Labor Economics of Sports I:

Wage Determination

An Overview Smoothly functioning markets

Labor Supply and Labor Demand Is LeBron James underpaid?

Human Capital Monopsony and Free Agency Salary Arbitration Superstars and Winner-take-all When to turn pro?

What’s the difference between Tara Lipinski

And Funny Cide?

To see answer: Consider Labor Supply

Indifference curves• Show desires• Personal trade-off

• Goods vs. Leisure

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To see answer: Consider Labor Supply

Indifference curves• Show desires• Personal trade-off

• Goods vs. Leisure

Constraint in 2 parts Exogenous Income (I)

• Vertical Segment Downward sloping

• Slope=wage (-w)

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L

To see answer: Consider Labor Supply

Indifference curves• Show desires• Personal trade-off

• Goods vs. Leisure

Constraint in 2 parts Exogenous Income (I)

• Vertical Segment Downward sloping

• Slope=wage (-w)

Best off at tangency Best possible mix

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LL*

Leisure

Work

T

What happens if I rises Pure income effect Moves straight up What causes this?

Leisure

Work

What happens if I rises Pure income effect

Can afford more of everything

Moves straight up What causes this?

Tara v. Funny Cide MoreLeisure

LessWork

Responses to changes What happens if w rises?

Constraint gets steeper Two effects

Substitution effect: • Leisure costs more• Work more• Longer careers in baseball

Income effect: • Can afford more of everything – including leisure• Oscar de la Hoya quits boxing

The Other Blade of Scissors The Demand for Labor

Firm weighs marginal costs & benefits Marginal benefit

Marginal Revenue Product=MR*MPL

Marginal cost Wage or salary (w)

Profits maximized when: w=MR*MPL

What happens to MPL when add workers? What happens to Demand when:

Workers become less productive? Output becomes more valuable?

Why did NBA salaries skyrocket in 1990s?

What is LeBron Worth? Simplify problem

Fixed Supply” of LeBron What sets wage? Demand!

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What drives demand? Attendance

Gate revenue up $5.3M in Cleveland Venue revenue

• Sponsorship revenue up 17% Media revenue

Local TV ratings up 265% Regional TV ratings up 231%

LeBron may be a bargain

Human Capital What is an investment? Can invest in people as well

Increase skills – why are you in college? General vs specific skills Worker pays for general skills

Firm cannot recoup investment Firm helps pay for specific skills

Firm can recoup investment• So why doesn’t it pay all?

Examples? A rationale for the reserve clause?

Monopsony Upside down Monopoly Lower wages Lower employment Deadweight loss Application to sports? Can you buy a suit from

Jim Thome? Might have 30 years ago

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Monopsony and Baseball Early years marked by “thievery”

Nat’l Assn of Professional Base Ball Players Pittsburgh Pirates named for piracy of players

William Hulbert – a unique thief Steals 5 players from other clubs Calls for end to thievery

Forms National League of Baseball Clubs Key: Teams reserve 5 players Eventually extended to all players: Reserve Clause

Seemingly Innocent Reserves for length of contract

PLUS one year Key: Players not allowed to play

without a contract Recursive system keeps players stuck Other leagues copy – often verbatim

Free Agency All major sports have eliminated

Reserve Clause (later we’ll see how) Limits on Free Agency differ

NHL has many classes of free agency NFL allows teams to keep “franchise

player” – at a price Salary caps in NBA & NFL limit

movement

A-Rod and the Yankees Do rich teams get all the best players? The Yankees and Alex Rodriguez

Didn’t pursue him Pursued him

Why did they change their minds? Think Marginal Product

Ronald Coase and The Curse of the Bambino

Economists believe free agency overrated Were things different pre-free agency?

In 1920 Red Sox sold Babe Ruth to Yankees Connie Mack twice sold off championship teams

Key is the Coase Theorem First applied by Ronald Coase to pollution Don’t need government to solve an externality Just need well-defined property rights

The Idea of the Coase Theorem

Consider: pizza factory and a brewery Brewery’s fumes affect pizza makers

If Pizza factory has property rights Brewer compensates pizzeria Or reduces pollution

If Brewer has property rights Pizzeria compensates Brewer Or cuts back pollution

Result independent of rights Pollution – or its impact - reduced Only difference: who gets paid

The Coase Theorem and Free Agency

Free Agency does not affect talent Babe Ruth worth more in NY

Yankees paid owner of Red Sox in 1920 Now he would pay Babe Ruth

Players flow to most valued use Only difference is who gets paid Implications of Revenue Sharing?

Rank Order Tournaments Market bases reward on productivity

As productivity rises – so does reward Some rewards are discontinuous

Second by one stroke or ten? Senior VP vs CEO

Based on “rank order” in contest Not on actual contribution

Why Use Rank Order? Best to pay MRP

Incentives appropriate Equivalent to paying “piece rate”

Usually don’t pay “piece rate” Pay by hour, month, year Seems inefficient

Key: How to judge productivity?

Tournaments Stimulate Effort

Want workers to try hard Cannot always see how hard they try Easier to see who tries hardest Set up distinct rewards

Winner makes much more than loser Bigger spread gives greater incentive

Problems with Tournaments What if contest seems uneven?

Joe Louis & the “Bum of the Month” Participation and effort may fall

Is trying hard the only way to win? Tonya Harding whack, whack, whack Shoot first, pass second May compress wages to avoid sabotage

The Economics of Superstars

Like tournament – skewed rewards Disproportionate reward to being

best Who wants 2nd best surgeon?

Fixed supply Rationed by price

TV skews rewards Greater access to best Decline of minor leagues

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Problems Caused by Superstar Effect

Little Girls in Pretty Boxes Eating disorders rampant –especially gymnasts

• 2/3 among college gymnasts – not even elite! Would violate labor laws – if paid Injuries go untreated

• “Would lose muscle tone” in cast

Faust’s Gold East German girls given “vitamins” Birth defects, medical and sexual side-effects

What about the boys? Some want to be big: BALCO scandal Some want to be small: jockeys and tapeworms

Measuring Inequality Does free agency affect salary distribution?

Measure with Lorenz Curve Compares population with income

To see line up by income (Excel) Fish-eye increases with inequality

What do absolute equality/inequality look like? Problem: Curve is hard to interpret Gini Coefficient: a more precise measure

Ratio of fish-eye to triangle Has risen with Free Agency in all sports

Arbitration A way to deal with disputes Mediation – play the middleman Arbitration – play the judge

Binding vs non-binding Danger of arbitration

Can be addictive Must consider motives of arbitrator

The Problem with Arbitration Arbitrator likes job Doesn’t want to offend

either side Chooses middle Lose incentive to

compromise Arbitration “addictive”

Labor Firm

Arbitrator

Final Offer Arbitration Each side makes final offer

Arbitrator must choose one Restores incentive to compromise Problem with practice in baseball

Ignores ½ the market Can consider only credentials & peers Worse than free agency

Ripple effect of others’ errors

When to Turn Pro? When to cut down tree or sell wine? Key tradeoff for all three the same:

Waiting => lose current income Selling => miss out on higher value

Consider LeBron James If went to college: Would improve skills But: Would delay earnings

• For simplicity assume career length fixed Risk may also play a role

• Insurance as scouting report

A Simple Decision Rule Simplifying assumptions

Earns S if turn pro right away• Ignore uncertainty or risk of injury

Skills & earnings rise at rate g in school• Would earn (1+g)S if wait one year

Earnings worth less in one year• Interest rate = r• Present value of waiting:

LeBron stays in school if g>r Turns pro if g<r

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