Market-Distorting Regulations Helped Cause the Formula Shortage

Agency rules, tariffs and government programs contribute significantly to U.S. supply chain problems

By Andrew L. Mercado and Giorgio Castiglia

Supply chains around the world remain stretched thin by COVID-19 lockdowns, the war in Ukraine and disruptions in shipping markets. Infant formula shortages, however, are a uniquely American problem. In a time when Amazon can deliver nearly anything to your front door within two days, supermarket shelves are noticeably lacking any meaningful supply of formula. The formula shortage demonstrates how regulation often restricts competition, wherever such market-distorting regulations (MDRs) prevail.

The shutdown of Abbott’s Michigan facility due to bacterial growth and “egregiously unsanitary” conditions might have predictably taken one brand of formula off the shelves for a short time. However, the widespread shortages seen today are a function of greater market distortions rather than the temporary shutdown of a single facility.

The primary blame for the formula shortage lies with MDRs. Policies such as smothering tariffs, the WIC program and new product waiting periods, all instituted by Congress, laid the groundwork for this crisis, and the prolonged Abbott shutdown instituted by the FDA made it worse. To avoid similar shortages going forward, the government should avoid policies and regulations that make markets more vulnerable to economic shocks.

Market-Distorting Regulations

Markets work because they align the incentives of producers and consumers, even though each group may be self-interested. Consumers demand the best-quality goods for the lowest prices, and producers want to make the most profit possible. Through the market process, producers vigorously compete for a consumer’s dollars, and since no two consumers have the same preferences, a number of companies emerge, competing to satisfy consumers’ tastes.

When the incentives of producers and consumers become misaligned, generally through government regulatory interference, market participants’ behavior changes, setting off a complex chain of reactions. Calls to increase competition by breaking up some companies or using government funds to subsidize small companies actually don’t promote true competition; rather, they distort incentives for every consumer and producer.

Critical to understanding the formula shortage is that fewer regulations and interventions, rather than more, might have led to a decidedly different outcome. Had incentives and competitive pressures been free from regulatory interference, the shutdown of a single facility would have simply meant one fewer brand to choose from, not a widespread shortage.

When a federal policy effectively impedes competition in a way that does not address a legitimate market failure, it is a market-distorting regulation. MDRs undermine competition and sometimes create federally backed monopolies. These MDRs are especially damaging to competition since they have the implicit backing of the government. Thus, specific federal regulations are often the cause of competitive concerns, not the cure.

For example, in the case of sugar, market-wide U.S. production allotments and import quotas have the effect of entrenching incumbent producers and making it nearly impossible to start a new company, since the amount of sugar produced by a new company has to come from existing allotments or quotas that are already owned by existing companies. Similarly, in postal markets it is illegal for any company other than the U.S. Postal Service to deliver first-class mail to any address in America. Policies such as these distort competition so that the market is unable to efficiently operate.

Specific MDRs that affect the infant formula market have in no small part caused the current crisis. Some people blame a lack of competition in the infant formula market, citing the statistic that 90% of the market is dominated by four major firms. While this statistic is true, it is misleading because it says nothing about why such concentration exists. If policymakers want to minimize the risk of future crises of this magnitude, determining the root cause of the concentration and market disruption is critical.

Harms to competition are not always, or even usually, driven by private anti-competitive conduct. Often, these harms are the result of MDRs. An overcautious FDA; federal trade restrictions and tariffs; and the federal Supplemental Nutrition Program for Women, Infants and Children (WIC program) all played a part in the concentrated infant formula market. They also each contributed to exacerbating the shortage by restricting supply.

The Food and Drug Administration

The FDA was a key factor in the length of the crisis since it presented significant regulatory hurdles for Abbott and competing companies. In Abbott’s case, the regulatory hurdles were centered around cleanliness, and in the case of competitors FDA regulations slowed the entry of new products.

While the CDC did not find a causal link between the bacteria found in the Abbott facility and the tragic passing of two infants who consumed the formula, conditions in the facility were deemed unfit for production. Following a shutdown of Abbott’s facility in mid-February and the completion of an investigation on March 18, Abbott and the FDA reached a settlement on May 16, nearly three months after the initial shutdown and more than seven months after initial reports of food safety violations were reported to the FDA. It took the agency over three months to even investigate the facility, and another two weeks before the formula was recalled and the facility was shut down.

While there are reasons to believe that the shutdown of the facility was warranted, the most troubling sanitation violations were confined to non-production areas of the facility. What’s more, the FDA, in its Current Good Manufacturing Practices, has conceded that it is not possible to manufacture a completely sterile infant formula. Even so, there is no evidence that Cronobacter sakazakii (the bacteria found in the Abbott facility) was found in unopened shipments of formula, nor was that specific strain of bacteria linked to Abbott’s production facility. The facility, then, was primarily shut down out of an abundance of caution rather than a likelihood that a prolonged shutdown would add to public safety.

This is not the first time that the FDA has disrupted a market for the sake of caution. During the height of COVID-19, the FDA held up the rollout of AstraZeneca’s vaccine due to claims that it might cause pulmonary embolisms, even though there was no evidence to support this claim.

The FDA has a history of erring on the side of caution, willing to accept some risk of shortage in the case of formula, or hospitalization in the case of vaccines. But this tradeoff seriously degrades competition. By allowing fewer products to come to market and delaying those that are eventually introduced, the FDA gives a significant head start to the first company to introduce a new product. While the magnitude of a first-mover advantage can be debated, it is generally agreed that first movers in highly regulated industries have a significant leg up over their rivals. Quick and accurate approval from the FDA is critical to maintain and increase competition in these highly regulated industries over the long term.

Additional barriers for companies wishing to enter the infant formula market are the immense regulatory requirements to get formula on a store shelf. Formula manufacturers are required to use specific ingredients, label their products properly and wait at least 90 days before bringing a new product to market. This 90-day waiting period applies for both new manufacturers and new formulations from existing manufacturers. A new formulation might include use of new equipment, changes in packaging and changes to ingredients. While there may be good reasons to have such strict guidelines to ensure the health and safety of infants, these requirements make it incredibly difficult to enter the infant formula market.

This lack of competitive pressure has significant costs. Incumbent formula manufacturers know that there is a significant waiting period for new formula, so they have little incentive to fix problems quickly or innovate. New production methods that are more sanitary or changes to workflow that require different manufacturing capabilities all come with a waiting period. Even changing the workflow of a facility to make critical repairs will likely trigger a waiting period. The unsanitary conditions in the Abbott facility may have been caused by a reluctance to trigger a waiting period if necessary improvements to their facility were made.

Tariffs

Tariffs are the long-term MDRs with the greatest effect on the import of infant formula. The tariff rate on infant formula imposed under the U.S. Harmonized Tariff Schedule is between 14.9% and 17.5%, but the effective duty rate is often much higher. By comparison, the average tariff rate across the economy is around 1.6%. Of the $149 million in infant formula imported into the U.S. between 2012 and 2021, $29 million entered duty free, and the rest faced an effective duty rate of 25.1%. The average demand for formula over that same period was $2 billion annually, so imports accounted for a small but significant fraction of overall demand.

A complicating factor in the tariff story is that annual exports are more than 20 times annual imports because U.S. formula manufacturers produce more than necessary for the American market alone. During times of normal production, there are few incentives to import infant formula even in the absence of tariffs. And because of FDA restrictions, suitable infant formula from outside of the U.S. tends to be more expensive.

The problem comes during times of supply shortage. Since the Abbott facility was shut down for a significant period, the U.S. would have become a net importer of formula, in the absence of high tariffs.

Shifting to foreign formula, even in the absence of burdensome FDA regulations, was infeasible mainly because of cost. The average cost per kilogram of U.S. manufactured infant formula is around $4.40. The average cost of imported formula is over $2 more per kilogram, at $6.60. The main supplier of imported formula is Ireland, which has an average cost per kilogram of $7.48. Chile, which is not subject to tariffs on formula, has an average cost per kilogram of $2.79, but it only exports around 1.2 million kilograms per year to the U.S.—a little more than 0.2% of U.S. annual demand. A sudden increase in demand for Chilean formula would have likely caused the price per kilogram to skyrocket.

Combined with FDA restrictions, the tariffs represent a significant impediment to demand by erecting barriers to international market entry. On average, imported formula is around 50% more expensive than domestic formula for roughly the same product, with around half of that increase in price coming from tariffs. Switching over to a product that is 50% more expensive than normal would fall far outside the price-gouging guidelines set forth by states such as California, which sets the threshold during times of crisis at 10%.

The main U.S. formula companies do not see international companies as a legitimate threat to their market power. While in the present moment any formula is better than none, foreign formula companies face significant uncertainty in the U.S. In the short term, high prices may be able to support their entry since they would provide the only formula on the shelves. However, now that Abbott has turned the taps back on and is able to significantly undercut the international competition, the importers will be pushed off the shelf. With the current environment of domestic companies producing a surplus before the shortage, and foreign imports subject to average tariffs over 25%, there is no competitive pressure on the incumbent formula manufacturers.

The WIC Program

The WIC program is a mix of federal and state-level MDRs culminating in a concentrated market with few incentives to enter or innovate. On the federal level, the WIC program provides low-income women and children up to age five with a range of foods to supplement nutrition for those at high risk of nutritional deficiency. While this program covers significantly more than just formula for infants, the coverage for infants is widespread. According to the USDA, over half of infants in the U.S. are covered by the WIC program. As of 2018, 56% of all formula produced for domestic consumption was purchased for use in the WIC program, making the federal government far and away the largest buyer of formula in the U.S.

One problem, however, comes from the way these funds are distributed and purchases are handled. States receive money for the WIC program and accept sole-supplier bids for all WIC formula in their state. While this sole-supplier system can lead to significant cost savings for consumers, who are able to purchase deeply subsidized formula for a fraction of what it would cost without the program, it also leads to formula market concentration. Since contracts are awarded based on which company can produce a certain number of units at the lowest cost, those companies with the largest, most efficient operations will end up on top.

This is how two companies have come to dominate the formula market, both with over 40% of the WIC formula market. Abbott, the subject of the facility shutdown controversy, leads the way with 47% of the market, consisting of 49 WIC contracts with states, territories and tribal organizations. Mead Johnson comes in second with 40% of the market, consisting of 15 contracts. These two companies together, because of their immense scale, can continually win contracts and service nearly 90% of the entire WIC market.

Conventional wisdom about monopolies holds true for the infant formula market: When one company becomes a monopolist, prices rise. In the quarter following the award of a WIC contract, the brand of formula covered by the program raised its prices between 8 and 14 cents. The data also show a price increase of noncontract brands by between 3 and 10 cents, meaning that regardless of which company is awarded the contract, prices of all formula are higher because of the WIC program.

Additionally, winning a WIC contract means higher sales on other non-WIC products from that company. Following the award of a WIC contract, non-WIC formula from the same company doubled in sales after only a year of the contract. Not only does the WIC program apportion a guaranteed revenue stream for the winning company on their WIC brand of formula, but it also shifts consumption toward all that company’s products and away from competitors.

All this seriously diminishes competition. By allotting lucrative contracts on a sole-supplier basis, the firms that are already large and efficient are more likely to win. This single win can then be leveraged into additional wins, as the company invests the WIC contract profits into further expanding its manufacturing capability to promise additional supplies of formula at lower prices. These low prices, however, are not reaching the end consumers. WIC participants and nonparticipants alike are forced to pay higher prices as a result of a firm attaining a WIC contract.

Learning from the Formula Shortage

While eliminating all MDRs like those highlighted above is unlikely, policymakers must rethink the regulatory requirements surrounding infant formula if they intend to learn from this crisis. Among the most damaging MDRs are the FDA’s waiting period restrictions and the WIC program as a whole. By instating a significant waiting period, the FDA is keeping out new entrants that could easily bring critical supplies of formula to the market, while the Abbott facility only recently reopened after nearly five months. Reducing the waiting period would go a long way to increase competition in formula markets and make them more robust to supply shocks.

Further, the WIC program chooses winners and losers from the market, boosting those companies that are able to produce most efficiently at the expense of market stability. The program badly needs reforms to increase the number of companies supplying a state. To prevent a crisis like this in the future, the program must focus on the stability and efficiency of the entire supply chain, not just a single supplier. While the price of the WIC program may increase, these reforms would ensure that a single supplier shutdown cannot cause an entire market to collapse.

It is no wonder that the formula crisis has continued for so long, since there are significant regulatory barriers to entry and few long-term profit opportunities absent winning a WIC contract.

External forces beyond the direct control of the government often contribute to supply chain shocks. However, domestic policies such as MDRs should not exacerbate the situation. MDRs inhibit competition without addressing true market failures. They are on display in the formula market shortage, which offers a glimpse of how policymakers can search for MDRs in other industrial sectors as well. Tariffs, long waiting periods for newcomers to the market and sole-supplier state contracts have restricted the supply of formula at a time when it is most needed. We should keep a sharp eye out for other regulations that restrict the flow of goods and make supply chains less robust.