The Miguel Cabrera Extension: Sunk Costs, Mental Accounting, and an Overpay

There is a lot we do not know about the decision to give Miguel Cabrera his new, enormous contract extension. There is a lot we will never know about it. There are factors that might or might not have factored into the decision. We could say that this has been the plan all along. We could say that at this juncture, this is what the Tigers thought was best for the franchise or that this what the Tigers thought was the best allocation of their resources. People will also say that the Tigers may have done this to justify the Doug Fister trade and/or to justify not extending Max Scherzer. People will probably respond to this by saying that maybe the plan was to extend either Scherzer or Cabrera, or both. People will say a lot of things about a person getting paid that much money to play baseball.

Again, we were not in the room (this is an assumption I am boldly making) and we do not know what Dave Dombrowski or Mike Ilitch were thinking. As individuals, I have no idea how either of them usually thinks in these situations. What we do know is how people think; we know how most people think. Consequently, there are some behavioral economic factors that are related to how people might think if in they were in the same situation as the Tigers’ leadership. In other words, the below is not about how the decision was made, but rather about how decisions are often made.

Sunk Costs: The difference between a loss and a cost
Whether we view something as a cost or a loss has a large effect on how we make decisions. Here is an example I have stolen from my behavioral economics class:

Imagine that you purchased two very good (and expensive) tickets to a concert one week ago, but there is a big snowstorm. Traffic promises to be terrible and the road conditions will probably be unsafe. If you hadn’t already purchased the tickets, you definitely wouldn’t do so now. Would you go?

Most people would go to the concert. They would do so because they do not want to lose the money they have spent on the ticket. If we say that this is not a loss of let us say $600, but rather a cost of $600 for living in the northeast and being able to secure the tickets ahead of time, people would probably be less likely to go. Either way, we face a net negative of $600, but whether we view it as a loss or a cost can make a difference in our behavior.

This brings us back to trading away Doug Fister and not extending Max Scherzer. For now, let us assume that Fister’s lat strain is just lat strain. The Tigers had six capable starters, a barren farm system, and a Cy Young Award winner due for an extension. Instead of trading away a cheaper, less productive starter like Rick orcello or Drew Smyly, the Tigers traded away Doug Fister. Again, we will assume this option was chosen as a way to make room for a salary extension for Max Scherzer given the press release and the subsequent Cabrera extension. Let us put this into example form:

Imagine that you traded away Doug Fister a couple months ago to free up money to sign Max Scherzer to an extension, but the extension talks fell through after you offered what you thought was a very reasonable contract. If you had not traded away Fister with the intention of extending Scherzer or if you had been successful in extending Scherzer you would not consider giving Miguel Cabrera a $248 million extension. Given all that you have given up, would you give him a $248 million extension now?

Like the concert-ticket example, would the decision have been any different if we view trading away Fister not as a loss, but as a cost of having the opportunity to extend Scherzer? Maybe, but we will probably never know. Alternatively, this could have all been according to plan. That plan being: (i) trade away an extra starter to free up cash, and then (ii) extend Max Scherzer or Miguel Cabrera, or both. This brings us to our next point.

Mental Accounting: Spending a dollar here is different than spending a dollar there
“People spontaneously generate their own mental accounts, and where we place these boundaries subtly (but profoundly) influences financial decision making.” Do you remember that time you told your kids that you could not go out to eat because you went out to eat the night before? Let us say that the cost of dinner the night before was $50. Do you remember that other time when you bought $50 worth of gas and then you went out to eat the next night? This is mental accounting. In either case, you spent $50 the day before, but how you spent that $50 dictated whether you were willing to go out to eat the next night.

This brings us back to Scherzer and Cabrera. Could extending Cabrera be completely separate of extending or not extending Scherzer? Absolutely, but given what we know about know about mental accounting, the fact that the Tigers did not extend Scherzer might have made the Tigers more likely to agree to a Cabrera extension. This point falls into the “did we need all these words to point out common sense” bucket, but that is not the point at all. The point is that relying on arbitrary mental accounts can cause sub-optimal decision-making. When deciding small things, like what size coffee to get in the morning, these mental accounts are helpful because the cost of a full-scale analysis would not be worth the benefit of ensuring an optimal decision. Now we know revenues in baseball are up, but it is probably worth weeding out mental accounting when giving out $248 million. Maybe the Tigers did weed out the mental accounts, but we know that many people would not have.

Regardless of Cabrera being the best hitter baseball, most of us would say that this deal is going to look very ugly for the Tigers at the back end. Maybe the Tigers do not care if it does. The Tigers could very well know something we do not know. Whether any of these things are true or untrue, what we do know is that the Tigers gave us a fascinating case to think about regarding decision-making.

Source: Behavioral Economics class taught by Simon W. Bowmaker, Clinical Associate Professor of Economics, New York University