By Darren Smith, Weekend Contributor

“I don’t think there’s a lack of supply in Washington State.”—Rick Garza, Director, Washington Liquor Control Board.

Marijuana Retailers in Washington ran out of their cash crop after three days of sales. A few were never provided a supply before their grand opening. The Liquor Control Board blames licensees for causing the delays but the first licensees were given their licenses via e-mail around 1:30 AM on the opening day. The board issued the first licenses for growers / producers after the optimal time to begin marijuana cultivation and even went so far as to restrict certain growers by reducing their capacity due to what the board described as “over supply issues.” Prices remain high. It seems the command economy will continue for a while and the black market in all likelihood remains largely untouched.

While supply and price issues are expected to lessen over time the current price of marijuana is greatly above the black market price of the state average of slightly over eight dollars per gram. Marijuana at retailer Altitude in Prosser, WA sold between twenty to thirty dollars per gram while Spokane Green Leaf is twenty five dollars. Most retailers are selling for an average of twenty five. The prices, if unchanged, could be unsustainably high in the long term if supply problems and wholesale cost of up to four thousand dollars per pound are not addressed favorably. The black market will most likely still be a player.

With any legal or black market, market forces are going to be important. With Washington’s approach heavy regulation and high taxation could lessen the chance of eliminating the black market as was proffered by Initiative 502.

The supply chain for the black market is well established and its customer base is accustomed to dealing with it. Several economic factors will play a role.

Taxation

Washington’s marijuana tax is much higher than Colorado’s. It is taxed at twenty five percent at the producer/grower level, twenty five percent at the processor level, and twenty five percent at retail. This is an excise tax not an income tax where expenses could be factored in to reducing what the merchant pays. Of course, the black market does not pay taxes and could enjoy a greater than seventy percent cost advantage. Furthermore the tax is value added in that the retail tax is based upon markup plus wholesale cost which also includes the producers’ twenty five percent excise tax and the processor’s twenty five percent, compounding the taxation.

Regulatory Cost

The operation of wholesaler, producer, transporter, processor, and retailer are heavily regulated. Often as has been seen in the pre-licensing stage to be frequently and suddenly changing which can burden merchants with extra costs and down time spent toward compliance. The regulations dictate nearly every aspect of the supply chain from security requirements, signage regulations, procedures, extensive paperwork down to the seed level, store layout that must be approved by the Liquor Control Board, employment restrictions, THC testing for all batches with narrow tolerances for concentration levels and even such granularities such as all employees must wear identification badges, dimensions of the letters on signage, location restrictions, and zoning restrictions at the local level

The punishments for simple violations can be draconian. A retailer can be subject to thousands of dollars in penalties for nearly every violation on a first offense including such violations as an employee who does not wear their nametag or if a grower having a malfunctioning security camera on a second offense could be forced to destroy twenty five percent of their crop. If a THC test is out of range the grower can be required to destroy the entire batch. If the enforcement is heavy this could foster growers to add additional markup due to the possibility of losing a percentage of any given crop due to regulation issues.

The Liquor Control Board has shown that it can increase costs to growers by regulating the production capacity. Taking productive capacity away causes simple supply and demand forces to unfold where the growers’ operation overhead can remain constant so markup will be higher to address the per pound price and to maintain a desired return on investment. The Board requiring a producer to store excess inventory amounts to what is referred to as “Carrying Cost” which is the cost of maintaining an inventory that sits idle and is not shipped. These costs can include storage fees and cost of preventing spoilage. The longer the carrying cost, the greater the expense. Since current trends in the market of conventional goods have become more “just in time” in nature, the marijuana supply chain possibly might not have such a benefit if production supply is overregulated.

The black market has almost no regulatory cost other than the effect of criminalization which has not been fully a deterrent. The producers and distributors have had years of experience factoring costs of a percentage of product seizures into end prices.

Moreover there is always the specter of a catastrophic action against the businesses by the federal government, putting individuals in jeopardy of lengthy prison terms and seizure of assets of the company. The current federal deference is entirely provided by a prioritization by the justice department as to its enforcement actions against legal businesses on the condition of heavy regulation by those states and the efforts to make the product unavailable to minors. A change of administration or policy on the federal level could prove a death blow to the legal industry. To avoid this, the states might increase the regulations and consequently the costs to the legal market in order to protect its tax revenue source.

The federal specter is also likely keeping very large corporations, having great capital resources from setting up shop in these states which would provide significant downward costs to consumers through production efficiencies and greatly increased productivity. Moreover low wholesale costs to the retailer will result in a lower total price paid by the consumer based upon the resulting lower taxes.

On the retailer side state law prohibits the sale of products or services that are not marijuana, marijuana products, or marijuana paraphernalia related. The business cannot sell other items that could be used to allow for marijuana products to be sold at lower cost than competitors. An example of this with conventional retailers would be Loss Leaders of other products to draw in customers to buy the more profitable main products. Plus, the restriction to only certain products makes the business as a whole more vulnerable to wholesale price swings if producers are low to chose from and their sole offering is one product line.

Low Supplier Availability to the Consumer

We have shown in recent articles that there is a growing trend among counties and municipalities to prevent legal marijuana entities from setting up shop in their jurisdiction. There are presently entire counties within Washington having prohibition, requiring consumers to travel for sometimes hours to obtain a legal product elsewhere. This is a great deterrent to engaging in legal trade and since demand continues to be present in these areas the black market remains the only source.

Also due to federal regulations interstate and international commerce is prohibited even between legal states, thereby reducing supply and outsourcing. The black market has multiple suppliers from differing countries and even a local option depending on market and growing conditions. Black market distributors may choose wider and more diverse sources thereby enjoying greater flexibility and cost control.

Costs of Production

The black market will have lower production costs due to constraints against the legal market.

The most efficient locations for growing marijuana are located largely in Eastern Washington in open spaces having access to water. Sunlight is free, and often is water. Since the large illegal grows are often located outside on land unregulated by landlords or property ownership the cost to the producer for infrastructure is low. Moreover, the efficiency of outdoor grows is significantly greater than indoor which is required by statute. Indoor grows require high amounts of electricity due to lighting and HVAC. Plus, grows are constrained by the size of the building where the outside grows are elastic. Utility costs are higher in Western Washington as is cost of land and building space. While indoor operations are maintained by the black market, they can still be less costly due to less constraints as to location regulations and other factors previously mentioned.

The Black Market Is A More Liberal Free Market

One large constraint to the legal market is the possibility of single point of failure by the Liquor Control Board to all aspects of the marijuana economy. Three individuals, the Liquor Control Board Members themselves, have no marijuana experience have almost total regulatory authority over the industry. Poor decisions by these three individuals can have systemic and cascading negative effects on all stakeholders. The black market however has greater influence over conditions of supply and costs and can bypass nearly all specific regulatory constraints, other than the illegal nature of its business that has existed for decades to which the industry has become accustomed to. Moreover, if a link in the supply chain fails in the black market another can take it over readily. If on the other hand a legal retailer fails for whatever reason and is the only source of product within a geographic location the time and cost necessary for replacement is significantly greater.

Edible marijuana products offer an insight into free market constraints. In Washington the labeling of food products is slow. Every product label must be approved, similar to liquor labeling requirements. The effect this has is to bottleneck the process and restrict the industry to changing its products quickly to address consumer demands or take advantage of niches that quickly come forth. The constraints also apply to THC levels where the black market can supply product to what it gauges its customer base more quickly.

Inelastic Consumer Base

The number of individual consumers willing to regularly use marijuana might not rise as easily as with those who adopt other products. Some products were virtually unknown or unavailable to consumers have become common household goods, such as smart phones and televisions which are ubiquitous. The present marijuana consumer could remain at a fairly static percentage but individuals who previously did not smoke marijuana likely will not do so in great numbers. The pre-prohibition consumer is accustomed to trading with the black market. Over time newer generations of consumer could be more resistant to trading in the black market if socialized into the legal trade. It remains to be seen of course how many new users enter the marijuana market but one needs to factor in the downward trend of tobacco smokers as a possible analog to gauge overall marijuana use. If the potential consumer base is too low attracting large companies with high capital and competition that can effectively reduce prices might prove to be difficult. This would lend advantage to the black market.

Costs to the Consumer

In the end, what could be the ultimate factor in whether the black market or the legal market prevails is going to be price. With all the factors listed previously involved at the present stage the black market enjoys a great advantage over the legal market. The tipping point will come when the consumer has freely available product for a price that is satisfactory. The legal market can enjoy a higher price if the allure of the black market is lower such as the want to deal with a legal seller and not dealing with sometimes unsavory providers of the black market. But this discrepancy cannot be wide.

One way the black market might address this would be to flood the market with cheap marijuana. Since the black market is not constrained by price controls, tariffs or anti-dumping laws, it is free to do so. An advantage they have would be that the distributors and cartels have vast cash reserves to endure selling marijuana at a loss to crush the competition with the legal market. A wide availability of cheap, illegal marijuana can be put fledgling stakeholders, having greater costs and constraints, out of business.

Conclusion

At this stage in the legalization of marijuana the overall success of defeating the black market is going to be largely economic in nature. If the state and federal governments are not responsive to the needs of the legal market we can expect to see the entrenched black market remain the greater supplier. As a result, the war on drugs could be a war of attrition between the market stakeholders on both sides of the law.

By Darren Smith

Sources:

KGW News
Time.com
V. Vizu, Photo Credit
Law Enforcement Sources

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