Legalizing marijuana is hard. Regulating a pot industry is even harder.

June 29, 2013

It’s not every day that a former Microsoft executive holds a press conference to announce his new venture into the exciting and profitable world of drug dealing.


(Ted S. Warren/AP)

But that’s exactly what happened earlier this month when Jamen Shively, a former Microsoft corporate strategy manager, announced that he wants to create the equivalent of Starbucks in the newly legalized pot industry in Washington state.

All this is happening at the same time that the Washington State Liquor Control Board is looking to finalize rules on the new, legal marijuana industry. And one of the major debates right now among board members is how much they ought to prevent or encourage the kind of market consolidation in which a few firms dominate the whole industry.

As Chris Marr of the Liquor Control Board argued, “How do you prevent a Microsoft millionaire from getting this idea and deciding that — playing by the rules — they’re going to dominate the market?” And if that is the concern, what can economics inform us about how this new market should be set up?

To provide some background, voters in Washington state passed Initiative 502 last fall in a general ballot, creating a statewide legal market in pot. Unlike Colorado, which has passed a bill to expand its medical marijuana industry and make pot legally available to everyone, Washington is folding pot under regulations for the liquor industry. As such, the Washington Liquor Board has regulatory control over the new marijuana industry.

As with alcohol, a marijuana firm is classified as a producer, processor or retailer. The first question, therefore, is how aggressively regulators should try to check the market power of front-line sellers. As of now, if there is excess demand for licenses, which cost $1,000 each, they will be subject to lottery. Licenses can’t be traded in a secondary market, and it is possible that the regulators will cap the number of licenses per holder.

The law also requires regulation for public safety and public health. As with the tobacco industry, voters don’t want firms marketing and selling pot to underage users. And public health officials are concerned about companies marketing to "problem users" who would like to quit or reduce their usage but find themselves unable to.

If that’s the case, then perhaps having pot dealers with large market power is a good idea. Economists usually consider monopolists a problem because they produce too little of a product and charge too much for it, earning substantial profits. But that could be a good thing for the pot industry. Safe profit margins mean that a firm might be less likely to compete on price for every potential consumer -- and also much more likely to follow the law.

Yet people involved with the Washington law have two main responses to this. The first is that firms with market power could go outside the market and use their extensive profits and influence to exert political power.

“The idea is to prevent the retail industry from becoming so large that they have enough wealth and power to roll over anyone trying to enforce, expand or update the public-health-focused rules that are designed to protect the public’s health and safety,” says Roger Roffman, a University of Washington professor and author of the forthcoming book "Marijuana Nation."

Second, consolidated firms may that they themselves pose threats to public health.  “If a firm has market power, the profits they get from selling above market costs means that they can have a bigger marketing department," says UCLA public policy professor Mark Kleiman. "In the real world, spending here will increase their market share by creating additional problem users. This, combined with lobbying efforts that will rival the alcohol industry in terms of avoiding taxes and adjusting the rules, is a major problem.”

A third argument comes from University of Chicago economics professor E. Glen Weyl. He argues that “long-term players who have market power have an incentive to get people addicted. A monopolist, in particular, has a big incentive to advertise to get people addicted over the long-term, as they are sure to reap all those rewards.” If a marijuana firm has a monopoly, then the financial gains of turning someone into a heavy, problem user of a product (rather than a specific brand) will all go to that firm. A market with smaller, fragmented firms with greater turnover would be a check on this dynamic.

Both Weyl and Kleiman argue that Washington should consider bolder ideas to regulate the industry. Weyl suggests some sort of mandatory turnover policy to discourage firms from turning people into problem users. Another possibility, which Kleiman considers, is to create a state-run nonprofit retail firm that has no interest in creating problem users or expanding the market. (Given that pot is still illegal at the federal level, this isn't likely to happen).

Market consolidation is also an issue when it comes to a firm’s vertical structure. Under Washington state law, if a firm is a retailer, it can’t be a producer as well as a processor. This is meant to fragment the vertical chain of production, and it contrasts with Colorado’s system, in which dealers are required to grow 70 percent of what they sell (as that is how the medical marijuana system works).

Another related economic issue is the location of pot retailers. The law in Washington, as currently structured, requires pot retailers to be at least 1,000 feet away from a school, day-care facility, playground, teen arcade game center, recreation center, transit center or library. Though this may sound minor, in practice it means that it will be very difficult to put pot retailers in dense population spaces. Retailers might be limited to industrial or largely depopulated areas.

That could force what economists who study spatial models of economies call the agglomeration model -- as when certain kinds of restaurants all cluster together to create an area people go to for certain goods. As Weyl notes, "often ethnic restaurants cluster into neighborhoods so that people can find the best places, creating ethnic neighborhoods. Do we want a 'pot town' to grow up in our cities? Perhaps not, but that is the logical consequence of forcing dealers away from a convenience model."

Kleiman thinks the main issue with regard to pot retailers' ultimate location has more to do with advertising and discretion than anything else. “An alcoholic trying to quit drinking will pass by alcohol in bars, billboards and grocery stores. That person uses up a lot of emotional energy always having to say no.” Instead of focusing on 1,000 feet within certain buildings, the bigger issue Kleiman emphasizes is whether storefronts and signs aggressively advertise their product.

It’s important to get these issues right because they interact with the three background constraints on this new market. The first is the black market, while the second is the legal medical marijuana market. For some reason, the medical marijuana market won’t be taxed, while the new legal market will be taxed around 25 percent. (The black market is, of course, not taxed at all.)

Note that if the price goes too high, or if the location restrictions prove too inconvenient, pot consumers might just stick with medical marijuana or the black market. State lawmakers are currently trying to get the medical marijuana market folded under the same regulations that the Liquor Board is creating for the legal pot market, and Mark Kleiman notes that police may need to escalate crackdowns on illegal distribution as they legalize the market.

A third constraint is the federal government, which enforces laws that still make pot illegal. If legalization is seen as a disaster, it is possible that the federal government will move to shut down the process by preempting state law. But even if it doesn't, background laws will probably hurt the scale and efficiency of pot retailers.

As Jack Finlaw explains, since marijuana is banned at the federal level, new pot retailers “often cannot conduct their businesses through banks. They also cannot deduct business expenses from their federal taxes.” It is possible the normal interactions between businesses that allow them to thrive things like having a legal bank account won’t be immediately available.

Markets are constructed through laws and regulations, and the market for pot that is being created in Washington state is no exception. The regulators see how the consolidated alcohol industry is able to avoid taxation and accountability and are determined to avoid these problems in the new pot industry. Thus this market may help economists understand a crucial role of regulations that has lapsed in recent decades: the role of government in curbing the excess power of the private sector.

Mike Konczal is a fellow at the Roosevelt Institute, where he focuses on financial regulation, inequality and unemployment. He writes a weekly column for Wonkblog. Follow him on Twitter here.

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