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Source: Flickr user Isabel Mancera.

The marijuana industry could be a giant in the making.

According to a 2014 report from GreenWave Advisors, a research firm for the up-and-coming marijuana industry, if all states and the federal government were to legalize recreational and medicinal marijuana, it would be a $35 billion industry by 2020. Even if this scenario seems unlikely, GreenWave predicts that by 2020 the marijuana industry will expand to become a $21 billion market, with 37 states in total legalizing the product for medicinal purposes, and 12 states legalizing marijuana for recreational, adult use.

But, despite all this promise, the marijuana industry is nothing if not nascent and unproven.

Are marijuana prices primed to plummet?
A new report issued this past week from research firm Convergex, and as noted by Bloomberg, highlights a number of interesting price and traffic comparisons on a year-over-year basis when it comes to Colorado's marijuana industry.

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Source: TaxRebate.org.uk. via Flickr.

As you'll recall, Colorado and Washington were the first two states to legalize marijuana across the board, with their voters approving each states' individual measure in 2012 and implementing the law in 2014. Thus, Colorado and Washington represent the very important "guinea pigs," if you will, to the experiment of legalizing marijuana.

Based on Convergex's data, which it obtained by interviewing legal shop owners, the price per 1/8th of an ounce of marijuana has been plummeting on a year-over-year basis. At the midpoint, the average price of an 1/8th of an ounce currently sits at $37.50, while an ounce sells for $275 at the midpoint. Comparatively, this is down 38% and 21%, respectively, since last June. Convergex cites an increase in competition and the maturation of the marijuana industry as reasons for the declining price per ounce.

Yet, that wasn't all. Convergex also notes that while visitors to legal marijuana stores have generally remained consistent (100 to 300 visitors per day), the average amount they're spending per visit has dropped by about half, to $50 from $100. Convergex surmises that there are two reasons why total sales amounts are trending lower. These include a marijuana tax holiday on Sept. 16 where the states' 10% sales tax will be removed, which could be prompting consumers to hold off on making larger purchases until that date, and that the novelty of being able to buy marijuana legally could be wearing off -- perhaps even among tourists, who make up a significant portion of recreational buyers.

Why marijuana price data is worth watching
While monitoring marijuana prices might seem pointless, it actually serves an important purpose for potential investors in marijuana stocks.

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Source: Flickr user Dank Depot.

For example, most research firms seem to agree that the marijuana industry is only going to increase in size over the coming years. Colorado's own legislative forecasts call for its marijuana industry to grow from $699 million in 2014 to approximately $1 billion in retail value by 2016. However, falling prices could change the dynamics of the business entirely.

On one hand, falling prices could very well increase demand for marijuana. Just as with any product, consumers are picky about their spending and would much prefer to feel like they're getting a good deal. With the "novelty" of buying marijuana wearing off for some consumers, they very well may be more choosey about where they purchase their marijuana. However, if prices are falling, volume would presumably be expected to climb. It's a bit tough to tell if that will happen given the marijuana sales tax holiday on Sept. 16 and both consumers and growers likely waiting to make big buys on that day, but economics 101 would tell us that volume should improve.

But, lower prices can also affect business margins, which is another reason why it's important to keep your eye on marijuana pricing. Low prices can be indicative of increasing competition, or even the commoditization of an item if the supply has grown too large. In Colorado, it doesn't appear that supply is necessarily the issue, but costs for growers and retail shops are certainly worth monitoring since falling marijuana prices can have a direct impact on their profitability.

Econ 101 would suggest that unless volume can grow to outpace the decline in marijuana prices, and thus margins, the market value estimates suggested by GreenWave Advisors, the Colorado legislature, and other research firms, could be too optimistic. It also could mean that states may see less in tax revenue collection from the sale of marijuana as time progresses.

Finally, we still don't have much of a clue how the black market will play into legal marijuana pricing. According to Colorado state, only 60% of marijuana sold last year was done so in legal shops. The remainder is sold on the black market, where prices aren't very transparent. It's difficult to predict how this black market will affect legal marijuana sales, even with Colorado's plan to lower its state sales tax from 10% to 8% in 2017.

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Source: Flickr user Robert Couse-Baker.

This has "avoid" written all over it
What investors need to be able to do when evaluating the marijuana industry is to separate their emotions and American's perception of marijuana from the actual business model of marijuana companies. In other words, think of the marijuana industry as you would any other business.

Generally speaking, falling prices to the tune of 21% to 38% on a year-over-year basis is very worrisome. It typically means tighter margins, falling profits, and it could squeeze some growers or retailers out of the picture. It also means the profit ceiling for marijuana companies is likely shrinking.

Until we get past the Sept. 16 tax holiday in Colorado and get more data to work with on pricing in other legal states (which could take a few years), it could be tough to tell where the true floor for marijuana prices really is. And, if we can't ascertain whether marijuana will be a profitable industry a few years from now, then it's probably not worth your investment dollars.

Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

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