Food Assistance: Information on WIC Sole-Source Rebates and Infant
Formula Prices (Letter Report, 05/11/98, GAO/RCED-98-146).

Pursuant to a congressional request, GAO provided information on several
issues related to Special Supplemental Food Program for Women, Infants,
and Children (WIC) rebates for infant formula, focusing on: (1) how
prices in the infant formula market changed for non-WIC purchasers and
WIC agencies after the introduction of sole-source rebates; (2) how key
characteristics of the infant formula market may contribute to the size
of rebates offered by the manufacturers; (3) whether there is any
evidence indicating that non-WIC purchasers of infant formula subsidized
WIC purchases through the prices they paid; and (4) whether the
significant cost savings WIC agencies have achieved by using sole-source
rebates for infant formula have implications for other WIC products.

GAO noted that: (1) at about the time the WIC rebate requirement went
into effect in 1989, the wholesale prices paid by non-WIC purchasers
rose faster than usual while the net prices paid by WIC agencies
decreased; (2) since few data are available on the factors that could
have affected the price of infant formula, GAO could not analyze the
extent to which the accelerated price rise in infant formula was due to
the rebate requirement; (3) WIC agencies, which paid the same price as
non-WIC purchasers between 1982 and 1989, paid significantly less for
infant formula after the rebate requirement was implemented in 1989; (4)
key characteristics of the infant formula market are the likely reason
that manufacturers are able to offer WIC agencies significant rebates;
(5) in particular, the method of marketing infant formula--through
physicians' recommendations--contributes to strong brand loyalty among
parents; (6) although GAO did not have access to the price and cost data
that could determine definitively whether non-WIC consumers subsidized
WIC through prices they paid for infant formula, GAO's analysis
indicates that it is doubtful that such a subsidy has occurred; (7) a
subsidy would occur if a manufacturer sold formula to WIC agencies for
less than its cost of production and the price paid by non-WIC
purchasers compensated for this loss; (8) although prices have differed
substantially between the WIC and non-WIC markets, available evidence
indicates that manufacturers are still covering their production costs
in the WIC market; (9) furthermore, it is unlikely that manufacturers
would have an incentive to sell formula at a loss to over 50 percent of
the market--the share accounted for by WIC; (10) rebates for other food
products purchased by WIC can help reduce the program's costs but
probably will not generate the level of savings generated by infant
formula rebates; (11) savings for other products would be lower than for
infant formula in part because no other single product accounts for as
large a portion of WIC costs as infant formula and because the market
characteristics of other products make it likely that manufacturers
would offer smaller rebates per item; and (12) ultimately, the states
may find that other cost-reducing options are more effective than
rebates in generating savings for some WIC foods other than infant
formula.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  RCED-98-146
     TITLE:  Food Assistance: Information on WIC Sole-Source Rebates and 
             Infant Formula Prices
      DATE:  05/11/98
   SUBJECT:  Food programs for children
             Infants
             State-administered programs
             Subsidies
             Economic analysis
             Cost control
             Competition
             Marketing
IDENTIFIER:  WIC
             Special Supplemental Food Program for Women, Infants, and 
             Children
             California
             Texas
             
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Cover
================================================================ COVER


Report to the Chairman, Committee on the Budget, House of
Representatives

May 1998

FOOD ASSISTANCE - INFORMATION ON
WIC SOLE-SOURCE REBATES AND INFANT
FORMULA PRICES

GAO/RCED-98-146

WIC Sole-Source Rebate

(150275)


Abbreviations
=============================================================== ABBREV

  FNS - Food and Nutrition Service
  WIC - Special Supplemental Program for Women, Infants and Children
  USDA - U.S.  Department of Agriculture

Letter
=============================================================== LETTER


B-279607

May 11, 1998

The Honorable John R.  Kasich
Chairman, Committee on the Budget
House of Representatives

Dear Mr.  Chairman: 

Established in 1972, the Special Supplemental Nutrition Program for
Women, Infants and Children (WIC) provides federal grants to the
states for food, health care referrals, and nutrition education for
low-income pregnant and postpartum women, infants, and young
children.  The U.S.  Department of Agriculture's (USDA) Food and
Nutrition Service (FNS) administers WIC in conjunction with state and
local health departments and related agencies.  Typically,
participants receive food benefits in the form of vouchers that they
redeem at authorized retail vendors to obtain, at no cost to the
participants, certain approved foods, including infant formula. 
Then, on the basis of the redeemed vouchers, the state WIC agencies
reimburse the retail vendors for the food sold to the WIC
participants.  In fiscal year 1997, an average of 7.4 million
people--including about 1.9 million infants--participated in the
program.  These infants receiving WIC benefits accounted for about 46
percent of all infants born in the United States in 1996.  Because of
the large percentage of infants enrolled in the program, WIC
purchases of infant formula, according to industry estimates, account
for over 50 percent of this product's sales in the United States. 
During the 1980s, as WIC participation grew and the price of infant
formula rose, infant formula became a large and growing portion of
WIC costs. 

In 1989, the states were required by law to implement measures to
contain the cost of infant formula.\1 These measures have primarily
taken the form of state programs that award a contract to a
manufacturer for the exclusive right to sell its infant formula to
WIC participants.\2 These sole-source contracts are awarded on the
basis of competitive bids.  Under current statutory authority, the
firm offering the lowest net price (wholesale price minus rebate)
wins the WIC contract.\3 The contract-winning manufacturer is then
billed by state WIC agencies for rebates on all infant formula
purchased by WIC participants with vouchers at authorized retail
outlets.  The competitive bidding process has resulted in significant
rebates to state WIC agencies for infant formula, dramatically
reducing their costs.  As a result, rebates have divided the market
for infant formula into a discount market segment (the WIC market
with rebates) and a standard market segment (the non-WIC market). 

You asked us to provide information about several issues related to
rebates for infant formula.  Specifically, this report discusses (1)
how prices in the infant formula market changed for non-WIC
purchasers and WIC agencies after the introduction of sole-source
rebates, (2) how key characteristics of the infant formula market may
contribute to the size of the rebates offered by manufacturers, (3)
whether there is any evidence indicating that non-WIC purchasers of
infant formula subsidized WIC purchases through the prices they paid,
and (4) whether the significant cost savings WIC agencies have
achieved by using sole-source rebates for infant formula have
implications for the use of rebates for other WIC products. 


--------------------
\1 P.L.  101-147 (Nov.  10, 1989).  Under the law, state agencies are
required to procure infant formula using a competitive bidding system
or an alternative method of cost containment that yields savings
equal to or greater than those produced by a competitive bidding
system.  Some states had voluntarily negotiated sole-source contracts
with infant formula manufacturers before the sole-source rebate
requirement went into effect. 

\2 Some groups of states jointly have contracted for a sole-source
provider of infant formula.  Therefore, the geographic area covered
by some contracts may be larger than a single state. 

\3 P.L.  105-86 (Nov.  18, 1997).  The state must award the contract
to the firm offering the lowest net price, unless the weighted
average retail price for different brands of infant formula in the
state can be shown to vary by less than 5 percent. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

At about the time the WIC rebate requirement went into effect in
1989, the wholesale prices paid by non-WIC purchasers rose faster
than usual while the net prices paid by WIC agencies decreased. 
Wholesale prices for non-WIC purchasers rose an average of 9 percent
annually after adjusting for the general rate of inflation in the
economy at about the time the sole-source rebate requirement went
into effect, compared with increases of about 3 percent at other
times during the period of our analysis.  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.  WIC agencies, which paid the same price as non-WIC
purchasers between 1982 and 1989, paid significantly less for infant
formula after the rebate requirement was implemented in 1989.  After
accounting for rebates in 1996, for example, WIC agencies paid, on
average, 85-percent less than the wholesale price for infant formula. 

Key characteristics of the infant formula market are the likely
reason that manufacturers are able to offer WIC agencies significant
rebates.  In particular, the method of marketing infant
formula--through physicians' recommendations-- contributes to strong
brand loyalty among parents.  In addition, only a small number of
firms--currently, three major producers--sell infant formula.  These
characteristics are often associated with market prices that are high
relative to the costs of production, indicating the likelihood of
high profit margins and making high rebates possible.  However, the
nature of the market is changing because a new firm has
entered--Carnation--that is offering infant formula at significantly
lower wholesale prices. 

Although we did not have access to the price and cost data that could
determine definitively whether non-WIC consumers subsidized WIC
through the prices they paid for infant formula, our analysis
indicates that it is doubtful that such a subsidy has occurred.  In
economic terms, a subsidy would occur if a manufacturer sold formula
to WIC agencies for less than its cost of production and the price
paid by non-WIC purchasers compensated for this loss.  Although
prices have differed substantially between the WIC and non-WIC
markets, available evidence indicates that manufacturers are still
covering their production costs in the WIC market.  Furthermore, it
is unlikely that manufacturers would have an incentive to sell
formula at a loss to over 50 percent of the market--the share
accounted for by WIC. 

Rebates for other food products purchased by WIC can help reduce the
program's costs but probably will not generate the level of savings
generated by infant formula rebates.  Savings for other products
would be lower than for infant formula in part because no other
single product accounts for as large a portion of WIC costs as infant
formula and because the market characteristics of other products make
it likely that manufacturers would offer smaller rebates per item. 
Ultimately, the states may find that other cost-reducing options are
more effective than rebates in generating savings for some WIC foods
other than infant formula. 


   BACKGROUND
------------------------------------------------------------ Letter :2

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.\4 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.\5 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.\6 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. 


--------------------
\4 These companies are Mead Johnson Nutritionals (Bristol-Meyers
Squibb), Ross Laboratories (Abbott Laboratories), and Carnation
(Nestlï¿½ Corporation).  Wyeth-Ayerst Laboratories (American Home
Products Corporation) announced in 1996 that it would stop producing
infant formula under its own name for the domestic market.  It has
recently begun to produce infant formula sold under store labels. 

\5 Carnation received the Food and Drug Administration's approval for
its infant formula late in 1988.  It took some time, however, before
the company's presence was felt in the market.  Carnation infant
formula was approved by WIC in 1989, and the first wholesale price
quote available to us was for 1990. 

\6 States may set an income threshold lower than 185 percent,
provided it is not set below 100 percent of the poverty level.  In
1997, for example, the annual WIC income limit for a family of four
was $29,693 in the 48 contiguous states and the District of Columbia. 
Poverty guidelines are established separately for Alaska and Hawaii. 


   PRICES PAID BY NON-WIC
   PURCHASERS ROSE FASTER THAN
   USUAL WHEN REBATE REQUIREMENT
   WENT INTO EFFECT
------------------------------------------------------------ Letter :3

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.\7
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. 


--------------------
\7 Wholesale prices represent approximately the amount non-WIC
purchasers pay for infant formula.  The actual price paid is the
retail price, which is typically higher than the wholesale price by
the amount of the retailer's markup.  Because data on retail prices
were not readily available, this report focuses on wholesale prices
for the product. 


      PRICES FOR INFANT FORMULA
      INCREASED FASTEST AFTER
      REBATES INTRODUCED
---------------------------------------------------------- Letter :3.1

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. 

   Figure 1:  Rate of Increase in
   Prices for Infant Formula,
   Adjusted for Inflation, 1983-96

   (See figure in printed
   edition.)

Note:  The rate of price increase in the figure is the average annual
rate of increase above inflation. 

Source:  GAO's analysis of infant formula prices. 

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.\8

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.\9 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.\10


--------------------
\8 We contacted the three major manufacturers of infant formula
currently producing infant formula, as well as the manufacturer that
left the market as a brand producer in 1996.  Three of the firms
responded to our requests but would not discuss the prices or price
changes for their products. 

\9 These experts included representatives of infant formula
companies, university professors, and consultants. 

\10 In fact, the structure of demand in this market may have changed
throughout recent years because of a dramatic increase in the number
of infants enrolled in WIC.  From 1982 through 1996, the percentage
of infants in WIC grew from 18 percent of infants born in the United
States to 46 percent.  As lower-income women were drawn into WIC and
the non-WIC market became composed of higher-income consumers,
economic principles would suggest that, other things being held
constant, prices of formula for non-WIC consumers would rise. 


      NET PRICES FOR INFANT
      FORMULA SOLD TO WIC AGENCIES
      FELL SIGNIFICANTLY WITH
      INTRODUCTION OF REBATE
      REQUIREMENT
---------------------------------------------------------- Letter :3.2

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.\11 Manufacturers sold
infant formula to WIC agencies, however, for about $0.38 per can. 

   Figure 2:  Average Infant
   Formula Wholesale Price,
   Rebate, and Net WIC Price,
   1989-96

   (See figure in printed
   edition.)

Source:  GAO's analysis of infant formula prices. 

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. 


--------------------
\11 We used 13-ounce cans of infant formula concentrate as the unit
of our analysis. 


   KEY CHARACTERISTICS OF INFANT
   FORMULA MARKET MAY HAVE
   CONTRIBUTED TO HIGH REBATES
------------------------------------------------------------ Letter :4

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.\12

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 Nestlï¿½ 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. 

   Figure 3:  Infant Formula
   Wholesale Prices for Carnation
   and Other Infant Formula
   Manufacturers, 1982-96

   (See figure in printed
   edition.)

Source:  GAO's analysis of wholesale infant formula prices. 

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.\13 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. 


--------------------
\12 While investigating the structure of the infant formula market,
we did not investigate the competitiveness of the market under
federal antitrust statutes. 

\13 In addition, a Federal Trade Commission case and a number of
court cases have considered the industry's pricing practices.  These
cases could also have put pressure on the industry to maintain lower
prices. 


   SUBSIDY OF WIC INFANT FORMULA
   BY NON-WIC PURCHASERS IS
   UNLIKELY
------------------------------------------------------------ Letter :5

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.\14 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. 

We conclude that an economic subsidy probably did not occur for
several reasons.  First, firms do not generally choose to sell a
product at a loss, and if they find they cannot make a profit, they
will leave the market.\15 For example, according to Wyeth-Ayerst
officials, the company withdrew from both the WIC and non-WIC markets
for infant formula in 1996 because of increasing costs in the overall
infant formula market and the increasing size of the WIC market in
which the firm found it could not meet its costs of production. 

Second, firms that sell a product in two market segments will usually
attempt to earn the highest profit possible in each segment and will
not sell in a segment in which it cannot make a profit.  Given these
general conditions, however, a firm may choose to sell its product at
a loss in one market segment if by doing so it can increase demand
and profits in the other segment enough to compensate for the
loss.\16 In the case of infant formula, a firm would have to believe
that by selling at a loss in the WIC market it could significantly
increase sales in the non-WIC market--either through increased shelf
space and/or physician recommendations--and profits from these
additional sales would at least compensate for the loss in the WIC
market.  While such an effect could occur, it is unlikely that it
would be sufficient to give manufacturers an incentive to sell to the
WIC market--currently accounting for over 50 percent of all infant
formula sales--at a loss.\17

Third, while no data are available to us to estimate the actual cost
of producing a can of infant formula, information presented in a 1992
court case suggests that infant formula manufacturers were not
selling infant formula to WIC at a loss.  In this case, an infant
formula manufacturer's representative presented information on the
costs of producing a can of infant formula in 1989 and 1990.\18 We
compared these reported production costs to the WIC net price at the
time and found that the WIC net price exceeded the cost of production
by 2 to 13 cents per can, depending on the year.\19 While these
estimates are dated and rebates have grown since 1990, possibly
eroding the margin by which the WIC net price may exceed the cost of
production, one infant formula manufacturer told us that the company
does not and would not consider selling infant formula to WIC at a
loss. 


--------------------
\14 The cost of producing additional units of a good will typically
include production or marketing costs but will not include any fixed
or overhead costs.  This is because "fixed" costs will not increase
as more of a product is produced.  Therefore, even if sales from a
particular product line make no contribution to fixed costs, there
may be no subsidy.  For example, it is possible that only non-WIC
sales contribute to fixed costs.  As long as revenue from the WIC
market covers all marginal costs of production, however, there is no
economic subsidy between the two markets. 

\15 This statement is based on the assumption, common to the field of
economics, that a firm is primarily motivated to maximize profit. 

\16 For example, a retail store may choose to sell a product for less
than its cost (as a loss leader) because it can increase profits by a
greater amount through increased sales on an array of other products. 

\17 Experts on the infant formula market told us that, in fact, these
effects did not appear to be significant.  For further discussion of
a related issue--whether the possible spillover was sufficient to
offset the decline in net prices from rebates in the WIC market--see
app.  I.  That analysis shows that, in 1996, spillover effects would
have had to result in a price of $3.82 per can of infant formula,
instead of the actual price of $2.48 per can, to offset the lower net
price in the WIC market and maintain manufacturers' revenue at the
level it would have been in the absence of sole-source rebates. 

\18 Testimony presented in infant formula antitrust litigation in the
U.S.  District Court for the Northern District of Florida,
Tallahassee, June 2, 1992. 

\19 Some corroborating evidence about the cost of producing infant
formula appears in an unpublished USDA study conducted by the
Research Triangle Institute in Apr.  1992 (Josephine Mauskopf and
Nancy Dean, "WIC Program Rebates:  An Economic Analysis," Final
Report.  Contract, # 53-3198-0-033, Task 6.1.  Center for Economic
Research) in which the cost of producing a can of infant formula was
estimated on the basis of the ingredients that went into it. 
However, USDA officials expressed concerns about the validity of
these cost estimates because of methodological limitations, including
the unavailability of firsthand data on the procedure for
manufacturing infant formula. 


   COST SAVINGS FROM WIC REBATES
   FOR OTHER PRODUCTS WILL NOT
   REACH THE MAGNITUDE OF THOSE
   FOR INFANT FORMULA
------------------------------------------------------------ Letter :6

Rebates for other WIC food products could provide additional cost
savings.  However, such rebates will not generate the level of
savings obtained through the rebates on infant formula, in part
because these other food products do not account for as large a share
of WIC food costs and in part because market characteristics for
other products make it likely that manufacturers will offer smaller
rebates for each item.  Additionally, because there are multiple
products within the juice or cereal food groups, the costs associated
with administering rebates for these food products could be higher
than those for infant formula.  These higher administrative costs
would partially offset the savings in food costs obtained from
rebates.  Finally, some other options to reduce costs may be more
effective in generating savings for WIC than sole-source rebates for
foods other than infant formula. 


      REBATES FOR OTHER WIC FOOD
      PRODUCTS WILL NOT GENERATE
      AS HIGH A LEVEL OF SAVINGS
      IN WIC FOOD COSTS AS
      OCCURRED WITH INFANT FORMULA
---------------------------------------------------------- Letter :6.1

Rebates for other food products will not generate the magnitude of
savings that occurred with infant formula for two reasons.  First,
these other food products do not account for as large a proportion of
WIC food costs as does infant formula.  Before rebates were
introduced, the cost of infant formula represented about 45 percent
of WIC food costs.  Because infant formula constituted such a large
portion of total costs before rebates, the potential savings from
rebates were sizable.  Other products make up a much smaller share of
total WIC food costs, as shown in figure 4, leaving less opportunity
for rebates to reduce total WIC food costs.  For example, adult
cereals and juices, which have been identified as potential sources
of cost savings from rebates, currently account for about 14 percent
and 15 percent of WIC food costs, respectively, after adjusting for
rebates on infant formula.\20

   Figure 4:  Contribution to
   Fiscal Year 1996 WIC Food Costs
   After Rebates for Infant
   Formula

   (See figure in printed
   edition.)

Note:  Other WIC foods include eggs, peanut butter, infant cereal,
and beans. 

Source:  GAO's analysis of USDA's data. 

The difference in the level of savings between infant formula and
other WIC foods can be seen by California's experiment with rebates
for adult juices.  In March 1997, the California WIC agency
implemented rebates for juices and expects to receive $12 million
annually in juice rebates, or about 19 percent of its pre-rebate
costs for juice.  While these savings may well be worth pursuing,
they do not come close to the $183 million in savings that California
receives annually in infant formula rebates. 

Similarly, as we reported in September 1997, nine states have
introduced rebates for infant cereal, and three states have
introduced them for infant juices.\21 However, these two products
account for less than 1 percent each of total WIC food costs.  In
fiscal year 1996, rebates for infant cereal and infant juices
provided $6.2 million in savings to the program and reduced food
costs by about 0.6 percent in these states. 

Second, rebates for other WIC foods will not result in the level of
savings achieved for infant formula because the manufacturers of
these other products are unlikely to offer such large rebates for
each food item.  In particular, characteristics of the infant formula
market appear to have led to high prices relative to costs,
indicating the likelihood of high profit margins and making high
levels of rebates possible.  In 1996, infant formula manufacturers
returned 85 percent of the wholesale price of their product to WIC
agencies in the form of rebates.  The markets for other WIC food
products, however, do not share certain characteristics of the infant
formula market. 

Specifically, while the infant formula market has only a few
manufacturers, the markets for other WIC products, such as adult
cereals and adult juices, generally have more firms as well as
generic brands.  In addition, while the purchasers of infant formula
are likely to be very reluctant to change brands once one has been
recommended by their physician, the purchasers of juice and cereals
are not likely to be as reluctant to switch.\22

Finally, manufacturers may have less incentive to offer substantial
rebates for other WIC food products because they do not sell as much
of their product to the WIC market.  While WIC purchases of infant
formula may account for more than half the infant formula market, WIC
purchases of other food products account for a much smaller
percentage of the markets for those products.  For example, in 1996,
supermarket sales of cold cereal totaled $7.5 billion, while WIC
purchases of these cereals totaled $387 million, or 5 percent of the
total.  Therefore, a manufacturer of other WIC products would not win
a significant share of the market by obtaining a sole-source WIC
contract.  The inability to gain a significant share would tend to
reduce the firm's incentive to pursue the contract and hence reduce
the size of rebates. 


--------------------
\20 The potential for saving on milk and cheese is complicated by the
USDA commodity support programs, which affect the prices for these
products. 

\21 Food Assistance:  A Variety of Practices May Lower the Costs of
WIC (GAO/RCED-97-225, Sept.  17, 1997). 

\22 Firms producing other WIC foods, however, could benefit from
brand loyalty for their product among WIC purchasers who, unlike
consumers of infant formula, could continue to use the product for a
number of years after they have left WIC. 


      ADMINISTRATIVE COSTS MAY
      VARY BY FOOD PRODUCT AND
      REDUCE THE ADVANTAGES OF
      REBATES
---------------------------------------------------------- Letter :6.2

Because infant formula products are nutritionally identical across
brands, it is relatively easy to develop and administer rebate
contracts.  These contracts can be narrowly defined according to
product type (e.g., milk-based or soy-based), and the state WIC
agency's infant formula needs can generally be met by one contract. 
As a result, WIC agencies can use the redeemed vouchers to track the
type and quantity of formula sold to WIC participants in order to
determine the level of rebates they should receive from
manufacturers. 

In contrast, it will be more difficult to set up and administer
rebate contracts for other WIC food products, such as adult cereal
and juices.\23 Because there are multiple products in a juice or
cereal food category and WIC participants may consume several types
of each of these products, neither the design of the contracts nor
the administration of the rebate program is as straightforward as is
the case with infant formula.  More specifically: 

  -- Complexities in design of contracts.  California's WIC agency
     developed five contracts for adult juices.  California officials
     told us that, unlike infant formula which required only one
     contract, multiple contracts were necessary for adult juices
     because (1) there are many different types, (2) WIC officials
     wanted to provide participants with a choice of product, and (3)
     no single company was able to meet all WIC juice needs.  Because
     the costs of designing and implementing multiple contracts were
     significant, a California WIC official said that state officials
     probably would not attempt to design rebate contracts for adult
     cereals. 

  -- Complexities of monitoring sales and billing for rebates.  With
     multiple products in a food category, tracking sales to ensure
     appropriate billing for rebates becomes more difficult.  For
     example, a redeemed WIC food voucher will indicate that frozen
     juice was purchased but does not specify the type of juice among
     approved varieties, nor the quantity that was purchased.  To
     overcome this problem in California, the state WIC agency
     contracted with a company to supply data on the quantities of
     each brand and type of juice sold in the entire California
     market.  Then, assuming that the manufacturers' shares of the
     WIC juice market mirrored those shares in the entire juice
     market for the state, the WIC agency estimates the amount of
     sales for which companies should be billed.  Although juice
     companies helped devise this billing method, one company has
     begun to question the amount of WIC sales for which it is being
     billed.  Texas WIC officials also told us that the use of
     rebates in their state would not be feasible until it is
     possible to accurately track product sales.  One possible
     solution to these problems would be the use of a
     method--currently under design in some states--whereby WIC
     agencies provide an electronically coded card to WIC
     participants to be used at grocery stores for the purchase of
     WIC-approved items.  When the card is used, data are
     automatically collected about each purchase; therefore, the card
     would provide an efficient and accurate way to keep track of WIC
     sales for rebate billing. 


--------------------
\23 Infant cereal may be one of the other WIC products for which it
is relatively easy to administer a rebate contract.  Like infant
formula, infant cereal is sold by only a few firms.  In fact, Texas
WIC agency officials told us that the ease of contract and rebate
administration was one of the primary reasons rebates were
established for infant cereal. 


      OTHER FORMS OF COST SAVINGS
      MAY BE MORE EFFECTIVE THAN
      REBATES FOR SOME FOOD
      PRODUCTS
---------------------------------------------------------- Letter :6.3

Other forms of cost savings, such as the use of the least costly
brands, may be more effective than rebates for some food products. 
For example, the Texas WIC agency determined that the savings
generated by specifying that WIC participants use the least costly
product available would be greater than from using rebates.  The
least costly product could be, for example, a generic label or a
national brand.  The use of such products is possible for cereal and
juice because, unlike infant formula, generic brands are available
for these products.  However, there is a drawback to requiring the
purchase of the least costly brands, particularly if they are
generic:  If WIC participants do not like the product, they may find
the WIC food basket less attractive and stop using it.  For example,
the Texas WIC agency stopped using generic peanut butter because WIC
participants did not like the product and redeemed fewer WIC coupons
for the product. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :7

To develop the information on the issues discussed in this report, we
spoke with, and obtained documents from, officials at FNS
headquarters and the California and Texas WIC agencies.  In addition,
we spoke with an economist at USDA's Economic Research Service;
industry representatives for infant formula and cereal and juice
manufacturers, academic economists, and professors of business and
marketing.  We reviewed an economic study on WIC sole-source rebates
produced by the Research Triangle Institute, as well as information
presented in judicial proceedings concerning antitrust litigation on
infant formula. 

We analyzed the wholesale prices for infant formula from 1982 through
1996, as well as prices and price indexes for pharmaceutical, juice,
and milk products, and general inflation in the economy from the
DRI/McGraw-Hill economic database.\24 We also collected data on WIC
rebates and WIC net prices for each of the infant formula
manufacturers from officials at FNS headquarters.  To adjust prices
for inflation, we used the gross domestic product implicit price
deflator, which is the generally accepted method for determining real
prices.  We used 1996 as the base year for this adjustment.  In our
analysis of infant formula prices, we used a 13-ounce can of infant
formula concentrate as the basic unit of analysis because this is the
predominant form in which infant formula is used in WIC. 

We obtained information on the structure and characteristics of the
infant formula, cereal, and juice markets from representatives of
firms producing these products, as well as from economists
specializing in the analysis of the infant formula and cereal
markets.  In addition, we contacted the three current major
manufacturers of infant formula as well as the manufacturer that left
the market as a brand producer in 1996.  Three of the firms responded
to our requests but would not discuss prices or price changes for
their products and did not provide us with data.  Since much of the
information on manufacturers' cost of production and pricing policies
is proprietary to the firms, no empirical evidence was available to
enable us to definitively answer the question of the economic subsidy
of the WIC market. 

We conducted our work from July 1997 through April 1998 in accordance
with generally accepted government auditing standards.  While we did
not independently verify the data used in this report, the data are
commonly used by economists and other analysts studying WIC and the
infant formula market. 


--------------------
\24 DRI/McGraw-Hill is a company that focuses on economic analyses
and data collection. 


   AGENCY COMMENTS
------------------------------------------------------------ Letter :8

We provided copies of a draft of this report to the U.S.  Department
of Agriculture's Food and Nutrition Service for its review and
comment.  We met with agency officials, including the Chief of the
Program Analysis and Monitoring Branch, Special Supplemental Food
Division; the Chief of the Special Nutrition Analysis Branch, Office
of Analysis and Evaluation; and the Chief of the Audits and
Management Control Branch, Grants Management Division.  The Food and
Nutrition Service generally agreed with the report's findings and
provided us with a number of technical comments that we incorporated
into the report as appropriate. 


---------------------------------------------------------- Letter :8.1

We are sending copies of this report to the appropriate congressional
committees, interested Members of Congress, the Secretary of
Agriculture, and other interested parties.  We will also make copies
available upon request. 

If you have any questions, please call me at (202) 512-5138.  Major
contributors to this report are listed in appendix II. 

Sincerely yours,

Robert A.  Robinson
Director, Food and
 Agriculture Issues


WHAT THE CALCULATION OF WHOLESALE
PRICE IN NON-WIC MARKET WOULD HAVE
TO BE TO OFFSET THE LOWER WIC
PRICE
=========================================================== Appendix I

This appendix discusses the analysis we used to estimate the
wholesale price for infant formula in the non-WIC market that would
have kept manufacturers' revenue--with rebates in effect--the same as
it would have been in the absence of rebates.\25 Our analysis
indicates that in 1996, for example, when the WIC net price was $0.38
per can of infant formula, the non-WIC price would have had to be
$3.82 per can to keep manufacturers' revenue the same as it would
have been in the absence of sole-source rebates.  This $3.82 price is
significantly higher than the actual wholesale price of $2.48 per can
for that year.  Therefore, although spillover effects may have
resulted in increased demand and prices in the non-WIC market, these
effects did not generate price increases large enough to offset the
decline in net prices in the WIC market segment resulting from
rebates. 

In order to conduct this analysis, we first had to calculate what the
wholesale price would have been in the absence of rebates.  We did
this by assuming that after the introduction of sole-source rebates,
wholesale prices increased at the same rate as prices in the
pharmaceutical industry.  We chose the pharmaceutical industry
because infant formula is produced by pharmaceutical companies and
because infant formula tracked increases in pharmaceutical prices
through the mid-1980s. 

Next, we calculated the price in the non-WIC market that would have
kept manufacturers' revenue, with rebates in effect, equal to what it
would have been in the absence of rebates.  We refer to this price as
PC, or the WIC compensating price.  We used the following equations
to calculate the WIC compensating price: 

(1) Total sales revenue without rebates = (PNR * Q)

(2) Total sales revenue with rebates = (PW * WMS * Q) + (PC * NWMS *
Q)

PNR = Wholesale price in the absence of rebates

PC = Price in non-WIC market that would have compensated for low
price in WIC market

Q = Quantity of infant formula sold, with and without rebates

PW = WIC price, with rebates

WMS = WIC market share, with rebates

NWMS = Non-WIC market share, with rebates

Total sales revenue without rebates--equation 1--is set equal to
total sales revenue with rebates--equation 2-- and the equation is
solved for PC: 

(3)



(See figure in printed edition.)

(3a)



(See figure in printed edition.)

(3b)



(See figure in printed edition.)

(3c)



(See figure in printed edition.)

We conducted a number of interim calculations to provide data that
enabled us to calculate the WIC compensating price.  For example, we
calculated the WIC and non-WIC market share for any given year by
linear interpolation.  We did this because, according to industry
sources, the WIC proportion of the infant formula market increased
from about one third in 1989 to over one half by 1996, but we did not
know the actual rate of increase.  Linear interpolation allowed us to
distribute the 6-year increase equally among the intervening years. 
Because the infant formula market is divided between the WIC and
non-WIC segments, the analysis specifies that the WIC and non-WIC
portion of the market equal 1.  In addition, the analysis assumes
that WIC and non-WIC purchasers of infant formula are not sensitive
to price changes and that the total quantity sold is the same both
with and without rebates. 

The results of our analysis are shown in figure I.1.  They indicate
that although spillover effects may have resulted in higher demand
and therefore higher prices in the non-WIC market, the increased
prices were not large enough to fully offset the declines in net
prices in the WIC market resulting from rebates. 

   Figure I.1:  Estimated
   Compensating Non-WIC Price
   Compared with Actual non-WIC
   Wholesale Market Price

   (See figure in printed
   edition.)

Note:  The actual non-WIC market price is the average year-end
wholesale price of Mead Johnson, Ross, and Wyeth-Ayerst.  The
estimated compensating non-WIC price is a calculated, rather than a
market, price. 

Source:  GAO's analysis of infant formula prices. 


--------------------
\25 This analysis is based on the methodology presented in Josephine
Mauskopf and Nancy Dean, "WIC Program Rebates:  An Economic Analysis,
Final Report," Contract # 53-3198-0-033, Task 6.1 (Research Triangle: 
Center for Economic Research, Apr.  1992), pp.  3-10. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II

Thomas Slomba, Assistant Director
Amy Abramowitz, Assistant Director for Economic Analysis
Carol Bray, Senior Economist
Carol Herrnstadt Shulman, Communications Analyst


*** End of document. ***