Strategic Pricing in the Infant Formula Supply Chain: A Theoretical Model of Wholesalers and Retailers

By the 1960s and 1970s, infant formula became widely accepted as the nutritional standard for supplementing infants' diets. One of the biggest issues surrounding infant formula was the high costs. In 1972, the federal government instituted a pilot program called the Special Supplemental Nutrition Program for Women, Infants, and Children (WIC), aimed at providing infant formula to low-income mothers. However, the cost of infant formula continued to rise throughout the 1980s and 1990s, making it increasingly difficult for the federal government to assist all WIC participants. To contain WIC expenditures, state agencies began experimenting with cost-containment strategies, such as the sole-source rebate system. Under this system, manufacturers would bid for the contract, and the one offering the lowest monthly net price was awarded the exclusive right to supply formula to all WIC participants within that state. The system proved so effective at controlling costs that in 1989 the federal government required all WIC state agencies to adopt this approach or an alternative cost-containment method that provided equal or greater cost savings. This study theoretically models the infant formula industry, incorporating the market structure of upstream manufacturers, downstream retailers, and the purchasing power of the federal government through the WIC program. The theoretical model suggests that as the take-up rate and the quantity of WIC purchases increase, infant formula manufacturers will raise their prices. This occurs because WIC participants, who are the most price-sensitive consumers, do not pay for infant formula, which not only increases demand as more low-income households join the program but also reduces the price sensitivity of demand for formula. Consequently, manufacturers raise prices for higher-income, self-paying mothers, who are less price-sensitive. By doing so, formula manufacturers can effectively subsidize the lower-margin sales to WIC participants with higher-margin sales to self-paying customers, allowing them to participate in the WIC program while maintaining profitability.