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INSIGHTS BLOG > How Regulations Shape the Cannabis Industry

How Regulations Shape the Cannabis Industry

Written on 16 May 2020

Ruth Fisher, PhD. by Ruth Fisher, PhD


The cannabis industry is highly regulated, and the various regulations play a powerful role in shaping the structure, and thus outcome, of the industry. This analysis examines the following questions:

  1. How do cannabis market regulations shape market structure?
  2. Are the resulting outcomes favorable to suppliers and/or consumers?
  3. What are the pros and cons of vertical integration in cannabis markets?

Players: Who They Are and What They Want

Let’s start by considering who the major players in the cannabis game are – the Suppliers, the Regulators, and the Customers, plus the Distributors and Testing Labs – and what they seek by participating in the cannabis industry (see Figure 1). It’s important to understand what each party wants because the what they want, together with the extent to which they’re getting what they want, will determine (i) how well they follow the rules and (ii) the actions they might take if they decide not to follow the rules.

Figure 1

1 mj game 


Cannabis Suppliers

The players who supply product in the cannabis industry include Cultivators, Processors/Manufacturers, and Dispensaries. The Suppliers provide the products that Customers purchase and consume. Cannabis Suppliers care about three issues in particular:

  • Suppliers want to run profitable businesses, which means they must be able to generate revenues that cover their costs.
  • Suppliers want to comply with laws and regulations so they don’t lose their licenses to operate.
  • Suppliers want to differentiate their products to attract Consumers. The primary modes of product differentiation include offering nuanced products, creating product brands, and educating Consumers.

Distributors and Testing Labs

Distributors and Testing Labs grease the wheels of the industry. Without appropriate distribution and testing services, compliant products cannot make their way through the supply chain from Cultivators to Processors and Dispensaries to be sold to Customers. Distributors and Testing Labs care about two issues in particular:

  • Distributors and Testing Labs want to run profitable businesses, and
  • Distributors and Testing Labs want to comply with laws and regulations so they don’t lose their licenses.

When there are enough Distributors and Testing Labs to create competition, then

  • Distributors and Testing Labs want to differentiate their products to attract Customers.

State and Local Governments (Regulators)

The State and Municipal Governments are the regulators. Governments use state and local laws and regulations to achieve two goals: (i) ensuring all activity is tracked and taxes are paid, and (ii) ensuring cannabis activity does not intrude upon local communities.

  • State and Municipal Governments want to make sure all product is accounted for, only licensed activity occurs, and all taxes are paid.
  • State and Municipal Governments want to make sure cannabis activity is inaccessible to minors and nonintrusive to local communities.


Consumers of medical and recreational cannabis want cannabis products that are safe to consume and that are reliable in providing the expected effects. Also, finding the “right” cannabis product to meet a particular Consumer’s needs is no easy task. So then once a specific product is found that provides the desired effects, the Consumer wants to be able to continue to purchase the same product from dispensaries. What we have, then, is

  • Consumers want product safety.
  • Consumers want product variety.
  • Consumers want product continuity.

Unconstrained vs. Constrained Cannabis Supply Chain

Let’s consider what the basic, seed-to-sale cannabis supply chain would look like under a market without any regulations (see Figure 2). I’ll call this the unconstrained supply chain.

[1] Nurseries cultivate cannabis seeds or clones and sell them to Growers.

[2] Growers cultivate cannabis from seeds or clones, harvest mature plants, then dry and cure the flower. Growers sell flower to Customers and Dispensaries, and they sell flower/biomass to Processors/Extractors.

[3] Processors/Extractors extract resin/oil from flower/biomass and sell it to Customers, to Dispensaries, and to Processors/Manufacturers.

[4] Processors/Manufacturers incorporate extract into cannabis end products and sell their manufactured products to Customers and to Dispensaries.

[5] Dispensaries sell cannabis flower, extracts, and end products to Customers.

Figure 2

2 unreg supply chain 

Regulations shape the nature of supply chain by changing how products are required to flow through the supply chain, from its unconstrained configuration to a regulated or constrained configuration. In the cannabis industry, regulations constrain Consumers to only being able to buy cannabis product from Dispensaries. Regulations also require Suppliers to use licensed Distributors – as opposed to any licensed driver – to transport product between Suppliers. Regulations further require products to be lab tested before being sold to Dispensaries. Figure 3 displays the constrained supply chain with these three sets of regulations in place.

Figure 3

3 reg supply chain

In regulated markets Consumers are constrained from buying products from Growers, Processors or Manufacturers. Additionally, transport and testing regulations affect all product flows across the entire supply chain: A shortage of Distributors and/or Testing Labs can easily cause massive disruptions throughout the industry, making it difficult to get product from Cultivators to Consumers in a timely manner. At the same time, high costs of licensed distribution and/or testing can significantly increase costs throughout the industry, leading to higher consumer prices. Higher consumer prices decrease consumer demand and provide incentives for both Consumers and Suppliers to turn to Black Markets to buy and sell product.


Cannabis Taxes and Regulations

Now we know who the primary constituents in the cannabis market are, and we know what the supply chain looks like. We can now consider what the different laws and other (besides the ones already mentioned) regulations are and how they shape market activity.

Supplier Licensing

All states require Cultivators, Manufacturers, Dispensaries, Distributors, and Testing Labs to be licensed by the State. Aspiring Suppliers must pay fees to apply for a license, and if granted, Suppliers must pay a licensing fee to obtain the license, then annual fees to renew the license.

License fees are generally tiered, where larger Suppliers pay higher fees. Fees range from several hundred dollars for small Cultivators (AK, ME) to hundreds of thousands of dollars for larger Suppliers (AR, FL, IL, MD, MI, ND, OH).

Licenses create a barrier to entry for Suppliers. Even if there are no fees, the burdens of having to apply for a license and having to meet the established requirements (such as being a resident of the state or not having a criminal record) make it difficult for some people to apply. And of course, higher fees increase the costs to licensees of operating a business in the industry.

In addition to imposing licensing fees, most States have also capped the numbers of licenses granted. By limiting the numbers of licenses granted, States further limit the numbers of Suppliers that can participate in the market. With license caps, not only are there fewer participants in the market, but those who do participate generally face higher costs of obtaining permits, such as consulting fees or payoffs. Even if the license fees themselves are no higher, the nature of competition for limited numbers of licenses can heavily restrict who ends up obtaining a license.

So, requiring a license to operate in the market shapes the number and types of Suppliers in the market, where:

  • The need for a license enables the State to place restrictions on who can enter the market;
  • The magnitude of license fees determines how well-financed Entrants must be and how much sales volume they must generate to profitably serve the market; and
  • The capping of licenses determines how well-financed and/or how well-connected Entrants must be to enter to the market.

The large and well-established Black Markets in cannabis provide Suppliers with ready-made venues in which to participate. Of course, the Black Markets are not legal, but they do provide alternatives to Suppliers who aren’t able to obtain licenses to participate in legal markets. Greater restrictions on the numbers and types of Suppliers who can obtain legal licenses to participate in the cannabis market provide greater incentives for aspiring-but-ineligible Suppliers to shift their activity to the Black Markets.

Supplier Taxes

In addition to standard Federal, State, and Local taxes, participants in the cannabis market (Cultivators, Processors, and Consumers) must also pay cannabis excise taxes. Excise taxes increase the costs to Suppliers and Customers of participating in the market, which limits both supply and demand. Higher costs of participating in legal markets also provide incentives for Sellers and Buyers to shift over to the Black Markets.

Supplier Regulations

In addition to licensing fees and excise taxes, Suppliers must also comply with myriad regulations. In particular, Suppliers have struggled with seed-to-sale tracking requirements, reporting that software systems have been difficult and time consuming to operate.[1] Packaging and labeling regulations have also been burdensome. Specifically, packaging regulations have led to excessive amounts of packaging, not to mention packaging that’s unattractive or unappealing to consumers (opaque packaging requirements prevent consumers from being able to see product).[2] Suppliers have had problems with labeling requirements as well, finding the regulations inconsistent[3] and difficult to comply with (it’s difficult to fit all the required information on small packages).[4]

The excessive time and money costs cannabis Suppliers incur to comply with cannabis market regulations increases their costs of doing business.

Schedule I Burdens

In addition to the constraints cannabis Suppliers face from State and Local laws and regulations, Suppliers face additional constraints due to the Schedule I classification of cannabis at the Federal level. Specifically, cannabis Suppliers face higher Federal income tax burdens because they cannot deduct many business expenses from their reported income. The Schedule I classification of cannabis also generally prevents Suppliers from having bank accounts. As a result, cannabis businesses tend to be cash businesses, which means Suppliers incur high security costs to safeguard operations. A third added burden from the Schedule I classification of cannabis is the need for excessive legal and accounting services to navigate State and Federal laws and comply with all regulations.


Impact of Laws and Regulations on Market Structure

Higher Fixed Costs

Licensing fees, taxes, regulations and large, but necessary, legal and accounting fees all increase the costs of doing business in cannabis. Higher costs make it more difficult for suppliers in general, but for small suppliers in particular, to run profitable businesses. When fixed costs, such as licensing fees, equipment/set-up costs, and consulting fees, are large, businesses will increase profitability by increasing their size of operations. In other words, the large fixed costs in the cannabis industry favor larger suppliers at the expense of small businesses; it’s simply not profitable for small business to operate. Over time, then, we should expect the more successful suppliers to be those that have grown in size, either organically or through horizontal mergers with other suppliers

Greater Supply Chain Complexity

Figure 4 presents a side-by-side comparison of the unregulated vs. regulated market supply chains. The figure makes it clear that cannabis market regulations have granted undue leverage to licensed Distributors and Testing Labs vis-à-vis Growers, Processors, Manufacturers, and Dispensaries. It follows that opportunistic behavior on the part of Distributors or Testing Labs could significantly increase costs to Suppliers. Greater operating costs favor larger Suppliers over smaller ones.

At the same time, potential shortages in licensed Distributors or Testing Labs can create costly delays in getting product to market, thereby creating liquidity problems for Suppliers. So then in addition to increasing the scale of operations, Suppliers will also respond to regulation-induced complexities in cannabis supply chains by vertically integrating into distribution.

However, since product testing must be performed by independent Testing Labs, suppliers cannot fully avoid testing delays through integration. Instead, we may very well see much of the non-essential testing increasingly being performed in-house, unless independent testing becomes widely and cheaply available.

Figure 4

4 reg unreg supply chain

Loss of Direct Contact with Consumers

The side-by-side comparisons of unregulated and regulated market supply chains (see Figure 4) also reveal the striking difference in Supplier access to Consumers: In unregulated markets, Suppliers at all locations in the supply chain have direct access to Consumers, while only Dispensaries have access to Consumers in regulated markets.

The advent of the internet and social media have given Suppliers unprecedented direct contact with Consumers. Such direct relationships enable Suppliers to gather more information and feedback directly from Consumers, so they can better tailor their products to meet Customer needs. Direct relationships with Customers also enable Suppliers to develop stronger branding/relationships, which creates customer loyalty.

The fact that regulated supply chains allow only licensed Dispensaries to sell end products to Consumers makes it more difficult for upstream Suppliers (Growers, Processors, and Manufacturers) to establish relationships directly with their Customers. Cannabis market regulations have thus granted Dispensaries undue leverage over Growers, Processors, and Manufacturers. This loss of leverage provides strong incentives for Growers, Processors, and Manufacturers to integrate forward into dispensing.

Supply Chain Coordination Problems and Imbalances

As states have legalized cannabis, complete new markets have had to be created and to develop to manage market operations. Existing Growers have had to transition to new markets by passing through licensing processes. Newly established cannabis Growers, Processors, Manufacturers, Distributors, and Dispensaries have had to establish themselves from scratch, also by moving through licensing processes. Cannabis Testing Labs were likewise started from scratch, since existing non-cannabis Testing Labs did not want to risk their non-cannabis operations by working with Schedule I substances.

Licensing processes have been turbulent, to say the least. Understaffing, confusion, and in some cases outright corruption, have created long delays in processing applications and granting licenses. Delays in granting licenses, state-mandated caps on licenses, lack of transparency, and uncertain rules of operation have all created shortages, gluts, and general disruptions in moving product through supply chains. In fact, in their rollouts of legalized cannabis markets, states have generally experienced some combination of:

  • Testing bottlenecks (not enough Testing Labs)
  • Distribution bottlenecks (not enough Distributors)
  • Long lines (too few Dispensaries)
  • No lines (not enough Customers with access)
  • Empty shelves (too few Growers, Testing Labs, or Distributors)
  • Lack of shelf space (too many Growers or too few Dispensaries)
  • Price crashes (too many Growers or too few Dispensaries)
  • Price spikes (too few growers, Testing Labs, or Distributors)

(For specific examples of these problems, see Cannabis Industry Rollouts: Lessons Learned from States’ Experiences.). Supply chain coordination problems are to be expected when whole new markets have to be established. But that doesn’t make the disruptions any less painful for Suppliers who experience them. The trend in cannabis markets has been toward vertical integration by Suppliers seeking to reduce delays and costs associated with operating in regulated cannabis markets.[5]

Black Market Appeal

The overarching nature of cannabis laws and regulations will likely lead many existing small but unlicensed Suppliers who find the legal markets inaccessible and/or unprofitable to participate in Black Markets. Unless Governments either reduce the costs and burdens of regulations or shut down the Black Markets – neither of which seems likely – we should expect cannabis Black Markets to continue to have a large presence in society.


Benefits and Costs of Vertical Integration

We’re seeing tremendous volatility in cannabis markets as they spring up and start to evolve. Markets have been trending toward increasing amounts of consolidation and vertical integration. What do these trends toward integration mean for suppliers and for customers? Let’s take a closer look at the costs and benefits of vertical integration.

Structure of Market without Vertical Integration

In vertically unintegrated markets (see Figure 5), Suppliers at each stage of the supply chain are independent from one another. That is, each business specializes in only one stage of production. In the case of cannabis, no vertical integration means Growers, Processors/Manufacturers, Distributors, and Dispensaries are each independent and separate businesses. Each Processor/Manufacturer can buy from any and/or many different Growers and sell to many different Dispensaries. Likewise, Dispensaries are free to buy from any Grower or Processor/Manufacturer. And Distributors focus on transporting cannabis products between Growers, Processors/Manufacturers, and Dispensaries. Unintegrated businesses depend on markets to oversee transactions; that is, transactions take place by independent entities, who negotiate with one another through arms-length transactions.

Figure 5

5 no vi

Structure of Market with Vertical Integration

In fully vertically integrated markets (see Figure 6), each business carries out all operations along the seed-to-sale production chain, from growing to processing, manufacturing, transporting, and retailing. Whereas unintegrated businesses rely on markets to oversee transactions, integrated businesses rely on command-and-control to direct operations.

There’s also the possibility that markets have some integration, but not necessarily full integration. In this case, Growers may integrate with Processors to grow flower and extract their own oil or manufacture their own product, then sell that product to independent Dispensaries. Similarly, Manufacturers may integrate with Dispensaries, where they buy flower from independent Growers, but manufacture and sell their own products, perhaps along with other products from third-party Manufacturers.

Figure 6

6 vi

Pros and Cons of Integration vs. Non-Integration

With this understanding of the distinction between businesses that are vertically integrated (VI) and those that are not, we can examine the pros and cons of each. Figure 7 provides a summary of the various pros and cons associated with VI and non-VI industries.

Generally speaking, vertically integrated companies tend to involve less competition overall, provide fewer choices at each stage in the supply chain, and produce less varied output. On the other hand, vertically integrated companies tend to have more control over operations than independent companies. So there tend to be fewer hold ups, delays, and shortages with vertically integrated companies than with unintegrated companies.

Market Participation

With no VI, businesses specialize in one aspect of the supply chain. Specialization entails lower set-up costs, so smaller businesses can enter the industry and thrive. Markets end up with greater numbers of smaller firms.

With VI, on the other hand, each company performs multiple activities along the supply chain. Companies with wider scopes of operation generally entail larger set-up costs, and they also generally require more oversight, that is, larger bureaucracies, to cover the expanded scope of operations. Larger set-up and oversight costs require companies to generate higher sales volumes to cover the higher costs. So with VI, markets end up with fewer companies that are larger than those in markets without VI.


With no VI and smaller, specialized organizations, markets experience greater competition at every stage of the supply chain. Greater competition leads to greater product variety, higher quality, lower prices, greater overall output, and less potential for opportunistic behavior. Smaller, more competitive firms tend to be more agile, more adaptable to change, and more responsive to consumer demand. With greater numbers of smaller firms along the supply chain, you get a proliferation of transactions across firms in the marketplace, where any given firm tends to have less control over end-to-end (seed-to-sale) operations. With greater numbers of smaller firms, however, markets generate fewer economies of scale, which can lead to higher costs, and thus higher prices; however, effects from greater competition on pushing prices down may counteract effects from lack of economies of scale on pushing prices up.

With VI, there are fewer, larger firms with less competition between them. With fewer, larger firms, markets are less adaptable and less responsive to consumer demand, they produce less product variety and lower quality, and they experience higher prices, less overall output, and greater potential for opportunistic behavior. Larger firms have greater control along the supply chain, since activities can be coordinated in-house, which leads to fewer disruptions and delays in bringing products to market. The larger firms also tend to benefit from economies of scale and scope; lower costs put downward pressure on prices for consumers.

Whether prices overall are greater or less with VI than without depends on the relative weights of the different forces: fixed costs of operations, level of competition, and degree of economies of scale and scope.

The types of business-customer relationships depend on suppliers’ ability to access customers. In turn, access to customers depends both (i) on the distance between suppliers and end-market products and (ii) on regulations. In cannabis, Growers are upstream in the supply chain. On the other hand, in the case of flower, Growers provide end-products for Customers. At the same time, however, regulations generally prevent Growers from selling flower directly to Customers; rather, Customers are only allowed to buy from licensed Dispensaries. In these cases, Growers sacrifice their direct contact with Customers to Dispensaries. This distance may decrease Growers ability to fully respond to Customer demands.

Supply Chain Control

Since markets without VI tend to have larger numbers of smaller firms, these markets are more difficult for Government to control. To the extent that Government want to make sure only licensed activity occurs, Government will favor VI markets with fewer firms who are easier to track and control.

Markets without VI tend to be more chaotic, involving fewer direct paths from seed-to-sale. These markets tend to experience more disruptions, hold-ups, and delays. Customers who want great predictability in supply may very well prefer VI markets, with their tighter control systems and more direct paths along the supply chain.

Figure 7

7 vi table




[1] See, for example, Hymes, T. (2019, Jan 8). Track-and-Trace Systems Are Still Working Out the Kinks. MG Magazine. Retrieved from

[2] Krishnan, M. and Robinson, R. (2018, Feb 28). Weed Packaging Rules Are Wasteful Overkill. Vice. Retrieved from

[3] ISMP Warns that Medical Marijuana Product Labeling Problems Have Led to Errors (2020, Jan 13). Institute for Safe Medication Practices. Retrieved from

[4] Small Packaging Poses Problems for Cannabis Brands, Too (2019, May 15). Healthcare Packaging. Retrieved from

[5] See, for example Schaneman, B. (2020, Apr 22). 2020 Cultivation Snapshot: U.S. Wholesale Marijuana Prices & Supply. MJ Business Daily. Retrieved from