The supply-side effects of cannabis legalization

Abstract

Objective The purpose of this study is to examine how cannabis legalization and corresponding taxation would affect the supply-side of the cannabis market. Specifically, the study considers various scenarios in which Oklahoma legalizes recreational cannabis for adult use and simulates changes in state-level market sales for other legal states and the average grower profits in Oklahoma. We assume that legalizing recreational cannabis in medical-only states would significantly increase the demand quantity in the legalized states and the local government would levy a significant level of tax on recreational cannabis. These assumptions are based on the post-legalization phenomena in other legalized US states. Method We simulate outcomes in the cannabis industry under the assumption of representative consumers with constant elasticity of substitution demand behavior and profit-maximizing firms with a Cobb-Douglas profit function. All agents are assumed to take exogenous prices as given. We calibrate the model using state-level sales data from 2020 and explore potential policies in Oklahoma and at the federal level. Results We find that, under the scenarios we consider, legalization of recreational cannabis in Oklahoma would lead to a decrease in the quantity of cannabis sold in Oklahoma’s medical cannabis market as well as decreases in the quantity of cannabis sold in other states on average. Furthermore, we find that as the excise tax rate on recreational cannabis in Oklahoma is increased, the demand quantity in recreational cannabis market would decrease while the other markets’ demand quantity would increase on average. As the elasticity of substitution between state-level products increases, the overall demand quantity would increase and the market quantity across states become more sensitive to Oklahoma’s tax policies. This pattern could become starker as the elasticity of substitution between recreational and medical cannabis increases. In terms of profit, heavy taxation and price decrease due to legalization would significantly decrease cannabis producers’ production and profit levels unless the cost reduction strategies complement legalization. Conclusion Based on our results, the legalization of recreational cannabis has the potential to generate tax revenue to fund critical government projects and services. However, such legalization would have to be done carefully because heavy excise taxes would decrease the legal cannabis market demand and growers’ profit, which would incentivize producers and consumers to move to the illicit cannabis market. Policymakers would have to compromise between the levels of interstate transportation and taxation to ensure that cannabis suppliers also realize some profit within the cannabis supply chain.

Does sin tax on the legal market facilitate the illicit market? An ex‐ante assessment on the US cannabis market

“…For instance, in Arizona, the medical cannabis market quantity is almost identical to the results with no tax increase, although the sin tax policy significantly increases the illicit market quantity. These results suggest that even though consumers perceive recreational and medical cannabis as substitutes, the taxation on recreational cannabis would not significantly impact the demand for medical cannabis (Han & Ng'ombe, 2022).…”

“…To simulate the change in the cannabis market due to the sin tax policy change, we assume that US cannabis consumers exhibit the nested CES utility preferences due to their varying preferences for different cannabis products. The nested CES method is chosen due to its flexibility, which allows for different degrees of substitutability between products in a nested framework (Han & Ng'ombe, 2022; Sato, 1967; Van der Werf, 2008). We chose California, Oregon, Nevada, and Arizona as representative states to simulate the potential impact of cannabis policies on the US cannabis market.…”

“…Additionally, the online delivery assumption imposes uniform transportation costs for all consumers, implying that transportation costs do not influence purchase decisions within this framework. Consequently, the calibrated optimal quantity index $${Q}^{* }$$ illustrates the change in retail market quantity resulting from a policy change (e.g., an increase in sin tax for legal recreational cannabis) when interstate commerce is legalized at the federal level using the 2020 cannabis taxation rates of each state (Han & Ng'ombe, 2022) (see Table in the Supporting Information for the source of exogenous parameters, Q and t ).…”

“…Each condition could be justified as follows: We assume that if interstate commerce of cannabis is legalized, such as the MORE Act or HHS recommendations are adopted by the Federal government, there will likely be a national mailing service for cannabis products (Han & Ng'ombe, 2022). This expectation is based on the existing cannabis delivery services in states and countries where cannabis is already legal, such as California and Canada (Gill & Young, 2019; Mahamad et al, 2020).…”