Eco 383: PPT lecture slides, October 2006

• Topics:– Franchise finances– Competitive balance and market size– Player salaries, MRPL, and exploitation

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.

Computing team profits

• OPERATING PROFIT• = total revenues -

total costs• same as “operating

income”• what we focus on• reported in Forbes

(1997-), Financial World (1990-96)

• PRE-TAX PROFIT• = operating profit -

interest costs* - “player depreciation”

• < operating profit• declared to IRS• (* interest costs could

be from purchase of team, stadium debt…)

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• 34% broadcasting• 12% food,

merchandise• 7% ads, sponsorship• 6% other 0

51015202530354045

Tickets…

B'cast…

Food…

Ads…

Other

Breakdown of team costsIn rough 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• Contributions to MLB central fund• (MLB revenue-sharing; sums to $0)

Estimated profitability of MLB teams (source: Forbes)

Year Operating profit% increase in asset value(and return on assets)

1999 $1.0 million(0.5% of assets)

6%(6.5%)

2000 $4.3 million(1.8% of assets)

12%(13.8%)

2001 $2.5 million(1.0% of assets)

10%(11.0%)

2002 -$1.3 million(-0.5% of assets)

3%(2.5%)

Estimated profitability, cont’d

Year

Operating profit

% increase in asset value (and return on assets)

2003 -$1.9 million (-0.7% of assets)

3% (2.3%)

2004 $4.4 million (1.5% of assets)

15% (16.5%)

2005 $12.1 million (3.7% of assets)

15% (18.7%)

(Note: best measure may be long-term increase in asset value.)

Calculating a team’s (one-year)return on assets (ROA)

ROA =

% increase in estimated team value

+ (operating profit as % of previous year’s team value)

Note well: Because operating profit is usually a very small fraction of team value, ROA will usually be very close to the one-year percent change in team value.

To calculate ROA from the Forbes tableROA = (Operating income)(1 year change in value) + -------------------- | (Current value) | | ---------------- | | 1+(1 year change)|

(Tip: Compute in decimal form, then convert to %.)

Ex.: NY Yankees: Value: Current value (May 2006) = $1026 M Value: 1 year change = 8% (or .08) Operating income = -$50.0 M

– --> ROA = .08 + (-50.0)/[(1026/1.08)] – = .08 + (-50)/(950) – = .08 + (-.053) – = .027, or 2.7%

Is the sky falling on MLB financially?• YES, say owners and

commissioner (most notably in 2000-02)

• Selig: for 2001, a $232 M operating loss & a $519 M book loss

• 2000 report said 5 of 13 franchise sales in 1992-2000 were at a loss– Selig: “We’ve run out of

‘greater fools’ ”– weak resale market in 2001-02

• Lately, Selig and owners are less negative, thanks in part to current CBA

• NO, say most independent researchers

• Forbes: for 2001, a $75 M operating profit

• Franchises normally sell at big profits; high rates of asset appreciation– Weak resale market in 2001-02

was temporary and due to sluggish economy.

What a difference a year makes:Baseball finances in 2003, 2004, & 2005

2003 2004 2005

average operating profit

(as % of assets)

-0.7% +1.5% +3.7%

number of teams with positive operating profit

15 20 25

number of teams whose estimated value rose

17 28 30

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.

• Two media companies recently sold their teams.– (Fox) News Corp. sold Dodgers, Disney sold Angels

– Time Warner looking to sell Braves?

– MLB teams as unprofitable corporate divisions?

Criteria for investments, and how MLB teams stack up

• Rate of return (appreciation of asset value)– 12.4% in 1960-2002 (John Moag)– 8% in 1950-2000 (Rodney Fort)– 9% from time of purchase to 2004; average of 23 teams (Forbes)– stocks (benchmark): 6.9% in 1960-2002

• Safety (lack of risk)– Forbes, April 2004: 16 of 23 teams had long-term gains of 9% or more; 4

had gains of 5-7%; 2 had gains of 2-3%; one had loss of 2%– Operating losses are usually small but not uncommon.– stocks: returns are highly variable and often negative; but, can diversify.

• Liquidity (convertibility into cash; resellability)– poor; selling a team takes many months if not years– stocks: very liquid, easy to resell

• Cash flow– Minimal in relation to size of investment (ditto for stock dividends).– But, can be negative (whereas stockholders have limited liability).

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• (implies that finances and market size should have

minimal effect)

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 balance

• Standard deviation of team winning percentages• Number of WS or pennant winners, in comparison

with--– 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?

– Regular season: strong correlation between payroll and W-L %

– Postseason: • all WS winners were from top 25% of payrolls• only 4 teams from bottom 50% made postseason, won 5 games

• 2002-2006 WS winners and payroll rank: – Angels (15th-highest), Marlins (26th)– Red Sox (2nd)– White Sox (13th), Cardinals (11th) or Tigers (14th)

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

measure)

• 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

• Which teams are “large market” (~top 4?), “mid-market,” “small market” (~bottom 5?)?

• Market size perhaps cannot be measured precisely

Can the small-market teams compete?MAYBE MAYBE NOT

• First 15 years of free agency (1977-91) saw unprecedented parity, several successful small-market teams

• Insignificant correlation between payroll and W-L % through mid-1990s

• Recent success of some small-market teams

• Market size is not static

• Yankees: 4 WS titles in 5 years (1996-2000)

• 1997-2006: statistically significant correlation between payroll, W-L %

• 1992-2006: Only one small-market, low-payroll team has won WS

• Collapse of Montreal Expos (well-run small-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– low concentration of championships (but MLB’s is lower now)

– 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.• Owners have not asked for one since 1995.

– 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 current (2002-2006) Collective Bargaining Agreement.

Player performance and salaries

News flash:MLB players are highly paid

• Average MLB salary = $2.87 M (April 2006)

– Up 8.9% from previous year

– About 10 times as high as in 1983

– Less than NBA ($4.5 M in 2003)

– More than NHL ($1.6 M), NFL ($1.3 M) (in 2003)

• Median MLB salary = $1,000,000

– Fluctuates a lot more than the average • Was $975,000 in 2000, fell to $800,000 in 2003

– 409 players making $1 M+, fewer than in 2000-2002

marginal revenue product of labor (MRPL)

• = 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

• VOLUNTARY EXCHANGE = market transactions, including free-agent contracts, are agreed-upon by buyer and seller

• 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: Assumptions

• Many buyers, many sellers -- nobody has market power

• No restrictions on pay or employment

• No cartels among employers, no unions

• Diminishing returns --> downward-sloping demand curve for labor

• Upward-sloping supply curve for labor

Notation (goes with blackboard notes):

• 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• ECONOMIC EXPLOITATION

• = 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 ($327,000 in 2006)

3rd - 6th

Salary arbitration

After 6th

Free agency

The amateur draft• MLB’s annual selection of the top amateur talent

in the U.S.– Conducted each June. Worst teams draft first.– A player can deal only with the team that drafts him– Monopsonistic market.– In effect since 1965.

• Before 1965, teams just signed amateur players as free agents.– Competitive market– Signing bonuses were often quite high.– Once the draft began in 1965, signing bonuses dropped

dramatically.

Baseball’s salary explosion, 1976-present

• “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:

• “Exploitation index” (EXPL) = MRPL/salary– Alternatively, “pay-for-performance index,”

salary/MRPL

• Zimbalist estimated this with 1986-89 data– How to measure MRPL?

For hitters, the one common statistic with the highest correlation with team winning percentages is...

“OPS”(On-base Plus Slugging pcts.)

• = On-base percentage (OBP) + Slugging percentage (SLG)

• = what Zimbalist uses a measure of hitters’ productivity, in computing MRPL’s– --> next steps:

• 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:

• Younger players tend to be “exploited” (pay<MRPL)

• Players with 6+ years of experience tend to be “overpaid” (pay>MRPL)

Salary/MRPL, by service category (1986-89)

Year of service CategorySalary/MRPL,on average

1st - 2nd “apprentice” 16 – 25%(highlyexploited)

3rd - 6th “journeyman” 50 – 64%(exploited)

After 6th “master” 140%(overpaid)

Salary/MRPL: 2003 update(Source: Bill Felber of Total Baseball)

Years of service

Salary/ MRPL

1-2 27%

3-6 49%

7+ 156%

How do we explain those systematically “overpaid” veterans?

• Supply and demand: Even though most free agents are past their prime, teams still have holes to fill and supply of free agents is limited mediocre free agents can command top dollar

• Also of note:– Stats-based MRPL measure may be too narrow --

doesn’t count leadership, reputation, marquee value

– Free-agent contracts are often long term reduced incentive to work hard?