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December 22, 2009

The Real Curse

Supply, Demand, and Pricing

by Colin Wyers

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When is it a bad thing for a baseball team to win? On the field, of course, it never is. An extra-inning win may leave you with an overworked pen, for instance, but it's still better than having an overworked pen and losing. But when it comes to acquiring baseball talent, it is possible to lose by winning—something that economists call the "winner's curse." What we mean by winning in this case is having the winning bid for a player's services.

Of course, we don't often think of teams as being bidders. When we talk about the free agents market, we often talk about it as though teams are shopping for players on the open market—sellers set a price for their goods, buyers buy X quantity of goods based upon their reservation price, sellers adjust their price accordingly until they have maximized profit. There are certain qualities of that kind of a market that make it function properly.

Think about when you want to buy a car: when you go down to your local car lot, they have a variety of makes and models, all of which are to some extent or another a substitute for the other. Sure, a pickup truck and a sports car tend to appeal to different buyers, but both will get you to work; there are plenty of both besides. It's pretty easy for you to get an idea of what the car is worth. You can go to other car dealerships and see what they're selling similar cars for, and you can get a guidebook that will tell you the market value of almost any used car available based upon its condition. And everyone out there has access to the same resources to figure out what a car is worth. Each car has a roughly common value to everyone in the market for a car. That means each car is "worth" about the same to everyone, either as a trade-in, to resell it or simply to drive it.

Because these things are true, we can apply something called the "fundamental theorem of exchange," which states that people are likely to make an exchange that benefits both parties. Otherwise, why would both sides agree to a deal? If this were true in the market for baseball players, we would expect to see teams and players both mutually benefit from free agency. But how well does that reflect the reality we see?

So far this offseason we've seen the Mariners kick in a net $6 million to trade Carlos Silva to the Cubs for Milton Bradley. The Dodgers sent $10.5 million to the White Sox to unload Juan Pierre. The Blue Jays sent $6 million to the Phillies along with Roy Halladay. And none of that tops the August deal where the White Sox assumed over $61 million of Alex Rios's contact and the Blue Jays got nothing in return (except for the salary relief, of course—a lot of it). These are of course just the contracts that teams can get rid of, though. As much as they might like to, the Blue Jays are not going to be able to trade Vernon Wells. The Cubs can't get rid of Alfonso Soriano. No team will offer to take Barry Zito off the Giants' hands.

This raises the question: Why would teams sign players to these sorts of deals, if they are good at evaluating baseball talent and are rational actors? (And yes, we do think that MLB teams are pretty good at evaluating baseball talent, despite what you may occasionally hear on talk radio.) Simply put, the market for baseball players isn't much like the market for cars at all. It differs in some pretty significant respects:

  1. Asymmetry of information. Simply put, when bidding on free agents, the only party that knows the value of all of the bids is the free agent and his representation. Teams are forced to make an offer without always knowing what the market price for that player is.

  2. Differing valuations of players. Each team does their own scouting and evaluation and comes up with a value for a player—there is no Blue Book value for Juan Pierre a front office can consult.

  3. Lack of close substitutes. Baseball players are not as fungible as cars. As much as you might like to, you can't put just any left fielder at second base. You can usually put a second baseman in left field, but rarely is this optimum from any point of view.

Because of this, the market for baseball players seems to more closely resemble a sealed-bid auction than it does a market. Since the person who wins that sort of auction is typically the person with the largest bid, it stands to reason that the person who "wins" is in fact the person who overbids. This doesn't have to be the case, of course, but there is a tendency for things to behave this way.

This doesn't require you to be bad at evaluating players on the whole. But forecasting baseball players is at best imperfect, so anyone—even a major-league team, which has both the most resources and the greatest incentive to get it right—will be wrong at least some of the time. As it turns out, when you make those mistakes in a player's favor, those are the times you're most likely to actually sign that player. It's difficult for us to quantify how exactly this impacts the market for free agents—remember, most dollar-value estimates of a baseball player's worth are based upon actual free-agent salaries. So if the market is distorted, the model won't be able to figure that out.

There are ways to figure out a player's value without looking at other free-agent salaries, typically through a marginal revenue product model , where you compute the dollar value of a win to a team and go from there. This approach is fraught with problems as well. First, we lack a lot of information about team finances that would be useful to know in such an analysis, and second, there is the problem that not all wins are created equal from a marginal revenue standpoint. As a result, you have to figure out a baseline for comparison; economist Andrew Zimbalist, for instance, in his book Baseball and Billions, figured marginal revenue products compared to the average player. But then you're left trying to figure out the MRP of an average baseball player. I don't honestly think that we're at a point where we can firmly attribute differences between an MRP model and observed salaries to an actual cause rather than a problem with model specification.

So let's speak more broadly about the issue for a moment. Teams can account for the effect of the winner's curse and account for it in their bidding for free agents. Let's go ahead and suppose for a minute that some teams do, and some teams don't. (I think that's a reasonable theory, although certainly not the only one available. At this point it doesn't matter much either way, because it helps us to illustrate useful principles.)

The teams that do would seem to clearly benefit from the actions of those teams that don't, right? Sure, except that free-agent contracts are used as guidelines to set appropriate salaries for players in arbitration. If you ever wanted to know why the Pirates would non-tender Matt Capps, that's why: every time some other team signs a short reliever to an inflated contract, its more money you have to pay to hold on to your own guys. (And if you've ever wondered why your team refuses to offer such-and-such departing free agent arbitration… yeah, that's probably part of it as well.) Plus, you see the prices get driven up on free agents in general, making it more expensive for you to sign guys you do like but have appropriately valued.

So how do you prevent other teams from suffering the winner's curse? Realistically, you have two options. The first is one that the Player's Association would probably file (and win) a grievance over, because it's essentially collusion. If you end the information asymmetry—in effect, having teams tell each other what free agent offers they're making and at what price—you would tend to see a reduction in the offers made to free agents. Because of what happened the last time the industry tried to do that unilaterally, during the '80s, and the $280 million penalty they agreed to pay to settle the matter, let's just assume that this isn't an option.

The other solution would be to make more players free agents. By having more free agents, you would see an increase in the number of close substitutes available, and you would have more comparable players being signed in order to establish a player's market rate. In many ways, teams may be hurting themselves financially by keeping so many players off the market, either by signing long-term deals or by controlling a player's rights for six years prior to free agency. A market where all players were free agents every offseason could be cheaper for teams.

Colin Wyers is an author of Baseball Prospectus. 
Click here to see Colin's other articles. You can contact Colin by clicking here

Related Content:  Baseball Salaries,  Free Agents,  Free Agent,  Buyers,  Free

20 comments have been left for this article. (Click to hide comments)

BP Comment Quick Links

ferret

I believe Charles O Finley, former owner of the A's, strongly urged that all players should be free agents when their contracts expired and felt that the additional players on the market every year would significantly decrease salary costs for the owners.

Dec 22, 2009 10:59 AM
rating: 2
 
BP staff member Ken Funck
BP staff

True. And Marvin Miller was aware of that and worked to avoid it:

"The owners wanted as few players as possible to become free agents. I wasn't entirely opposed to this; I didn't want as many free-agent players as to flood the market . . . What would likely produce the optimal mix of supply and demand? With no history of free agent movement to study, it was impossible to know which requirement would be best . . . My gut feeling -- and I stress 'feeling' -- was that five years would be better, and if the choice lay between four and six years, I would choose the latter. The owners' committee proposed six years; I suggested five."

Dec 22, 2009 12:58 PM
 
BP staff member Colin Wyers
BP staff

Right.

I should point out - there are probably other considerations into the ideal rate of turnover besides the simple ones of supply and demand. Competitive balance is certainly one. Another is fan identification with the team - is there a rate of turnover that's too fast for fans, making them likely to enjoy the sport less?

I don't know if we know much more than Miller did back then about the "ideal" length of team control. (And of course "ideal" depends greatly upon where you sit as an observer.)

Dec 22, 2009 13:05 PM
 
graignettles

I believe - and I can't find the source to cite but would welcome someone else to find it - that Charlie O wanted players to be free agents at the end of EVERY season, not their current contracts. That's where the market flood that reduce prices would come about. That's what scared Marvin Miller.

So to answer The Real Neal's point "Except that this would shift most of the injury and decline risk back onto the players, who would then mitigate the risk by holding out for multiple year deals, which would lead in two or three years lead to positional scarcity again." - there would be no long term contracts in Charlie's world, no scarcity, no over bidding.

Dec 26, 2009 20:38 PM
rating: 0
 
TheRealNeal

"A market where all players were free agents every offseason could be cheaper for teams."

Except that this would shift most of the injury and decline risk back onto the players, who would then mitigate the risk by holding out for multiple year deals, which would lead in two or three years lead to positional scarcity again.

Also, without the benefit of the six years of MLB player control, prospects would become less valuable, and signing bonuses would decrease or vanish.

Eventually players systemically would wind up getting the same amount of money as they do today, simply because player salaries are not driven by free agency or signing bonuses or arbitration, they're driven by companies trying to maximize profit.

Dec 22, 2009 11:09 AM
rating: -1
 
Richie

Player valuations are becoming less different across teams, thanks to you guys, and guys like you guys.

There are also more close substitutes than I think you account for.

What I'd like to see is a study of pre-season activity regarding signing free agents, and season-ticket sales. I understand only winning moves overall ticket sales significantly. But does being active/inactive in the off-season player flesh market affect season ticket sales? Has this been studied?

Dec 22, 2009 11:41 AM
rating: 0
 
pbconnection

This seems to be a fairly well written and well argued article, but I'm missing the point as to why I should care. I don't mean that in an offensive way. I'm just saying that the article is written as if to be published in The Economist and not for an audience of baseball fans with rooting interests...

Dec 22, 2009 12:23 PM
rating: -3
 
deep64blue

This site is the Economist of Baseball :-)

Dec 22, 2009 13:27 PM
rating: 2
 
pbconnection

More or less, that's true, but articles such as this get significantly fewer comments than the editorials by Sheehan, Jaffe, etc that deal much more directly with individual team situations and viewpoints. Clearly, there's a lot less interest in articles like this.

Dec 22, 2009 13:55 PM
rating: 0
 
Brian24

It's entirely possible that this sort of article is less popular than, say, Joe's analyses. But what's your point? Does that mean BP should never run this sort of article? Surely there is room for m/ore than one type of content on the site.

If this type of article isn't your cup of tea, no need to read it.

Dec 22, 2009 15:17 PM
rating: 8
 
pbconnection

My subscription pays for these articles. As a consumer, you should be entitled to give feedback about the product you're receiving. More articles like this means I'm just getting less value out of my dollars.

Dec 22, 2009 19:09 PM
rating: -3
 
R.A.Wagman

Seriously? A subscription runs $35/year. Let's round that up to a whopping $3/month. BP produces, generally 4 articles a day, 6 days a week. 6 days a week for 52 weeks gives us 312. Let's remove five days for holidays and the like and we are left with 282 articles for $35. A single article (and I won't bother to include the cost of running the statistical engines) runs each of us around 12.4 cents!
I don't like every single article run on the site either, but the value of the whole package is so overwhelmingly in my favour, that even the stuff I find less than thrilling is generally worth 12 cents of my hard earned money.
I can also say that the time-value of my investment in writing this response was worse for me than even the worst BP article in the 4 years or so of my membership here.

Dec 22, 2009 19:47 PM
rating: 6
 
graignettles

While I agree with RA Wagman's point, I believe the math is a little fuzzy. Using the 4 articles a day, 6 days a week stat you cite, that's 24 articles a week x 52 weeks (let's say 50 weeks as these next two weeks are a little lighter than normal), we're looking at about 1200 articles a year. At $35 per annum, that's less than 3 cents an article. Supports your argument even more with the correct numbers. Maybe PB should ask for a refund of his three pennies :-)

Dec 26, 2009 20:31 PM
rating: 1
 
Brian24

I do, of course, agree that you have the right to offer feedback on your subscription. But I disagree with the premise that the addition of some articles that don't interest you detracts from your experience. I like the movie reviews in the New Yorker, and I don't care for the column on dance. But I don't think my subscription experience would be improved by replacing the Dance column with a second column on movies.

Dec 22, 2009 20:02 PM
rating: 6
 
eighteen

When explaining contracts like those given Juan Pierre, Vernon Wells, Barry Zito, Alfonso Soriano, Alexis Rios, Carlos Silva, and many, many others, I just can't buy the notion that information asymmetry, differing valuations, and lack of close substitutes are more responsible than abject ignorance.

Dec 22, 2009 12:28 PM
rating: 1
 
Llarry

Yes, but Abject Ingnorance will mainly manifest in differing (or if you will, wildly inaccurate,) valuations, and will spill into the other two. If you were such a Front Office Type, your Abject Ignorance would cause you to vastly overvalue certain players. Not knowing what others would bid for their services would lead you to overbidding, for fear that someone else will bid higher. Finally, Lack of Close Substitutes will lead you to value players based on imperfect comparisons, and dreams of converting a desired player to an inappropriate position to fit your team's needs.

In other words, your term of Abject Ignorance is already contained in the others, but by breaking them out, we may be able to better see the specific effects, and how they vary by organization. We can already see teams that are more likely to overpay for certain types of players rather than others, and those who are more active at the beginning or at the end of the off-season.

Dec 22, 2009 16:52 PM
rating: 1
 
Russell A. Carleton

Has someone yet put together an "offers database?" For example, if it's reported that Mapleland Bees offered 5 years and $7 gazillion for Jason Bay, and someone reported that, we can get some idea of the pricing process. Of course, some of those offers are bogus (probably floated by agents to inflate the price.) Some offers are likely never reported. Obviously we know the winning bid, but do we know the losing bids and how the rest of the league prices Player A.

I also wonder if the better market analogy isn't a rarities market. It seems that at the beginning of each off-season, before anyone can officially make bids, there's a generally accepted "contract that Larry Larfelschnarger will get." And he usually gets that. Teams can walk around this rarities market and either choose to buy or not buy, but it always seems that the price is set in advance.

Dec 23, 2009 08:24 AM
rating: 0
 
R.A.Wagman

We also have to keep in mind that it isn't always the highest bidder who gets the prize. Some vets have other motives. Some prefer multi-year deals at less per-year salary than short term, big bucks. Some prefer less to play for a contender. Etc.

Dec 23, 2009 08:26 AM
rating: 0
 
mattseward

Umm actually player evaluation works on the comparative valuation model.

Player's salaries are compared to free agents and other salaried players which is the height of the market most mistakes are made when clubs wrongly ascribe values to players based on superior players or outlying salaried players. For instance the Kris Benson deal inflated salaries as he could then be used as a comp for lots of inferior pitchers to claim higher salaries. Essentially, the valuation method in arbitration is used by agents to dictate free agent contracts.

Essentially my view is the top FAs are valuation based but economics and supply and demand come in more fully when the market gets close towards clearance and places and funds are limited

Dec 25, 2009 07:48 AM
rating: 0
 
BP staff member Matt Swartz
BP staff

Colin was explaining in this article how economics is not just basic supply/demand models you see in intro courses. "Valuation" is economics. Prices are always relative, unless you strongly crave green-tinted pictures of ex-presidents. It is fully accepted that labor markets, particularly those for specialized skills, will not follow basic supply/demand principles without some adjustments, but you don't need to throw out economics in evaluating things. You can just go beyond the first 20 pages of the econ textbook. There may not be any markets where that framework is enough.

Of course businesses compare and mimic other business practices in determining prices of goods and labor. People don't actually sit there and take derivatives and set them equal to zero any more than billiards player do differential equations on each turn. They mimic what has worked, and what has worked best will look like they were doing calculus over time.

Dec 25, 2009 09:18 AM
 
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