What would a legal American marijuana industry look like?

November 19, 2012: 10:45 AM ET

Voters in Colorado and Washington have legalized marijuana in their states. Other states will likely follow suit. But there won't be a real "marijuana industry" until federal laws are repealed. If that happens, everything will change.

FORTUNE -- Last week, Jerry Brown, the governor of California who leads the world's eighth-largest economy, issued his strongest plea yet for the federal government to back off enforcing federal marijuana laws in his state. President Obama and the Justice Department, he said, must "recognize the sovereignty of the states" and stop trying to "nullify a reasonable state regulation." He sounded almost like a Southern libertarian as he invoked "states' rights."

Brown's statement came in the wake of the passage of ballot measures in two states, Washington and Colorado, to legalize marijuana. In California voters came very close in 2010 to doing the same, and such a measure seems likely to pass next time out. Other states are sure to follow as well.

But that doesn't mean that a real marijuana industry will grow out of the country's changing sentiments toward pot -- with large-scale distribution, marketing, and retail sales -- any time soon. For that to happen, the federal government would have to do a lot more than merely back off and recognize "state's rights." It would have to repeal the federal laws banning the possession, use, and distribution of marijuana. And that might take a long while yet, given that the politics in, for example, Georgia, are a lot different from the politics in Washington, Colorado, and California (even Oregon isn't quite there yet -- its ballot measure failed on Election Day). There needs to be a national consensus, and the nation isn't there yet.

And until full federal repeal of prohibition, a multitude of insurmountable barriers will remain in place. The chief one is simple economics: the industry simply can't scale to a degree that would attract investors (who would be scared of investing anyway). One of the many reasons that pot costs so much -- about $300 an ounce on average -- is that growers must keep their operations relatively small and, usually, hidden. Forget for the moment the direct impact that pot's illegality (meaning, risk) has on prices: the costs of production alone are enormous just because economies of scale aren't achievable. Even if the state police are no longer coming after growers, the feds might be.

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Then there is the problem that medical-marijuana businesses already face in states where they are allowed: vendors of all kinds of necessary services can't or don't want to deal with them. Banks won't lend them money. Insurers won't insure them. Many landlords won't rent to them. Credit-card companies won't process their payments. If your customers can't sign for something with dignity, and you can't obtain health insurance for your employees, it's unlikely that your business will ever scale.

Even after federal repeal, should it come, there will be hurdles. For one thing, pot will be tightly regulated. This is as it should be. One thing that legalization advocates need to do (as many already are) is to stop pretending that there are no downsides to legal pot. There are many. The harms pot causes aren't as bad as those associated with tobacco and alcohol, but they are harms nonetheless. Legal pot will cause a massive increase in consumption, including among underage people (this even though their consumption would remain illegal.) The health-related drawbacks (and benefits) of marijuana are debatable, but pot-smokers are still breathing the smoke of burning leaves into their lungs, which isn't good for them. Dependency on pot isn't anything like addiction to narcotic drugs, but it's still a problem for many people. Legal pot means there will be more stoned drivers on the road. And -- lets face it -- pot has a tendency to make people stupid, so legal pot means there will be a lot more stupid people in the country, at least while they're high. More people will be high at work, and more kids will be high at school.

All of these are social costs, and they could be huge. The marketing and distribution of legal pot will have to be as closely regulated as the marketing and distribution of cigarettes and alcohol. That means high costs -- not just for regulatory compliance, but for the taxes that would be levied to finance enforcement (of course, there will also be huge savings from not having to enforce current criminal laws and imprison people).

Let's say repeal happened, though. What might a big American marijuana industry look like?

First of all, prices would plummet, probably by a startling degree. Pot is basically a commodity, and since its being legal would lead to large-scale production, that means prices (before taxes) would be determined mainly by the cost of that production, plus distribution. The authors of the refreshingly fact-driven new book, Marijuana Legalization: What Everyone Needs to Know estimate that wholesale ("farm gate") pot prices would fall to about $20 a pound for high-quality varieties and about $5 for the mid-grade stuff. Basing their estimates on a variety of factors, including the costs of production of similar commodities such as tea and, in Canada, industrial hemp, the authors say the wholesale price of legal pot could be about 100 times less than it is now.

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That doesn't mean it will be quite so ultra-cheap to consumers, since, as a vice not unlike cigarettes and booze, it would be subject to heavy taxation (it's estimated that Colorado will be collecting $100 million a year in pot taxes starting in a few years). It's hard to know with any kind of precision how cheap it would be at retail, but it's safe to say it would so much cheaper that consumption patterns would radically change: many more people would be consuming marijuana, and doing so more often.

Even less certain is what the industry itself would look like. The assumption has long been that the tobacco companies would take over the industry. But they have (understandably given their PR problems and strained relationships with the government) been silent on the issue. Rumors abound that they have purchased and set aside huge tracts of land in places like Calfornia's so-called Emerald Triangle, but solid evidence for that has not been forthcoming.

We do know that the industry has expressed interest in the past. In the '70s, a report commissioned by Brown & Williamson enthusiastically advised that the company start viewing marijuana as "an alternative product line." The report was based on the assumption that legalization was not far off, which was not a rare opinion at the time.

A few years ago, much was made of Altria (the parent company of Phillip Morris) lodging a legal action to wrest ownership of the Web domains altriamarijuana.com and altriacannibis.com away from their anonymous owner. They succeeded, but it seems likely this was more of a trademark issue than an indication that Altria (MO) was gearing up to enter the pot business.

With tobacco consumption in the U.S. headed ever downward, marijuana would give the tobacco industry a new way to reach millions of American consumers. And they have much of the infrastructure and basic know-how already in place for a relatively quick rampup. It seems like a no-brainer, but the industry will likely tread very carefully, even if federal repeal happens.

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Whether Big Tobacco gets involved or not, the pot industry would likely fall into the hands of large companies, given the economies of scale that would be necessary for the industry to function efficiently. Of course, there will certainly also be lots of boutique producers, just like there are microbreweries. (And there will probably also be "boutique producers" that are actually owned by large companies, as is the case with many craft beers and certain cigarette brands.)

Meanwhile, legalization would send ripples through the rest of the economy. Yes, yes, sales of Cheetos and Pink Floyd's back catalog would rise, ha-ha. But more seriously, the liquor industry might take a hit, since pot is, in some ways, a substitute good for booze. (Although it might also be seen as a complementary good, at least in some circumstances.) This would affect not only liquor producers, but also retailers and bar owners, though what those effects would be can only be known in actual practice.

It seems likely that legalization at the federal level is at least a few years off, despite the groundswell of support, and despite the growing recognition that the "war on drugs" is worse than futile, especially when it comes to marijuana. In the meantime, all eyes will be on Washington, Colorado and whichever other states decide to legalize. What happens there will offer some clues as to what might happen nationally if America decided to end prohibition and turn marijuana over to big business.

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