Building a Legal Marijuana Industry From the Ground Up

Washington's Initiative 502 legalized pot across the state, but provided only a few guidelines for how to produce, process, and retail the drug. What regulations will lawmakers put in place—and will they convince black market users to switch to a new, regulated industry?
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Washington's Initiative 502 legalized pot across the state, but provided only a few guidelines for how to produce, process, and retail the drug. What regulations will lawmakers put in place—and will they convince black market users to switch to a new, regulated industry?


If all goes according to plan, by the end of this year farmers across Washington State will begin large-scale cultivation of a commodity they’ve never been allowed to mass-produce before—marijuana. Washington won’t just have the kind of quasi-legal medical marijuana regime now operating in 18 states and the District of Columbia. We’re talking about a place where weed can be produced, sold, and consumed as openly and legally as milk.

As a result, state officials are also getting down to the business of cultivating pot, but in a different sense. Now that the voters have spoken, the government’s task is to establish the regulatory furrows and field boundaries that will shape the growth of the legal marijuana industry itself. Governments invariably help shape markets through rules, subsidies, tariffs, and other interventions designed to promote some priorities at the expense of others. Do you want factories that produce as much as possible? Then make it easy for big manufacturers to buy up smaller ones. Do you want to preserve jobs? Then do the opposite. But when it comes to marijuana, the question of what kind of garden it’s best to grow is particularly complex.

That’s why Washington has hired Mark Kleiman, a jovially argumentative professor of public policy at the University of California-Los Angeles. Kleiman is a burly, gray-bearded man whose office is cluttered with haphazardly shelved texts on drug policy and criminology, his own books on those topics, and a paperback edition of The Hobbit. He has assembled a team of some 40 researchers to analyze the key issues confronting the Washington State Liquor Control Board, the body overseeing the whole legal-marijuana endeavor, and sketch out the potential outcomes of various approaches the board might take. “This isn’t just about making marijuana use legal,” says Kleiman. “It’s about creating a legal industry. Very different proposition.”

For the industry to succeed, prices need to settle at a just-right “Goldilocks point”—not so high that they drive people to the black market, but not so low that they promote overindulgence and an illegal export market.

Initiative 502 (PDF), the ballot measure that legalized marijuana, spells out only a few guidelines. Producing, processing, and retailing weed will each require a license and will each be taxed at 25 percent. The product will be sold only to adults over 21, and only in government-licensed stores that carry nothing but pot products and related paraphernalia. “They can’t even sell the Doritos,” deadpans Kleiman.

That leaves several key questions unanswered. How many licenses do you hand out? Who gets them? How big can a retailer, processor, or grower get?

One route Washington could take would be to issue lots of grower licenses and limit farm size to end up with a large number of small producers. Call it the mom-and-pop, artisanal-weed option. That would generate competition, which keeps prices low, encourages innovation, and makes it much more difficult for the industry to accumulate the kind of political power wielded by, say, Big Tobacco—the three companies that control 85 percent of the national cigarette market. On the other hand, it’s more difficult to monitor and regulate hundreds of small businesses than a few big ones. “And,” points out Kleiman, “they’re not making as much, so each of them has a stronger incentive to push stuff out the back door”—into the black market.

If the state instead allowed only a few big growers to operate, they might get rich enough to become powerful players in state politics. But their centralized operations would be much easier to keep tabs on, and they would have a powerful incentive to abide by the law. “Otherwise they could lose their oligopoly position, which is basically a license to print money,” says Kleiman.

The first round of draft regulations, issued in May for public comment, seems to at least leave the door open for the mom-and-pop option. The rules don’t mention any cap on the number of producers’ licenses to be issued. But nor do they set a limit on how big grow operations can get. And the rules could well change before they are finalized in late summer.

One major advantage of having a few big growers is it would likely keep prices high. That’s a plus not only for state tax revenues, but for public health as well, because of the way price influences the behavior of a particular group—serious potheads. “The daily and near-daily users are the ones who really drive the market,” says Beau Kilmer, the co-director of the RAND Drug Policy Research Center, who is working with Kleiman. “They’re about 20 percent of total users, but they account for about 80 percent of total consumption.” The proportions are similar among alcohol drinkers. Studies have found that higher prices keep a lid on how much those hard-core boozehounds imbibe, says Kleiman. Which is a good reason to keep weed prices up too. Marijuana may be a relatively benign drug, but it’s not harmless.

But here’s where the legal-pot industry runs into a unique and fiendish challenge: Washington can’t let the price drift too high because, of course, marijuana is not really a “new” industry. There is already a well-established system of marijuana producers, processors, and consumers—it’s just not a legal one.

Coaxing the estimated half-million-plus Washington residents who currently get their ganja from either the black market or the grey medical market to switch to a new, regulated industry amounts to a social-engineering project something like trying to divert a wild river into an improvised canal.

A certain amount of illegal trade is pretty much guaranteed to continue. About a quarter of total cannabis use is by people who are under 21, for whom marijuana won’t be legal even after legalization, Kleiman noted in a recent radio interview. “It means we’re only legalizing about three-quarters of the market,” he said.

For adults, the legal market will have the huge advantages of being, well, legal, and of providing reliable, tested products. But prices are bound to be higher than in the medical and black markets. Producers in those systems don’t have to shoulder the costs of complying with regulations and paying taxes. The multimillion-dollar cigarette smuggling business attests to how many people are willing to run a little risk to get something cheap. Or think about digital music: iTunes has cut down on illegal file sharing by offering fans music that is easily procured, reasonably priced, and of guaranteed quality. But millions of songs are still illegally downloaded for free every year. And scoring a joint in Washington is almost as easy as pirating a song on your laptop. “Anyone who wants a medical card can get one,” says Kleiman. Which raises the question: Suppose they threw a legalized pot industry and nobody came?

For the industry to actually succeed, prices need to settle at what Kleiman calls a just-right “Goldilocks point”—not so high that they drive people to the black market, but not so low that they promote overindulgence and an illegal export market. Regulations can’t set those prices; they can only try to influence them.

All of which makes it exceedingly difficult to figure out how much tax revenue Washington will actually pull in from legal pot—a key point in selling the initiative. The state’s Office of Financial Management recently published its best guess on how Initiative 502 will impact Washington’s bottom line. Regulating the pot industry, the report points out, will certainly incur millions of dollars in administrative costs, as well as lots of other potential bills. (Don’t forget the teensy detail that the federal government still considers all marijuana flat-out illegal. That means it’s possible Washington will find itself having to pay for the legal defense of state employees targeted by federal prosecutors.) Best case, the report estimates, the state could gross nearly $2 billion over five years. Worst case? “The total amount of revenue generated to state and local government could be as low as zero.”