Motley Fool Money - Weed Economics 101

Episode Date: June 4, 2022

Price elasticity, supply & demand curves....what better way to learn about economic fundamentals than through weed? (C'mon, isn't it more interesting when there’s an illegal market involved?) Robin Goldstein and Daniel Sumner are economists at UC Davis and co-authors of “Can Legal Weed Win?”, a book about how the economics of legal, and illegal weed intersect. Ricky Mulvey talks with them about: - How federal legalization could help or hurt weed investors - Economic lessons from pot laws in Oklahoma and California - One surprising way that weed is like bacon Additional resource: https://www.fool.com/investing/stock-market/market-sectors/healthcare/marijuana-stocks/ Host: Ricky Mulvey Guests: Robin Goldstein, Daniel Sumner Engineer: Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

Hi everyone, I'm Charlie Cox. Join us on Disney Plus as we talk with the cast and crew of Marvel Television's Daredevil Born Again. What haven't you gotten to do as Daredevil? Being the Avengers. Charlie and Vincent came to play. I get emotional when I think about it. One of the great finale of any episode we've ever done. We are going to play Truth or Daredevil.

What? Oh, boy. Fantastic. You guys go hard. Daredevil Born Again official podcast Tuesdays, and stream Season 2 of Marvel Television's Daredevil Born Again on Disney Plus. But what's highly elastic is the substitution between legal and illegal. And that's a big theme in our book.

People don't have a lot of compelling reasons in many cases to buy the legal stuff when the illegal stuff is available at half the price. I'm Chris Hill, and that was Robin Goldstein, an economist at the University of California Davis and co-author of the upcoming book entitled, Can Legal Weed Win? Today we're going to talk about some basic economic concepts through the lens of weed. It's been said that pot makes movies and food more interesting, so, you know, why not demand curves? Come on, if you've been listening to this show for a while, you already know. This is not your grandpa's financial show.

Ricky Mulvey talked with Goldstein and his co-author, Daniel Sumner, about their new book and why it's been so difficult for investors to find opportunities in this emerging space. fools. We're using weed as a gateway drug to get you hooked on economics today. Joining me now are Robin Goldstein and Daniel Sumner. They're co-authors of the book Can Legal Weed Win and Economists at the University of California, Davis. Welcome, Robin and Daniel. Thanks, Ricky. Good morning. Starting off. Why are the economics of weed interesting to you? Daniel, I know you've particularly had an interest in this for four decades trying to survey weed growers in California. Yeah, well, I do the economics of food, wine. Robin likes to call all ingestibles,

and it was just natural to think about cannabis in that context. And you're right, back when I was a baby economist, one of the first things I thought about doing an empirical study on was the economics of weed farming or cannabis farming. Back when it was seriously illegal everywhere, we put out a survey, my buddy and I, and we knew we were in trouble when even his brother wouldn't return our survey. At that point, we decided to be theorists and give up trying to get data on weed. But four decades later, I jumped back into it in a big way. Robin, how about you? Weed is really interesting as a topic in economics because of this struggle between legal and

illegal that you don't have the equivalent of it in almost any other market. So you've had a market that's been illegal for decades, for most of a century, and then you suddenly have the introduction of a legal market. People have been getting their weed illegally. They've been getting good stuff from people they know, they know where to get it, they know how to get it, and then all of a sudden you launch this big legal market and set up a bunch of new regulations and taxes, and the state set up a whole new system for people to get legal.

The question is what motivates consumers to move from the illegal market to the legal market and what enables businesses to succeed in the legal market? And so that's super interesting. It's really hard as a topic in economics because of the lack of historical data. You don't have prices and quantities the way you do for most other industries. And so we have to get our data in some interesting and challenging ways. But I think it's a topic that's very fun and also illuminating in terms of public policy issues. Let me add one quick thing to that, and that is this is being played over and over and over again.

The country of Canada, very elaborate and interesting regulations, the state of Massachusetts, Oklahoma going its own route in an interesting way. So we have lots of samples of different governments. legalizing, if you will, in different ways. And economists love to study economic regulations. And this is a great example of that. Yeah, I'm trying to think there's really no products that you could use as a parallel in terms of essentially legal and illegal outside of maybe truffles would be there. But you guys talk about some of the ties between weed and other agricultural products. You mentioned that weed can also be like bacon in terms of price elasticity.

How is that? Let me just say, for some people, the price of bacon goes up. They don't change very much. They've got to have their bacon. Same is true for weed, of course. The difference is you don't have, for many consumers, a real close substitute for bacon. You know, I may have a piece of ham in the morning and I may eat bacon with eggs, or I may be a vegan. But for weed, legal weed, you have this, as Robin says,

this what seems to be a pretty close substitute for lots of potential buyers. And that makes it a challenging industry to be in. If you say, gee, I think I'll raise my price because customers want this product. And if they have a very good alternative, maybe Coke and Pepsi for many years is an example, consumers are pretty indifferent between which one. And then there's the low price store brand as well in that case. So there are parallels with food items and beverages and the like, but you're right. There's no perfect model for us. And in your research for can legal weed win, what did you learn about price elasticity, especially in the legal market? You're seeing states like, let's say,

Oklahoma and Colorado on the lower end, where maybe there's a lot of. little bit less regulation, and then states like Illinois, where it's taxed all the way. And you see the legal market very much running up against the illegal market. Yeah, so the real challenge is having data to really estimate that. Yeah. I mean, it's really hard to have historical data on elasticity. But when we look at the whole market, legal plus illegal, all weed, then we say, that's pretty inelastic, you know, because weed smokers as a whole,

you know, for the price of weed goes up or down a little bit, and people who smoke regularly want to get their weed either way. And so we think it's pretty elastic. But what's highly elastic is the substitution between legal and illegal. And that's a big theme in our book. People don't have a lot of compelling reasons in many cases to buy the legal stuff when the illegal stuff is available at half the price, or even three quarters of the price. If the illegal stuff, you take it out of the package, you smoke it, you get the same. kind of feeling. No one can just inspect a flower or smoke a joint and say, oh, from the taste or smell of that or the effects on me, I know whether that's legal or illegal. So fundamentally,

the products are very similar, the illegal and the legal stuff. And so that's why we think that it's pretty elastic substitution between those two goods. And that's in the market as a whole. Obviously, there are individual consumers. Some people will say, gee, I don't want to mess with an illegal market. I'm going to buy it down at the mall from somebody that's got a state license and is certified in various ways. Or maybe they say, gee, I trust the government to inspect this product. So I think it's safer. The product itself is safer. And these are perceptions that people have. And the same thing happens in other markets, of course. There are people that say, I'm only going to buy milk if it's organic. And there's a huge price different.

there. Organic milk is double the cost of conventional milk, but some people are convinced that's the route they're going to go, and prices obviously haven't kept them out of the organic market for milk. For the market as a whole, there's substitution there, and we know that looking at lots and lots of products. And Robbins point that the physical product, most people can't tell the difference, matters to a lot of consumers, and a lot of people are at the low end. Parallel with wine, again, most of the wine sold isn't $200 a bottle, Napa Valley, Cabernet, Sowne. Most of the wine sold comes from the broad acre agriculture where wine grapes are grown as a commodity. The same thing happens with weed.

And you guys do mention it in the book, there is a photo of, two photos of this is legal weed and this is a legal weed try to spot the difference. But there are some advantages to a legal market, which, you know, you have regular operating hours. You might have more choices for a consumer. A lot of people don't want to buy things illegally. And I think that is also a huge consumer driver of preference when you open up the market. You guys also talk about another tricky part for investors is finding the total addressable market for weed. And there's a lot of sky high. expectations from a lot of Wall Street banks. Why do you disagree with that and then have essentially

the total addressable weed market kind of close to what it is now, even with full federal legalization, possibly on the horizon? Let me jump in that very quickly, and then I'll turn it over to Rob. And the biggest point is to get volume to expand for legal weed, prices need to be more competitive. So prices come down. Secondly, there are a lot of. Secondly, there's a lot of the There's lots of room for innovation that lowers costs of production on the legal weed side. Just the kind of innovations we have routinely for corner kale, better farming techniques and improve lighting and all those sorts of things, technical change that will bring prices down that may well allow quantities to expand.

But you bring down price, your quantity expands, revenue may stay the same. same. So when we say the total size of the industry measured, say, by gross sales revenue, we see there are pressures to keep that not that much bigger than it is now. And it is, you know, we emphasize illegal weed as competition, but legal is still a quarter of the whole market in some places, up to half of the whole market in other locations. You know, as more states legalize, if you're looking at the, if you're looking at the whole U.S. market, More states legalize, of course, you grow the legal market by volume. As Dan says, in the long run, if prices come down, the total addressable market size is price

times quantity. And so if you have decreasing prices and increasing quantities, those two effects counteract each other. And so the total market size, as measured by total retail sales, may or may not go up a lot. There are a lot of people out there who say, oh, you legalize weed and the amount of total weed consume just goes way up. There's all these people out there who just start smoking weed suddenly when it's legal and who've never smoked before.

The data doesn't really seem to support that theory. When you look at historical data going back in the Netherlands and other places around the world, you don't see legalization tending to cause a huge increase. Maybe there's a little modest increase in the amount of weed total consumed, but we don't think that's a big effect. And so that's another kind of misconception we think that's being used to drive some overly high estimates of the total market size in the future. I've heard a lot of legalization proponents give the pitch of, hey, like, why wouldn't you want legal pot? You can just, you can, you can tax it so much.

And then people will enjoy that. And you guys push back against that in your book. Can you, can you describe why? It's really a combination of taxes and regulations, and not just the taxes. So in a lot of states, people have also said, oh, this is a new legal business. Here's every regulation we have ever imagined we'd like to put on anything, we'll put all of them on weed. We want it to be perfectly safe, perfectly healthy, absolutely pure as it's being grown, and we're going to regulate when the stores are open and when they're closed and everything else you can name. And every one of those regulations are costly. So we like to say wonderful regulations, but they're not free, and you need to take that into account. And then you start laying

taxes on top of that. California's governor announced a few days ago that he's going to try to eliminate the cultivation tax at least temporarily. We'll see if it happens. But here as other places, it's taxed all the way up and down the supply chain, both at the state level and at the local level. The worst thing in the world for investors, I think, would be federal-led legalization that added a whole new level of regulations and taxes on top of all that we've got now. And in that sense, federal legalization may be a disadvantage for the industry, sadly, just because it would be handled in a way that makes it that much harder for people to have the industry be a success. What are some of the lessons from California's long history of legalization?

You guys spend some time on Prop 64 and a lot of unintended consequences there, particularly with public consumption and that sort of thing. As you looked at some of those regulations, what did you learn? Let me jump in and say there are just two quick things there. One is, in some ways, by making it legal, you made it illegal. And what I mean by that is California had a very long history of medical cannabis, medicinal or medical cannabis that was very lightly regulated and had very few rules. To be legal, the consumer had to have a use card. They got that from a doctor.

You could get it in 15 minutes online. Some people did. And so the legal part, and there were a. retail stores called dispensaries, but the supply chain was unregulated and untaxed. And that meant people who are in the farming side or the processing side, the manufacturing side, were doing things really without any regulations or taxes. And then when you legalized it for adult use, they came in with a whole range of things that people had to comply with, including getting a license, which many companies, large and small

in the medical weed business, found it impossible to do, not because the regulations were too hard, but for example, you had to make arrangements locally, hire your lawyers, rent your space, do all that, then wait two years to get a license. and that was just a financial demand that people in the weed business couldn't do. So they thought they were legal before and they became illegal. And that was really rough on a lot of businesses there. The currently operating system is streamlined some of that. But it's still the case.

Let me give you Robin's favorite regulation to point to. I've been told, I don't know, I go to bed early, but I've been told people smoke weed after 10 o'clock. at night. And some people want to find the product after 10 o'clock at night, but the state law says any legal weed business closes it 10 o'clock at the latest. So what do you do? You're having a party. If you wanted to get a six-pack of beer, you'd go down the store, buy a six-pack of beer. But if you want weed, the illegal market's the only thing available to you. And you ask, why would you want to drive people to the illegal market in the middle of the night? It's hard to picture why you'd have a regulation to want to do that.

But it's all very well intended, but somehow doesn't seem to capture reality as well as it should. I was just going to add that when you have these kinds of regulations, you were talking about reliable opening hours. So it's ironically, having these reliable, predictable opening hours, that ends up in the case of a 10 p.m. curfew shifting market share away from legal and and toward illegal. I was just going to add that in the old system, before all these regulations and taxes went into effect in 2018, you had just the medical market. So it was limited to in-state consumers, and it was limited to people who had a California ID 18 and over

and had a doctor's recommendation. The doctor's recommendation was really easy to come by. and so that wasn't that much of a limiting thing. It was essentially a very open and free market and you had low prices and a lot of competition on quality and there were other things that went into effect after the more heavily regulated market. For example, consumers could go into a store before with the old medical system,

they could go into a store and smell and inspect the buds from a big jar. And when consumers, you know, it's still kind of in its infancy, this consumer awareness or understanding, or understanding of what the product is and how to evaluate quality. But one of the big ways is you smell it. You pick it up, you hold it, you smell it, you look at the bud.

And so you could always do that. They'd take a jar and you could look at the product and that's how you could decide between brands or between different strains. And now with the packaging regulations, you can't do that. It's all prepackaged and it's often an opaque packaging. So sometimes they give you a little sample in a glass jar, but you can't smell it and you can't hold it and look at it. And so that's, again, another pressure that might make people want to stay in the illegal market because their illegal dealer is going to allow them to look at stuff and inspect it. Or at the very least, it becomes difficult to, more difficult to sell when you don't have that kind of tactile experience.

Kind of on the flip side of California, you guys highlight Oklahoma. What are some of the economic lessons you guys found from Oklahoma, which has a very low-priced weed, but as of now, just a medical-only market? Yeah, Oklahoma is a really interesting case that we talk about in the book and Ken Legual Weid Win. And one of the reasons it's so interesting is because it's medical only, as you say, but the density of dispensaries of retailers is much higher than anywhere else in the country. Oklahoma has more dispensaries or more retail shops where you could buy weed, legal weed, than California does with a population one-tenth the size.

You know, they're just on every street corner. And so it's a competitive market. Some people will fail. Maybe in some cases, there's too many stores and there's a fierce competition, but it's good for consumers. And overall, the industry there is really robust and growing fast in spite of being medical only. We think one of the main reasons for that is they just made it really easy to get a license.

So you apply for a license. It's like getting a hunting or fishing license. You send in the paperwork and you get back to license and you have the states go ahead to open the store. A story we like to tell is that in Oklahoma, the amount of time that elapsed between passing the ballot question, legalizing medical weed, and the first store's opening was about nine hours. The stores opened the next morning after the ballot question passed.

In Vermont, the ballot question passed, and four years later, they still don't have a single store open. You guys write, quote, outside investors have already lost enormous amounts of money on legal weed, and we expect that unless the, situation changes, many will continue to do so. What situational factors are you talking about there? Regulations and taxes coming back down to earth in terms of making viable businesses more possible. It varies dramatically by state. So in Colorado and Washington, you do see a legal weed market that's more competitive with illegal because the prices are much lower. On the other hand,

when the prices are much lower, you don't make as much money with your illegal weed business. Once there's interstate trade, which is something that will probably come with federal legalization, you will see these opportunities for larger scale, for companies that can really be national scale, instead of opening mini-businesses in 20 different states like the multi-state operators are doing now, you'll have the ability to really have more centralized facilities and really efficient production. And so there'll be some winners in that game for sure. Who knows where they're going to be? Maybe they're going to be in Wyoming or Oklahoma.

or maybe within a national trade, maybe Saskatchewan is going to become a big player or Mexico. So the problem is that for states where it's really expensive right now to produce because of local regulations and also just higher priced places that are for economic fundamental reasons, like high electricity costs or high labor costs, water, just the input costs are high, those places are going to have a hard time competing, just like they have a hard time competing. You know, Massachusetts doesn't have a big, isn't very competitive in the avocado market. And we don't expect that it's going to be that easy for Massachusetts companies where it's, you know, because of climate and other factors, it's not that cheap to produce weed there.

It's going to be hard for them, too, to compete in export. So there's going to be some concentration of production in places that are cheap and favorable and with favorable climate conditions kind of coming to dominate the market. And so I think that's what it's, investors need to think about really long and hard. Robin, you've closely studied how marketing affects perceptions, especially in the case of high-priced wine. Is there a big difference in how consumers consume or perceive high-end weed? Are there parallels with the flour, the oils, vapes, edibles? Yeah. So I did, like, the kind of way I got into economics originally, a long time ago,

was because of blind wine tastings. I was interested in why people couldn't tell the difference between $100 wine and a $5 wine and a blind tasting. You know, why are people going to spend so much more in wine when you pour out the liquid from the bottle or you cover up the label and people can't tell the difference or don't prefer the expensive product? You're definitely going to, you're seeing that in weed in spades.

So I think even more than with wine or beer because the consumer understanding of this product is just so rudimentary and in its infancy. It's just something that's been illegal. get, you know, get your weed from some dude on the street and you're not really, like, analyzing the quality of it very well. And so you're seeing the emergence of a lot of, in the legal market, of a lot of very high-end brands. There's a perception, there's a sort of common belief that, for example, the highest potency weed is the highest quality and therefore

the most expensive. So, like, the really fancy, expensive stuff is like 30, 32% T.30, 30% T. The cheaper stuff is like 20%, 25% THC. And so that's one of the hallmarks of expensive fancy weed at the moment. Interestingly, there's actually very little scientific evidence that the potency, as measured by THCA content, is actually that well correlated with either how high it gets you or how high quality the effects are. And so that may be kind of a red herring in terms of measuring quality that, you know, people don't evaluate the quality of one. based on what alcohol percentage it is. The other factor that you see is like these sort of designer strains, fashionable strains of weed.

For example, right now, purple strains are very popular and are commanding higher prices in the market. That's kind of a, I see that as a fashion trend, you know. And as with wine, these things come and go and ebb and flow. You have, you know, this year it's purple weed. Next year it's going to be orange weed, you know, who knows. And so it's just chaos. and I think that it's important for consumers to kind of look past the hype on these supposed quality markers

and just try things and figure out for themselves what they like and don't like. And it may have very little to do with the price. Robin Goldstein, Dan Sumner, authors of Can Legal Weed Win. Thank you so much for joining us on Motley Fool Money. Thank you. Thanks for having us, Ricky. As always, people on the program may have interest in the stocks they talk about and the Motley Fool may have formal recommendations for or against, so don't buy

ourselves stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.