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August 26, 2010

Prospectus Perspective

Acting Like Thieves or Rational Agents?

by Matt Swartz

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Many fans were outraged last weekend when the Associated Press, which had leaked some of the team's financial statements, reported that the Pirates had earned a profit while receiving money from Major League Baseball via revenue sharing while spending less on player payroll than nearly every other team in the sport. Apparently, fans are shocked that the people who charge them $5 for a hot dog are more interested in their money than their happiness. However, this is exactly what a system like MLB's revenue sharing is bound to do. It creates an incentive for small-market teams to earn more money by not investing in the product on the field.

The concept that baseball teams spend money because they want to make their fans happy is nonsense. They do it to make money. Sure, George Steinbrenner undoubtedly placed some value on wins when he owned the Yankees, but he was not to risk going to the poorhouse for the sake of winning a pennant. MLB is a business, and businesses like to make money. Until the structure of baseball changes such that franchises have the incentive to win because it enables them to make more money than by not winning, there will be outrage directed at the Pirates or Marlins or some other small-market team every time a story like this comes out.

Baseball players make a lot of money. The average player earned about $3 million a year, and there is a good reason why. Winning baseball games can be very profitable for some teams. Franchises in big cities like New York, Boston, Los Angeles, Chicago, and Philadelphia can make a lot of money by making the postseason, especially if they bring home a pennant or a World Series championship. The Phillies sold out their 100th straight baseball game last Thursday at Citizens Bank Park, and they are spending about $138 million on player salaries this year. These are not unrelated facts. The Phillies spent just $42 million on salaries in 2001, the year after they won 65 games. Those facts are not unrelated, either.

As a result of the differences in spending by poor and rich teams, MLB has instituted a “revenue sharing” plan whereby teams like the Yankees and Red Sox more or less funnel money to teams like the Marlins and Pirates, and this is somehow supposed to make the lower-revenue teams spend money on player on salaries. Of course, this assumes that the Pirates are owned by well-meaning poor people. The owners could have spent some of their own money on player salaries for the enjoyment of Pittsburgh fans if they so desired, but why would they? Clearly, they were not going to surrender some of their own money to make the fans happy without anything more than a charitable feeling coming from it. But why would handing those same owners cash via the revenue-sharing system somehow make them any more charitable? 

I know that you’re going to say that the rules dictate that revenue-sharing money should be spent on improving the competitiveness of the team, but why wouldn’t teams just say that the money went to salaries even if it did not change their behavior? The Pirates can simply claim that they would have spent less on salaries by the amount received from revenue sharing, and how could the average prove them wrong?

Trusting in the charity of billionaires is a foolish venture. The outrage should be directed at a system that provides the incentive to pocket the cash. 

The problem here is an issue of relative value. The Red Sox get more revenue added out of a four-win player than the Pirates do because it gives them a better chance of making the postseason, so it was not surprising that they worked out a deal to acquire Jason Bay from Pittsburgh during the 2008 season. Bay provided more value to the Red Sox than he did to the Pirates as he helped them make the postseason in both 2008 and 2009.

You do see examples of small-market teams picking up an expensive player, but those are almost always cases where a team like Tampa Bay is on the playoff bubble and spending on Pat Burrell or Rafael Soriano can provide a substantial amount of revenue by pushing them into a lucrative playoff berth.

But teams who are nowhere near the post-season contention simply do not have the same value for stars that teams from large markets and teams near the playoff bubble have. Spending $27 million a year on Alex Rodriguez costs the Pirates more than it adds to their revenue, but spending $27 million on Alex Rodriguez adds to the Yankees’ revenue more than their costs.

We see that the Pirates made $15 million in 2008 in this report, and let’s say for the sake of argument that they received $25 million in revenue sharing. I am contending that without $25 million in revenue sharing, the Pirates would have lost $10 million exactly, with no other real change in spending behavior because there was no reason for spending to be any different. If adding Rodriguez would only have made the Pirates $15 million but cost $27 million, then the Pirates would have only made $3 million instead of $15 million had they signed him. If there had been no revenue sharing, the tradeoff would be a $10 million loss without signing him versus a $22 million loss with signing him. Either way, they make $12 million less by signing him.

The solution could take a variety of forms, but the success of the luxury tax provides the clearest suggestion. Although the uber-large market Yankees regularly spend past the luxury tax threshold, the "regular" large-market Red Sox frequently push right up against it and stop. The reason is that the luxury tax does what marginal taxes generally do—it makes the marginal cost of signing players higher beyond that point. This luxury tax system makes it so that even though the Red Sox have a higher marginal value for signing big-ticket free agents, they have a higher marginal cost for signing the big-ticket free agents that push them over the luxury tax threshold.

By marginal value, I mean the extra value added by bringing in the player relative to the value of not having the player, and by marginal cost of a player, I mean the change in total cost as a result of bringing in the player, including both the cost of the contract itself and the extra luxury tax spent if a team goes over the minimum threshold for the luxury tax.“

The problem is that MLB has not employed the same logic in encouraging small-market teams to spend as it has in discouraging large-market teams to spend. If the league found a way to effectively subsidize the expenditures that the Pirates make on player salaries such that the marginal cost of signing those players was lower, then the Pirates might have an incentive to spend on free agents with the big boys, because even though they have a lower marginal value for adding those players, they also would have a lower marginal cost for adding those players.

Until then, the only way for small-market teams to win is to find a market inefficiency that they can exploit such that they actually do make more money by winning or by waiting for the stars to align such that their homegrown talent stock puts them on the playoff bubble on its own before they spend any additional money on free agents.

 There are a number of different ways to implement this “Anti-Luxury Subsidy” plan, and all of them will have their strengths and weaknesses, but simply giving billionaire owners cash and expecting that they will spend it without a change in the marginal cost or marginal value of making those expenses is not going to work. Until that changes, every few months some article will publish financial details that will outrage the fan who thought that his hometown team’s owners were spending millions of dollars a year for his personal happiness.  

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

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