INSIGHTS BLOG > Illicit Cannabis Is Driving Out Licensed Activity

• There Are Four Cannabis Submarkets

• The Informal Economy

• Has State Legalization Decreased Illicit Markets?

Industry corruption and bad practices are driving out licensed and compliant cannabis activity in favor of unlicensed and noncompliant activity.

Before jumping in to the discussion, we need to understand the different submarkets that are active in the cannabis industry.

There Are Four Cannabis Submarkets

Cannabis markets (marijuana and hemp) currently involve four distinct submarkets (henceforth submarkets will be referred to as markets):

• Licensed Markets (cultivation, processing, and dispensing) involve activities by suppliers who are either licensed to perform those activities or don’t legally need a license.

• I define Grey Markets as those involving products that are currently subject to legal dispute, namely the supply of hemp-derived intoxicating cannabinoids (HDIC) (e.g., delta 8) or high THCA hemp products. Eventually, legislators and regulators will decide which products are legal and which are not and then clarify the laws and regulations accordingly. (For a detailed discussion of the origin and nature of Cannabis Grey Markets, see my previous blog, Cannabis Grey and Black Submarket Dynamics.) Since Grey Market activities will eventually be subsumed by either Licensed, Noncompliant, or Unlicensed Market activity, I exclude them from the rest of the discussion.

• Noncompliant Markets involve (off-the-books) activities by suppliers who are licensed to engage in those activities, but who are not complying with all the legal or regulatory requirements, such as paying taxes, (accurately) testing products (some companies don’t test products, while other do but engage in “lab shopping” to inflate reported THC content^[1]), or buying from or selling to licensed parties. I also include in this category market participants who chronically fail to pay suppliers (the cannabis industry has developed a “culture of nonpayment”^[2]).

• Unlicensed Markets involve activities engaged in by suppliers who are not licensed to perform those activities.

As noted in my previous blog, Cannabis Grey and Black Submarket Dynamics, the distinction between noncompliant and unlicensed markets is important because it determines the jurisdiction under which enforcement falls. Unlicensed activity is generally criminal in nature and subject to criminal prosecution, including potential seizure (of cash and/or product) and incarceration.^[3] Noncompliant activity, on the other hand, generally involves business penalties, fines, and/or loss of license, but it generally does not carry the threat of seizure or incarceration (although there are plenty of examples of seizures associated with licensed activity).

Figure 1 provides an illustration of licensed (compliant), noncompliant, and unlicensed activity. An important point illustrated in Figure 1 is the fact that both noncompliant and unlicensed activities are embedded within and across all components of licensed market supply chain, which makes such activities extremely difficult to detect and deter.

Figure 1

Since the distinction between unlicensed and noncompliant activities is not relevant to the current analysis, henceforth I refer to them jointly as illicit activities.

Why Do We Care about the Illicit Cannabis Markets?

Let’s start by asking: why do we care about illicit activity? The fact that these markets exist is important for several reasons. 

Illicit Markets Are Large

By their very nature, illicit cannabis activities are hard to quantify. Even so, articles abound suggesting they are large and potentially increasing in size (as suggested above). For example,

• The size of the illicit cannabis market in California is generally understood to be significantly larger than that of the licensed market (“The illicit market outnumbers us by five to one” from a 2018 source^[4] and “Currently 2 out of every 3 cannabis purchases are made in the illicit market. Evidence suggests that disparity is getting worse” from a 2023 source^[5]). Notably, cannabis grown in California has been found across the nation. Furthermore, not only are illicit markets persisting alongside licensed markets, but illicit activity is thought to be increasing over time (“Black markets, however, actually persist even in states where the drug is legalized. In some states, such as California, the black market for marijuana has actually increased”^[6]).

• The lax licensing environment in Oklahoma has encouraged growers to relocate there from other states, and “illegal grow operations and bad actors continue to be the primary issue facing the industry.” In an effort to stem illicit market activity, Oklahoma put a moratorium on new cultivation licenses in mid 2023.^[7]

• As reported in New York: “As the first dispensaries have opened across the city in the last several months, and more than 60 licenses have been issued across the state, a sea of unlicensed, illegal shops still dot the streets of all five boroughs, selling marijuana everywhere from small bodegas to large operations that one might confuse for a legal retailer. “Officials have calculated conservatively that there are 1,400 unlicensed shops in the five boroughs. I think that number is probably quite a bit higher,” said Alyson Martin, founder of Cannabis Wire, which covers the marijuana industry in New York and nationwide.”^[8]

• Whenever states legalize cannabis, legislators/regulators recognize the existence of embedded illicit markets in their states, while claiming that the new licensed market will minimize, if not eliminate resident illicit markets: “Legalization advocates have long argued that regulating marijuana forces the industry out of the shadows and into the public eye, where the drug can be taxed and the black market effectively eliminated.” ^[9]

Illicit Markets Supply Potentially Unsafe Products 

Products supplied in illicit markets — by their very nature — generally do not adhere to the same growing, processing, and testing requirements as those in licensed markets that ensure products are safe for consumers. Illicit market products may thus contain unhealthy amounts of pesticides, fungus/molds, or any number of other toxins.

Illicit Markets Supply Minors

Suppliers in illicit markets — by their very nature — generally do not adhere to the same restrictions on access as those in licensed markets. More specifically, illicit markets provide ready access to cannabis products for minors.

Illicit Markets Squeeze Out Licensed Markets

Activities in illicit markets compete with those in licensed markets for resources (people with skills and know-how, funding, etc.). Furthermore, since suppliers in illicit markets generally don’t adhere to costly laws and regulations, they can generally undercut licensed market suppliers on price. Illicit markets thus threaten the financial viability of licensed market suppliers and in the process shift consumers away from licensed activity and into unlicensed activity.

Illicit Markets Undermine the Rule of Law

The rule of law is a concept that holds that everyone must abide by, and is subject to, a formal an equitably-adopted, legal and judicial system. The existence of illicit markets “can be seen as an indicator of a deficit of legitimacy of the present social order and the existing rules of official economic activities.”^[10] In other words, the continued existence of illicit markets undermines people’s respect for the law, which may lead them to start breaking laws in other areas of social activity as well.

Illicit Markets Consume Social Resources

Efforts to minimize illicit market activities (via law enforcement) require resources that could otherwise be used in more productive endeavors.

Illicit Markets Reflect People’s Discontent with Government

The presence of illicit markets also serve as an important reflection of people’s discontent with government laws and regulations. As researchers Schneider and Enste describe it:^[11]

A growing shadow economy can be seen as the reaction of individuals who feel overburdened by the state and who choose the “exit option” rather than the “voice option”. If the increase of the shadow economy is caused by a rise in the overall tax and social security burden together with “institutional sclerosis”, then the “consecutive flight” into the shadow economy may erode the tax and social security bases…

The shadow economy can be seen as an indicator of a deficit of legitimacy of the present social order and the existing rules of official economic activities. The exit-option shadow economy is an important constraint on the Leviathan state and can help secure economic freedom.

I would guess that the large presence of the legacy cannabis community in illicit cannabis markets reflects that community’s discontent with the way government has “opened up” [sarcasm] licensed cannabis markets.

In short, we care about illicit markets because they: are large and potentially growing in size, often supply products that are unsafe for consumers, provide an easy point of access for minors, squeeze out licensed suppliers, undermine the rule of law, and consume social resources through efforts to enforce against unlicensed activity. 

The Informal Economy

Partition of Economic Activity

In the economic literature, there’s a substantial amount of research on black markets and shadow economies, which are analogous to the illicit markets in cannabis. To better align the layout I’ve presented so far for the four cannabis markets I’ve described – licensed, grey, noncompliant, and unlicensed – let me provide a brief description of how Illicit markets are characterized in the economic literature.

Economic activity includes all monetary and non-monetary (e.g., barter) exchanges that occur in society. Economic activity may be partitioned into two subgroups, 

• The Formal Economy – exchanges that are taxed by the government – and 
• The Informal or Underground Economy – exchanges that are not taxed by the government, that is, “exchanges of goods and services which are hidden from official view.”^[12]

The Formal Economy may be further partitioned into two subgroups, 

• The Official Economy – authorized exchanges –and 
• The Grey Market – unauthorized exchanges, also known as channel diversion.

Grey Market activity is generally defined somewhat differently than the way I defined it. I use the term to refer to legally ambiguous activity, which is similar, but not identical to the more common definition: Grey market “commodities are distributed through channels which, while legal, are unofficial, unauthorized, or unintended by the original manufacturer.”^[13]

The Informal or Underground Economy may also be further partitioned into two subgroups, 

• TheBlack Market^[14] generally refers to the barter or sale of Illegal goods or services, such as drugs, prostitution, stolen or counterfeit products, and weapons.
• The Shadow Economy, which Friedrich Schenider^[15] defines as follows: 

a broad definition of the shadow economy includes unreported income from the production of legal goods and services, either from monetary or barter transactions – and so includes all economic activities that would generally be taxable were they reported to the state (tax) authorities... The shadow economy includes all market-based legal production of goods and services that are deliberately concealed from public authorities for the following reasons:

(1) to avoid payment of income, value added or other taxes,

(2) to avoid payment of social security contributions,

(3) to avoid having to meet certain legal labour market standards, such as minimum wages, maximum working hours, safety standards, etc., and

(4) to avoid complying with certain administrative procedures, such as completing statistical questionnaires or other administrative forms.

(For a more detailed analysis of the shadow economy, see my previous blog, The Increasing Significance of the Shadow Economy.)

Figure 2 provides a visual representation of the four sets of economies. 

Figure 2

There’s a pretty clean mapping from my four cannabis markets to these more widely defined economic markets:

• Official Economy ~ Licensed Cannabis Markets
• Grey Market ~ Grey Cannabis Markets
• Black Market ~ Unlicensed Cannabis Markets
• Shadow Economy ~ Noncompliant Cannabis Markets

One could argue that unlicensed cannabis activity may be considered part of the shadow economy rather than the black market, since licensed cannabis is legal at the state level, in which case unlicensed cannabis is simply but-for taxable activity. Regardless, the points being made below about the shadow economy and its relevance for cannabis markets is clear.

Factors Promoting Illicit Market Activity

While researching the nature of illicit markets, I was surprised to see how many of the factors that have been found to commonly promote them are present in cannabis markets. According to researchers Schneider and Buehn,^[16] illicit markets will be larger relative to licensed markets under the following conditions:

1. Taxes: The tax burden, including sales and income taxes, is higher.
2. Tax morale: The feeling that government is spending tax dollars effectively or efficiently, is lower.
3. Regulations: The burden of regulations is higher.
4. Unemployment: Unemployment is higher.
5. Self-Employment: Self-employment is more prevalent.
6. Rule of Law: The quality of institutions measured by the rule of law is lower, that is, there is more corruption or less enforcement of property rights, contracts, regulations, payment of taxes, etc.
7. Currency: A greater portion of transactions use cash or are otherwise untraceable.

Notably, in legacy cannabis markets, self-employment/mom and pop operations were the norm.

Under Rule of Law as it applies to cannabis, I would add, for example, a lack of: clarity as to what’s legal and what’s not (e.g., D8, high THCA hemp), common definitions, standards, product consistency, accuracy of information reported, and, of course, enforcement of laws and regulations to force all market participants to play by the same rules. 

Has State Legalization Decreased Illicit Markets?

Let’s consider the different market outcomes associated with the legal of cannabis activity in select states. 

Legalization Has Fostered Supplies of Illicit Cannabis

Legalization of cannabis by select states has fostered illicit cannabis supplies by enabling illicit suppliers to:

• Transition from unlicensed markets to noncompliant markets, that is, decrease their expected costs of getting caught. This has especially been true in Oklahoma, where license fees for cultivation and dispensary licenses are extremely low and widely available.^[17] Notably, Mexican cartels have benefitted enormously by relocating grow sites from Mexico to the US. “They face only misdemeanor penalties in California and no longer need to worry about getting the drug through border security.”^[18]

• Hide in plain sight, that is, to blend in with licensed suppliers. “Those of us in law enforcement kept saying, '(Legalization) will not stop crime. You’re just making it easier for people who want to make money. What we’ve done is give them cover,'” Colorado Attorney General Cynthia Coffman said.^[19]

• Piggyback on infrastructure available to licensed suppliers: Legalization "’has provided an effective means to launder cannabis products and proceeds, where in essence, actors can exploit legal mechanisms to obscure products’ origin and conceal true profits, thereby blurring the boundaries of the legal market and complicating enforcement efforts…”^[20]

The high burden of taxes and regulations, combined with unfavorable rules of law (high levels of  corruption requiring payoffs and connections to receive licenses, together with the lack of clarity and other factors previously enumerated) have led many legacy suppliers and newer market participants to voluntarily or involuntarily remain in and/or return to illicit markets, rather than participate in licensed markets.

Legalization Has Increased Demand for Cannabis

The legalization of cannabis by select states has increased consumer demand through several mechanisms. 

• The legalization of cannabis opened up its use to consumers who obey the law. This increases demand by people who may have used cannabis earlier, but-for the fact that it was illegal, and they consider themselves law-abiding citizens.

• The legalization of medical cannabis serves as validation that cannabis has legitimate medical applications. This increases demand by patients who were previously unaware or skeptical of the potential effectiveness of medical cannabis.

• The legalization of cannabis serves as validation that cannabis is relatively safe. This increases demand by people who were previously unaware or skeptical of the safety of cannabis.

• The legalization of cannabis serves as signal or reflection of the increasing social acceptance of cannabis.

Legalization Has Limited Supplies while increasing Prices of Licensed Cannabis

The limitation of cannabis licenses, combined with the hurdles associated with receiving and maintaining licenses (burdensome license fees, taxes, and regulations) potentially limit supplies, while creating artificially high prices, for licensed cannabis products, relative to prices of illicit market supplies.

Demand for Illicit Cannabis

Who buys illicit market cannabis?

• Consumers in states that haven't legalized cannabis.
• Consumers in legal states with dispensary deserts: In many legal states, there are large areas within the state that are not close to dispensaries. For example, over half (56%^[21]) of California cities have refused to allow any cannabis activity (cultivation, processing, or dispensing) within the city. While many dispensaries deliver into such areas, there are still large areas where licensed cannabis is not easily accessible by consumers.
• Consumers who prefer cannabis products by sources who have opted out of licensing their operations.
• Consumers who want lower prices.
• Consumers who trust their legacy dealers or other sources (e.g., friends or family).
• Consumers who want anonymity.
• Consumers who don't realize the products they’re buying don’t come from licensed sources. Many people assume unlicensed dispensaries are actually licensed businesses. 

Post-Legalization Demand for Legal vs. Illicit Market Cannabis

Figure 3 provides an illustration of state level cannabis demand before and after a state legalizes cannabis.

(For a more complete description of the different consumer groups portrayed in Figure 3, see my previous blog, Cannabis Regulators Determine the Portion of Legal Market Activity.)

Figure 3

The image on the left in Figure 3 shows that before a state legalizes cannabis activity, the population falls into one of two groups: 

• (1) Non-cannabis-consumers or 

• (2) Illicit Market cannabis consumers. 

After a state legalizes cannabis activity, 

• (1’) Some previously non-cannabis-consumers remain non-cannabis consumers

• Some previously non-cannabis-consumers now consume either 

(1A’) Licensed Market cannabis products or 

(1B’) Illicit Market products.

• Some previously Illicit Market consumers

(2’) Remain as Illicit Market consumers,

(2A’) Switch to Licensed Market consumers.

• People from out-of-state travel or relocate to the state to purchase cannabis from either 

(3A’) Licensed Markets or

(3B’) Illicit Markets.

Notably, the sizes of the Licensed vs. Unlicensed Markets are largely determined by regulators. With 

• Less corruption, lower taxes, and less burdensome regulations that enable greater participation by would-be suppliers and consumers,
• A stronger rule of law and better enforcement of laws and regulations providing not only clarity about the rules of the game, but also a level playing field for all, and/or 
• Access to banking services providing alternatives to a cash-based economy,

more consumers will 

• Enter licensed markets (i.e., consumers will transition from (1’) to (1A’)), and 

• Illicit Market activity will diminish in favor of Licensed Market activity (i.e., consumers will transition from (1B’) to (1A’) and from (2’) to (2A’)).

Has Legalization Decreased Illicit Markets?

Colorado saw more than $1 billion worth of marijuana sold in state-regulated and taxed stores last year.

“It’s safe to say that there’s less illegal activity taking place now than there was before,” Tvert [Mason Tvert of the Marijuana Policy Project] said. “We’re looking at a billion-dollar market that’s all now being produced and sold legally.”^[22]

Is it safe to say that there’s less illegal activity taking place in states that have legalized cannabis activity than there was before legalization?

We can see in Figure 3 that legalization will decrease illicit markets if the number of consumers from the pre-legalization illicit markets who transition to legal markets outweighs the number of non-consumers from pre-legalization markets who transition to illicit markets plus the number of tourists attracted to the state’s illicit markets.

Illicit Markets Shrink Post-Legalization   ⇔   (2A’)   >   (1B’) + (3B’)  

Notably, all four components, (2A’), (1B’), and (3B’), can be minimized with a healthy cannabis regulatory environment, namely inclusive licensing requirements (e.g., ample availability of licenses with relatively low license fees, taxes, and regulatory burdens), together with ample enforcement of laws and regulations. To my knowledge, most states have not accomplished this. Instead, as the analysis describes, legalization of cannabis has increased demand, while unsatisfactory regulatory environments have fostered illicit activity in favor of licensed activity. 

References

^[1] Jessica McKeil. Lab Shopping: The Industry’s #1 Dirty Little Secret. (2022, Aug 24). CannabisTech. https://cannabistech.com/articles/the-industrys-dirty-secret-lab-shopping/

^[2] TG Branfalt. California Cannabis Companies Form Group to Address Industry’s ‘Culture of Nonpayment’. (2023, May 17). Ganjapreneur. https://www.ganjapreneur.com/california-cannabis-companies-form-group-to-address-industrys-culture-of-nonpayment/

^[3] Bureau of Cannabis Control Announces Enforcement Action Against Unlicensed Cannabis Businesses. (2019, Mar 4). California Department of Cannabis Control. https://cannabis.ca.gov/2019/03/bureau-of-cannabis-control-announces-enforcement-action-against-unlicensed-cannabis-businesses/

^[4] Jack Kaskey. California’s Weed Black Market Ramps Back Up. (2018, Jun 28). Bloomberg. https://www.bloomberg.com/news/articles/2018-06-28/california-pot-industry-at-reckoning-as-new-rules-upend-market

^[5] Tiffany Devitt. Excessive taxes, local control allows California illicit cannabis market to thrive. (2023, Jun 22). Cal Matters. https://calmatters.org/commentary/2023/06/california-illicit-cannabis-market-thrive/

^[6] Adeline Dixon. Legalization of Marijuana and Its Effects on Licit and Illicit Markets in the United States, in Perspectives on Black Markets v.2. https://iu.pressbooks.pub/perspectives2/chapter/legalization-of-marijuana-and-its-effects-on-licit-and-illicit-markets-in-the-united-states/

^[7] Guillermo Molero and Bloomberg. In states like New York with legal cannabis, black market marijuana is a growing problem: ‘It really is a constant battle’. (2023, Jul 24). Fortune. https://fortune.com/2023/07/24/cannabis-growing-black-market/

^[8] Tim McPhillips. Weed is legal in New York, but the illegal market is still booming. Here’s why. (2023, Mar 28). PBS. https://www.pbs.org/newshour/nation/weed-is-legal-in-new-york-but-the-illegal-market-is-still-booming-heres-why

^[9] Trevor Hughes. Marijuana's legalization fuels black market in other states. (2017, Jul 31). USA Today. https://www.usatoday.com/story/news/nation/2017/07/31/marijuana-black-market/507417001/

^[10] Friedrich Schneider and Dominik H. Enste (March 2000), “Shadow Economies: Size, Causes, and Consequences”

^[11] Friedrich Schneider and Dominik H. Enste (March 2000), “Shadow Economies: Size, Causes, and Consequences”

^[12] Christopher Thale. Underground Economy. Encyclopedia of Chicago. http://www.encyclopedia.chicagohistory.org/pages/1280.html

^[13] Grey Market. Wikipedia. http://en.wikipedia.org/wiki/Black_market

^[14] Black Market. Wikipedia. http://en.wikipedia.org/wiki/Black_market

^[15] Friedrich Schneider. Shadow Economies and Corruption All Over the World: New Estimates for 145 Countries. (2007, Jul). https://www2.lawrence.edu/fast/finklerm/ShadEconomyCorruption_July2007.pdf

^[16] Friedrich Schneider and Andreas Buehn. “Shadow Economies in Highly Developed OECD Countries: What Are the Driving Forces?” (2012, Oct). https://www.researchgate.net/publication/256036313_Shadow_Economies_in_Highly_Developed_OECD_Countries_What_are_the_Driving_Forces

^[17] Martin Kaste. Despite Legalization, Marijuana Black Market Hides In Plain Sight. (2018, May 16). NPR. https://www.npr.org/2018/05/16/610579599/despite-legalization-marijuana-black-market-hides-in-plain-sight

^[18] Trevor Hughes. Marijuana's legalization fuels black market in other states. (2017, Jul 31). USA Today. https://www.usatoday.com/story/news/nation/2017/07/31/marijuana-black-market/507417001/

^[19] Trevor Hughes. Marijuana's legalization fuels black market in other states. (2017, Jul 31). USA Today. https://www.usatoday.com/story/news/nation/2017/07/31/marijuana-black-market/507417001/

^[20] Trevor Hughes. Marijuana's legalization fuels black market in other states. (2017, Jul 31). USA Today. https://www.usatoday.com/story/news/nation/2017/07/31/marijuana-black-market/507417001/

^[21] Where cannabis businesses are allowed. (2023, Dec). California Department of Cannabis Control. https://cannabis.ca.gov/cannabis-laws/where-cannabis-businesses-are-allowed/

^[22] Trevor Hughes. Marijuana's legalization fuels black market in other states. (2017, Jul 31). USA Today. https://www.usatoday.com/story/news/nation/2017/07/31/marijuana-black-market/507417001/