This takes place at the circus. Don't take all of the stuff in the lost and found yet since you'll need an excuse to get back in there for this. If you already did, then it's too late.
At the circus, buy a cotton candy. Then when you go to buy another one from the vendor, you'll have the option to steal the guy's slide whistle. Do it (don't worry, he'll get it back). Talk to the kid about getting his bottlecap to get access to the lost and found (which is with the Hot Dog Vendor).
Go to the lost and found and view it. Then, put the slide whistle in. Then, go back to the cotton candy vendor and when you are asking about the price of the cotton candy, you'll have a chance to mention that you saw his whistle. When you do that, you will learn the terrible secret of the cotton candy (and get another for free).