The Economics of Baseball

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					           Eco 383: PPT lecture slides,
              Oct.–mid-Nov. 2007
                    (last updated 11/13/2007)
• Third debate (Thurs., Nov. 8):
   – Topic: Resolved: MLB should have a payroll cap for the sake of
     competitive balance.
• Fourth debate (Thurs., Nov. 29):
   – Topic: Resolved: Most free agents are overpaid, so teams should
     make lower bids for them.

• Topics:
   – I. Franchise finances
   – II. Competitive balance and market size
   – III. Player salaries, MRPL, and monopsonistic exploitation
Franchise Finances
   Franchise finances: An introduction

• Why we care:
  – (1) To draw a conclusion about the health of the
    industry (MLB), we need to know about the
    health of individual firms (teams).
  – (2) Issue of whether the small-market teams can
    afford to field competitive teams.
      • If too many teams cannot compete, then demand for
        MLB will tend to fall.
MLB’s 2000 report concluded that...

• (1) 27 of the 30 MLB teams had cumulative
  operating losses in 1995-99.
• (2) Small- and mid-market teams can’t compete,
  because they can’t afford to field very good teams.

• Caveat: That was seven years ago. MLB officials
  say the picture is much brighter now.
         Computing team profits
• = total revenues -       • = operating profit -
  total costs                interest costs* -
• same as “operating         “player depreciation”
  income”                  • ≤ operating profit
• what’s usually focused   • declared to IRS
  on                       • (* interest costs could
• reported in Forbes         be from purchase of
  (1997-), Financial         team, stadium debt…)
  World (1990-96)
       Ways to hide a team’s profits
• Claim “depreciation” of your players as a loss (over 5
  years, up to 50% of what you paid for the team; legal
  under U.S. tax law).
• Deduct the interest paid on team-related loans.
• Related-party transactions: If you own another
  company that does business with the team, overcharge
  your team (or pay it too little) in those deals.
• Featherbedding: Pay yourself (and friends and
  relatives) an excessive salary and claim it as a cost.
      Breakdown of team revenues
            (Forbes, 1998)
• 40% tickets & suites   45

• 34% broadcasting       40
• 12% food,              30
  merchandise            25

• 7% ads, sponsorship    20
• 6% other               10
                              Tix B'cast Food Ads Other
          Breakdown of team costs
       In descending order of importance

•   Player salaries (~55% in 1992-2001)
•   Scouting & player development (farm teams…)
•   “General and administrative”
•   Team operations (front office, manager, coaches…)
•   Marketing, publicity, ticket operations
•   Stadium operations
•   (MLB revenue-sharing and general fund
    – Net cost for richer teams, net revenue for poorer teams
   What is the return on owning a
           baseball team?
• Operating profits are almost irrelevant…
• As with a stock, most of the return comes
  from the long-term increase in the value of
  your asset (team).
   Desirable properties of investments
• (1) High return, including
   – Short-term interest, dividends, or earnings
   – Long-term capital gain (can resell at profit)
   – Favorable tax treatment
• (2) Low risk of loss
• (3) Liquidity (ease of resale)
• (4) Cash flow
 Desirable properties of investments, as
         applied to MLB teams
• (1) High return – excellent
   – But, over 1998-2006, NFL franchise values grew much
     faster, and NBA franchise values grew a little faster.
• (2) Low risk of loss – excellent
   – Teams typically earn very high overall returns, with
     very few exceptions.
• (3) Liquidity – poor
   – Costly and time-consuming to resell a team
• (4) Cash flow – poor
   – Yearly return on assets (operating profit as % of assets)
     is tiny, less than interest on Treasury bonds
       Calculating a team’s (one-year)
        return on investment (ROI)

% increase in estimated team value
+ (operating profit as % of previous year’s team

Note well: Because operating profit is usually a very small
  fraction of team value, ROI will usually be very close to
  the one-year percent change in team value.
To calculate ROI from the Forbes table
 The example below uses the data from the May 2006 Forbes ($1026 M value,
    a one-year change of 8%, operating income of -$50 M in 2005) to compute
    the 2005-2006 ROI for the Yankees
 -- Note: The denominator under operating income needs to be the previous
    year’s team value, which Forbes does not provide. You can get it by
    working backwards from the current year’s estimated value and the “1-year
    change in value” (percent change from previous year’s value).
    -- Ex.: Forbes says the Yankees were worth $1026 M in 2006, an increase
    of 8% (or .08) from 2005.  The Yankees’ 2005 valuation was then
      ($1026 M)/(1+.08) = $950 M

           ROI  .08  $50 M 
                        $1026 M
                          1 .08

                                  $50 M
                     .08        $950 M

                     .08  .053
                     .027 ( *100%)  2.7%
Estimated one-year return on MLB teams
                 (source: Forbes)
       Operating profit % increase in team value
Year   (return on assets) (return on investment)
1999 $1.0 million        6%
     (0.5% of team      (6.5%)
2000 $4.3 million       12%
     (1.8% of t.v.)     (13.8%)
2001 $2.5 million       10%
     (1.0% of t.v.)     (11.0%)
2002 -$1.3 million       3%
     (-0.5% of t.v.)    (2.5%)
    Estimated one-year returns, cont’d
       Operating profit % increase in team value
Year   (return on assets) (return on investment)
2003 -$1.9 million       3%
     (-0.7% of t.v.)    (2.3%)
2004 $4.4 million        15%
     (1.5% of t.v.)     (16.5%)
2005 $12.1 million       15%
     (3.7% of t.v.)     (18.7%)
2006 $16.5 million       14.8%
     (4.4% of t.v.)     (19.2%)
 Is the sky falling on MLB financially?
• YES, said owners and     • NO, say most
  commissioner (until        independent researchers
  very recently)
• Selig: for 2001, a       • Forbes: for 2001, a $75
  $232 M operating loss      M operating profit
  & $519 M book loss       • sluggish economy
• several MLB teams          explains poor resale
  were for sale in 2001-     market in 2001-02
  02, few buyers           • franchises normally sell
                             at big profits; high rates
                             of asset appreciation
         Media ownership of teams
• Ownership of teams by media companies, esp. TV
  stations, complicates the profit picture.
  – Media companies often buy teams as programming
    content, not as separate investments; synergy strategy.
  – Large operating losses may be OK if media company’s
    own profits go up.
• Possible danger sign: Two media companies
  recently sold their teams.
  – (Fox) News Corp. sold Dodgers, Disney sold Angels
  – Time Warner looking to sell Braves?
        What a difference a year makes:
    Baseball finances improved dramatically
from 2003 to 2004 (and still more in 2005 & 2006)
                2003   2004     2005   2006

average operating -0.7% +1.5%   3.7%   4.4%
profit (as % of
# of teams with 15     20       25     29
positive operating
# of teams whose 17    28      30      30
estimated value        (only 1
rose                   fell)
What is competitive balance?
• Blue Ribbon Panel report (2000):
  competitive balance exists when
  – “there are no chronically weak clubs because of
    MLB’s financial structural features”
  – a well-managed club has a reasonable hope of
    reaching postseason play and winning
Why is competitive balance an
      economic issue?
• The demand for MLB will tend to fall if--
  – too many teams cannot compete
  – fans perceive that the richest teams have an
    unfair advantage
   Simple measures of competitive
• Standard deviation of team winning percentages
• Number of WS or pennant winners, in comparison
   – number of teams in league
   – previous years or intervals

• Average number of games out of first place?
 MLB’s competitive balance, then & now
•   1903-1950s: not much, but gradually improving
•   1965-1976: improved more; amateur draft helped
•   1977-early 1990s: peak of competitive balance
•   1995-2001: competitive imbalance?
    – strong correlation between payroll and W-L % and
       • no teams outside top 25% of payrolls won WS
       • only 4 teams from bottom half of payrolls made postseason
         (and they won just 5 of 224 games)
• 2002-2007 WS winners and payroll rank: Angels (15th-
  highest), Marlins (26th), Red Sox (2nd), White Sox (13th),
  Cardinals (11th), Red Sox (2nd) or Rockies (25th)
Does a higher payroll mean more wins?
• Regressions of regular-season win. % on Opening
  Day payroll for all 30 teams find –
   – About 25% of the variation in wins is explained by
     variation in payroll
       • Actual variation in wins is much larger than payroll-predicted
         variation in wins
   – Payroll has a positive effect on wins
       • $7-8 M in payroll = 1 more win
       • Marginal benefit of Yankees’ last $50 M in payroll = 0 wins?
   – This effect is small but statistically significant
What is “market size”?
• Market size is based on REVENUES (both
  actual and potential).
• Revenues are very dependent on the quality
  of the team’s product (wins, players,
  stadium, etc.), but also on local factors like
  – area population
  – area per-capita income
  – area level of interest in baseball (hard to
• Hard to separate team factors from local
  factors, actual from potential market size
  Two crude measures of market size
• TOTAL REVENUES, as compared with the other
  MLB teams
• ESTIMATED TEAM VALUE, as compared with
  the other MLB teams
   – more forward-looking, e.g., higher if team is about to
     move into new stadium

• Top third = “large market,” middle third = “mid-
  market,” bottom third = “small market”?
• Market size perhaps cannot be measured precisely
Can the small-market teams compete?
      MAYBE                    MAYBE NOT
• First 15 years of free      • Yankees: 4 WS titles in 5
  agency (1977-91) saw          years (1996-2000)
  unprecedented parity,       • 1997-2007: statistically
  several successful small-     significant correlation
  market teams                  between payroll, W-L %
• Insignificant correlation   • Only one small-market,
  between payroll and W-L       low-payroll team has won
  % through mid-1990s           WS since 1991
• Recent success of some      • Collapse of Montreal
  small-market teams            Expos (well-run small-
• Market size is not static     market team)
  Competitive balance in recent decades
• Recall:
   – 1977-early 1990s: peak of competitive balance
   – 1995-2001: some pattern of competitive imbalance
• Explanations:
   – Free agency (post-1976) helped comp. balance
      • Easier for also-rans to improve themselves with new talent
      • Rising salaries --> harder to keep championship teams intact
   – Growing revenue and wealth imbalance in 1990s
      • Growing importance of local media and stadium revenues
          – Value of MLB’s national TV deal fell 60% in 1994
      • Increasing corporate (esp. media) ownership of teams
 Competitive balance in other pro sports
• (NFL) National Football League: highest comp. balance
   – lowest concentration of championships
   – policies: ~70% of revenues are shared; hard salary cap;
     “unbalanced” schedule
   – lowest correlation between payroll and performance
• (NHL) National Hockey League: ????
   – Pre-2004: in the middle:
       • low concentration of championships (1991-2002: 8 different teams)
       • little revenue sharing, no luxury tax, no salary cap
       • lower payroll-performance correlation than MLB or NBA
   – 2004-05: season-long lockout by owners, who got a salary cap
• (NBA) National Basketball Association: least balanced
   – high concentration of championships (1991-2002: just 4 teams)
   – increasing standard deviation of win percentages since 1980
The English Premier League (PL; soccer)
• League membership not fixed (non-monopolistic)
   – no territorial rights
       • London: 9 PL teams since 1990
• Within the league, a hierarchy of divisions
   – bad high-division teams are relegated (demoted)
   – good low-division teams are promoted to higher ones
• Comp. balance is mixed
   – good in terms of standard deviation of win percentages,
     upward mobility of teams
   – high championship concentration (Manchester United)
How can be MLB’s competitive balance
           be increased?
• Payroll cap / luxury tax?
   – Payroll cap might work, but is not feasible -- players’
     union willing to strike to prevent one
   – MLB has a luxury tax on large payrolls, but threshold is
     too high to be binding for most teams
• Increased revenue sharing?
   – Could work, but details are key:
      • What if teams use accounting tricks to hide revenues?
      • Incentive for low-revenue teams to improve themselves?
   – Part of 2002 Collective Bargaining Agreement (CBA)
      • 2006 CBA keeps revenue sharing high, while supposedly
        providing better incentives for teams to improve themselves
Player salaries, MRPL, and
            News flash:
      MLB players are highly paid
• Average MLB salary = $2.9 M (April 2007)
   – 2 times as high as in 1998
   – 10 times as high as in 1983
   – less than NBA ($5.4 M in 2007)
   – more than NHL (~$2 M in 2007) and NFL ($1.4 M in
• Median MLB salary = $1 M in 2006 and 2007
   – Highest ever; previous peak was $975,000 in 2000
   – 66 players made $10 M or more
   marginal revenue product of labor
• = the amount of revenue that an employee
  generates for his employer
• standard economic answer to “How much is
  that employee worth?”
• can be measured in yearly terms (salary), or in
  hourly terms (hourly wage)
• marginal product of labor (MPL) = how much
  OUTPUT an employee produces
         MRP theory & player pay
• First, note that athletes are not the only very highly-
  paid people in U.S. society
• Also, free-agent contracts are examples of
  VOLUNTARY EXCHANGE (market transactions
  agreed upon by buyer and seller)
   – Nobody forces the owners to pay such high salaries.
• Rodney Fort: “talent is hired to produce [wins] in
  the long run.”
   – perhaps more than just wins...
   – Mark McGwire, 1998: extra MRPL of $15M?
  A labor market under perfect competition:

• Many buyers, many sellers
  – > nobody has market power
• No restrictions on pay or employment
• No cartels among employers or workers
• Diminishing returns
  --> downward-sloping demand curve for labor
• Upward-sloping supply curve for labor
    Notation (for diagram drawn on board):
•   L = # of workers ( = QL = quantity of labor)
•   w = wage ( = PL = price of labor)
•   SL = supply of labor
•   DL = demand for labor
•   MRPL = marginal revenue product of labor
     – MRPL = the amount of revenue that an
       additional worker generates for the firm
            Economic exploitation
• MONOPSONY: a labor market with just one buyer
      • = difference between a worker’s marginal
        revenue product and his wage
      • = MRPL - w
• In a monopsonistic labor market:
      • w < MRPL
      • w < w* (competitive wage)
      When the baseball players’
    labor market was a monopsony
• Until 1976, when all players were under the
  reserve clause.
• RESERVE CLAUSE: a provision in baseball’s
  rules that allowed owners to renew a player’s
  contract automatically for one year.
   – Players either re-signed with their teams after each
     season or retired (or were traded or released).
   – No free agency; no competitive bidding for players.
   – Held salaries down; average salary = $25,000 in 1969.
              Independence Day

• July 1976: new Basic Agreement gives all players
  free agency after 6 years of service.
   – Salaries surged after 1976; up 42% in 1976-77
   – Can use monopsony diagram to illustrate
       Baseball’s current system
Year of ML
service    Eligible for…

1st - 2nd   Rookie minimum (Team can pay
            ($380,000 in 2007) more if it wants.)

3rd - 6th   Salary arbitration

After 6th   Free agency
         Baseball’s salary explosion,
• “Freedom and prosperity”
• Shift from monopsony to competitive bidding was
  less sudden than it seems
   – Over time, more and more teams played the FA market
   – Collusion against FA’s held salaries down in mid-1980s
• Salary arbitration (1973-) allowed 3rd-to-6th-year
  players to piggyback on FA salary scale
• MLB revenues surged -- attendance rose, TV
  revenues soared, stadium revenues soared, ...
   Comparison of performance
     (MRPL) and salaries

• First, how to measure MRPL?
For hitters, the one statistic that has
the highest correlation with team
winning percentages is...
• =    On-base percentage (OBP)
      + Slugging percentage (SLG)

• OPS * (player’s plate appearances as % of team’s)
  = what Zimbalist and Bradbury use to measure
  hitters’ productivity, in computing MRPL’s
                 For pitchers
• Earned run average (ERA) is the standard
  – Bradbury prefers “Defense-Independent
    Pitching Statistics” (DIPS), which is like ERA
    minus the contributions of the team’s fielders
     • Includes walks, strikeouts, and home runs allowed
  – Then compare a pitcher’s DIPS with the league
    average, and multiply by his innings pitched as
    a % of his team’s total.
Next steps toward estimating MRPL

• Estimate the player’s contribution to
  team winning percentage, based on
  wins as a function of OPS
• Estimate contribution of additional
  wins to team revenues
    Comparison of performance
      (MRPL) and salaries:
• Exploitation = MRPL – salary
• Zimbalist (1992):
   – Younger players tend to be exploited (pay<MRPL)
   – Veteran players (6+ years in majors) tend to be
     “overpaid” (pay>MRPL)
• MRPL calculations by Bill Felber (The Book on the
  Book, 2005) echo Zimbalist’s conclusion
• MRPL calculations by Bradbury (p. 195) find
  pay<MRPL but a much smaller gap for veterans
   – But, “I don’t think this is exploitive,” if you take
     development costs into account.
MRPL - salary, by service category
                              MRPL – pay, on average

   Year of                    (Zimbalist; 2005; hitters,
   service     Category       1986-89)    pitchers)

   1st - 2nd   reserved       75 – 84%      89%, 90%

   3rd - 6th   arbitration-   36 – 50%      77%, 78%
               eligible       (exploited)

   After       free-agent-    -40%          8%, 36%
   6th         eligible       (overpaid)
    How do we explain those systematically
           “overpaid”* veterans?
•    (* overpaid by Zimbalist’s and Felber’s estimates)

• Supply and demand: limited supply of free agent players,
  high demand for players who can help a team
• Most free agents are past their prime (age 30+), which
  reduces their MRPL, but as free agents they’re in a
  position to earn the most money
• Statistical MRPL measure may be too narrow -- doesn’t
  count leadership, consistency, marquee value
• Many free-agent contracts are long term
      – --> reduced incentive to work hard?

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