsidized WIC through the prices they paid for infant formula, we relied on economic analysis and other available information to address the issue. Our analysis indicates that it is unlikely non-WIC purchasers subsidized WIC purchases of infant formula as a result of the rebate program. In economic terms, a subsidy of WIC by the non-WIC purchasers of infant formula would occur if a producer sold formula to the WIC market at less than the producer’s cost of production and used the profits generated by the non-WIC purchasers paying a higher price to compensate for the loss. Our economic analysis of the infant formula market, as well as other available evidence, suggests that while prices may have differed significantly between the WIC and non-WIC markets, it is unlikely that an economic subsidy of the WIC market by the non-WIC market occurred.