This study examines the effects of smallholder milk market participation on household and intra-household dietary diversity and on nutritional status of young children in Ethiopia. Using the FAO dietary diversity questionnaire, 164 households were followed for two consecutive days and all food items consumed by five household members were recorded. T-test and propensity score matching were used to analyze the data. Milk market participant households have significantly higher levels of milk production, household income, dietary diversity and nutritional status of young children. Despite significant differences in milk production between market participant and non-participant households, no significant differences were found with regard to animal source food consumption in general and milk consumption in particular. However, dietary diversity and nutritional status of children under five is better in participant households, thus indicating that smallholder market participation is positively associated with food security and nutritional status of farm households in rural Ethiopia.