EconoMonitor

Ed Dolan's Econ Blog

Will Washington’s Legal Marijuana Market Ever Get off the Ground? A Government Failure in the Making

Like a majority of my neighbors, I voted in favor of Initiative 502, legalizing the sale of marijuana, in the 2012 general election. Some voted for the measure so that they could get canabis of reliable quality at a reasonable price without risk of arrest. I voted for it because I believe in markets.

For the better part of two years, nothing happened. There is still no marijuana shop in our village shopping center. But this week things are starting to change—or are they? On Monday, the first licenses were issued for legal marijuana outlets. Will users get the safe and reasonably priced product they need? Will nonusers be free of the spillover of violence from drug criminals and the waste of law enforcement resources devoted to failed efforts to suppress them? The news says, “no.” Instead, at least in the short run, it looks like we are going to get shortages and high prices for the trickle of product that makes it into the handful of legal shops, while criminal purveyors continue business as usual.

Here is how I would explain what is going on to my Econ 101 students:

The market under prohibition

We start with Figure 1, a simple supply-and-demand diagram that shows the market under prohibition. SN is the supply curve for non-legal marijuana. Because this is the market for just one state, the supply curve is elastic, which is to say that only a small increase in the price will draw in supplies from other states, nearby British Columbia, and elsewhere. The demand curve DN shows the quantity of non-legal marijuana that users are willing to buy, after taking into account both the price in dollars and the risk of getting busted for possession. As drawn, the curves give us a retail price of $12 per gram and sales of 1,000 kg per month. (Prices and quantities should be taken as illustrative, since they are based on very sketchy information about the illegal market.)

What is supposed to happen after legalization

Figure 2 shows what is, ideally, supposed to happen after legalization. A new curve SL appears, representing the supply of marijuana legally produced in the state. At least for moderate quantities, the legal supply curve should lie below the non-legal supply curve, because it should cost less to produce the legal product. Legal growers do not have to pay as much for security, they can grow in natural light near convenient roads rather than under electric light or in the deep woods, and they do not personally risk jail. Legal marijuana will be taxed, but if taxes are moderate, legal producers should remain competitive.

The demand curve for legal marijuana, DL, lies to the right of the non-legal demand curve, DN. This presumes that most consumers of the non-legal product will buy from the legal market if its price is no higher and that some new users will enter the market if they can be more confident of product quality and if the risk of prosecution disappears.

Figure 2, then, shows the outcome that proponents of legalization hope to see. The price is a bit lower than before. More marijuana is sold, but not so much as to turn everyone turns into a zonked-out pothead. Quality of the legal product is higher, reducing health risks. High costs and uncertain quality render illegal suppliers noncompetitive, so legal producers and retailers take over the whole market. Law enforcement resources previously devoted to the war on marijuana are freed up for other purposes.

What may happen instead

Unfortunately, it looks as if Washington voters may not get the hoped-for outcome. Figure 3 shows what  may happen instead. In Figure 3, overregulation severely restricts the supply of legal marijuana. As a result, SL, the legal supply, intersects the demand curve at a price far higher than does SN, the non-legal supply. Many if not most current users would then be likely to continue patronizing their illegal suppliers.

If that happens, we will end up with a split market. The old, non-legal market continues much as before, selling 1,000 kg per month at a price of $12 per gram, as shown in panel 3a. The legal market, as panel 3b shows, will now be tiny (100 kg per month) and the price will be exorbitant ($26 per gram). In the worst case, sales in the legal market could end up being so small that legal suppliers would fail to earn a profit and would be forced to close.

The danger of a split market arises from three factors:

  • The licensing process is not going smoothly. As of Monday, the state had approved only 24 of 334 applications from retailers and only 80 of 2,600 applications from producers.
  • Taxes are high. There is a 25 percent excise tax at each stage of the supply chain (production, processing and retail). When the state’s sales tax is added (6.5 to 9.6 percent, varying by locality), taxes are likely to account for 35 to 40 percent of the retail price according to one analysis.  In terms of Figure 2, the higher the tax, the higher SL will move in relation to SN, making it easier for non-legal suppliers to remain competitive.
  • No processors have yet been approved for edible cannabis products. Edibles have proved very popular in Colorado. The legal market appears to have an inherent comparative advantage in the production of edibles and other high-end products. As long as only smokeable products are available, the non-legal market will find it easier to survive.

The bottom line

What we seem to be looking at is a government failure in the making. It is true that promises of new tax revenues helped build a majority for legalization, but marijuana taxes, like any other taxes, are subject to a Laffer curve. Raise them too high and revenue starts to fall as users return to the non-legal market. It is also true that the legal market could benefit from a reasonable government effort to certify the quality and safety of supplies, because the expectation of more reliable product quality is, for some users, a reason to choosing legal rather than illegal suppliers. However, regulatory overkill that unreasonably raises costs and restricts quantities will be counterproductive.

It is still early days. Optimists hope that overworked licensing officials will eventually deal with the backlog of applications, shortages will disappear, and prices will fall low enough to make legal suppliers competitive in the market. Pessimists worry that the regulatory bottleneck represents backdoor sabotage by the forces of prohibition. Time will tell.

Update (Jan 2015): Since I wrote this in July, things have evolved. More growers have been licensed and supply from growers has increased greatly, driving down wholesale prices. Two aspects of regulation appear to be sources of ongoing problems: (1) A lack of conveniently located recreational stores, and (2) poor integration of the medical market with the recreational market. Both problems are discussed in this post from SLOG. Be sure to read the comments as well as the text of the post.

Earlier posts on related topics:

Latest Jobs Data Show Employment Ratio Remains Low: Why Legalizing Marijuana Would Help it Recover

Cops and Economists: Contrasting yet Complementary Views on Drug Legalization

Econ 101, Hayek, and Why We are Losing the War Against Drugs

6 Responses to “Will Washington’s Legal Marijuana Market Ever Get off the Ground? A Government Failure in the Making”

BryanWillmanJuly 9th, 2014 at 9:13 pm

Assuming that support among the general population remains or grows, then we'll likely see a series of follow-on measures designed to finish the market setup, but also probably to arm twist employers, landlords and such. [I just read that a person shown in the paper being among the first to buy pot in Spokane expects to fail a drug test and be fired.]

So will we see rules that employer drug tests may only test for the employees *current* mental state (are they sober/not-stoned/not-impaired right now, as opposed to sometime in the last days/weeks/years???? Will we eventually see rules that compel banks to treat accounts (and credit) fairly to producers of all legal substances?

It will be interesting to see if the forces of liberalization (including people like me have zero desire to consume but thinking constantly hassling people over it corrosive and silly) versus the forces of restriction – those people and entities that want everybody to always be a straight up sober worker and consumer.

The long run answer to that strategic question will likely answer "will the market regulator structure be fixed"

Ed Dolan EdDolanJuly 10th, 2014 at 12:14 pm

Yes, I wonder that, too. On the other hand, the Washington effort seems to be staffed, at least in some high-level positions, by genuine proponents of legalization. According to some accounts, some of them seem to agree that the strict regulations will slow down the startup, but the argue that the regulations will ensure quality and consumer safety, and that is necessary for the market to succeed in the long run. There is also the problem that however much they want to please the people who have a libertarian perspective about drugs, they also have to go along with the people who voted just because they want the tax revenue.

Ed Dolan EdDolanJuly 10th, 2014 at 12:16 pm

You make good points about employers and banks. I hope the answer to your question is that yes, the regulatory structure will eventually allow the market to function.