FortisBC Inc. (FortisBC) Application for a Certificate of Public ...

in other industries or activities on the margin.
This is the key observation underlying the estimation
of the total number of illegal activities. It is
what links the unobserved illegal activity to the
known, legal world.
More formally, we write the value of output, PQ
(price times quantity) less cost, C, relative to the
value of capital, or in this case, cost. This gives a
rate of return to investment (cost) in a particular
year.
Thus R is a return over costs and looks like:
1. R = [PQ-C]/C
The value of output less cost is net income, PQ-C,
during the year, and the return over costs is akin
to the usual calculation of the rate of return to
capital. If we believe that the industry is in equilibrium,
about which more will be said later, then
the return on capital (or costs) is equated to the
rate of return in other industries or activities on
the margin. Thus R = R*, where R* is the market
rate of return.
Unlike the market, however, a grow-op includes
ingredients of extraordinary risk not captured by
legal market entities. Let us add a probability of
getting caught25 in a grow-op and consequently
the risk of losing the entire crop. If the probability
of getting caught is π, then the harvester has a
(1-π) probability of being able to sell quantity Q at
price P. Compared to a riskless sale, this lowers
the return to any given investment. 26
2. [(1-π)PQ-C]/C = R*
PUBLIC POLICY SOURCES, NUMBER 74
The left-hand side tells us that the harvester has a
(1-π) probability of being able to sell quantity Q at
price P. Compared to a legal sale, this lowers the
return to any given investment. The investor is
assumed to lose the costs, C, whether the crop can
be sold or not.
The expected return is equated to the return that
the investor can get in any other sector of the
economy, R*. In effect, we assume that the potential
investor in the marijuana business is faced
with two options: Our potential producer can invest
in those activities that are legal and receive a
normal rate of return of R*; or our potential producer
can invest in a grow-op that includes an extraordinary
risk of crop loss.
A refinement
The market rate of return, R*, constrains the
amount of investment in marijuana grow operations.
If more and more people get into the business,
eventually it will drive the return below that
which could be made in other business activities.
This limits the size of the sector. Symmetrically, if
the return to marijuana grow-operations is higher
than the return in other activities, this leads to
more investment going to the marijuana industry,
eventually driving the return toward the market
average. This basic framework may not fully
capture the essential constraints on an illegal activity.
Do potential growers of marijuana view
the market return on funds as relevant in assessing
their alternatives? If one were loaning funds
to a grow-op producer, the lender may insist on a
risk premium associated with the loan so that the
constraint associated with an equilibrium in the
25 In this context, “getting caught” includes being shopped by unscrupulous competitors, as well as having your crops catch
fire, or simply be stolen by thieves. A tip apparently led to the discovery of a “massive” hydroponic operation in Barrie, Ontario,
in the old Molson brewery—a site in plain view of Highway 400 (The Globe and Mail, January 12, 2004, p. A1, A6.) In
Vancouver, police speculate that a marijuana grow-operation is invaded each day by competitors.
26 The investor is assumed to lose the costs, C, whether the crop can be sold or not.
Appendix BCUC IR1 74.1
The Fraser Institute 13 Marijuana Growth in British Columbia