Economics of Sport

1. Economics of Sport Econ 3670 Applications of Choice Theory Roberto Martinez-Espiñeira

2. 1 Introduction to Economics of Sport • Two reasons why economists should be interested in team sports: • Professional team sports act as a laboratory for economists, since we can observe operations normally hidden and directly measure the productivity of individual employees • Sports leagues have used non-competitive forms of behavior (cartel behavior)

3. 2 Introduction to Economics of Sport • US and European economists differ on the objectives pursued by team owners: • profit maximization paradigm dominant in the US • non-profit objectives (maximization of games won subject to a profit constraint, etc.) in Europe • greater income from broadcasting and the tendency for sports teams to become listed on the stock market may have led to a more commercial approach in Europe that has narrowed such differences

4. 3 Team and League Objectives • Objectives of team owners and leagues that control them is a key question in the economics of sport, especially given their monopoly/monopsony nature • The question of profit-maximization versus utility-maximization can be viewed at two levels • Whether or not team profits are maximized • Whether or not leagues attempt to maximize joint league profits

5. 4 Team and League Objectives • North American literature de-emphasizes utility-maximization: no evidence that owners, whether sports fans or publicly-traded corporations, receive less than a market rate of return on their investment • Few teams in the US make losses in any season • In Europe, few soccer, rugby or cricket teams make consistent profits, relying on donations from wealthy directors and owners from supporters’ clubs to survive

6. 5 Team and League Objectives • How to test utility versus profit maximization : • (1) Accepting long-run losses is inconsistent with profit-maximizing behavior (firms should only stay on as long as short-run marginal revenue covers average variable costs and makes some contribution toward average fixed costs) • (2) Paying players more than the value of their marginal revenue product is inconsistent with profit maximization

7. 6 Team and League Objectives • (3) Hiring too large a squad (paying a higher salary to the last player signed than that player’s expected contribution to future team revenue) infringes the profit maximization rule • (4) Building a stadium larger than needed (i.e. where the marginal revenue product of capital is less than the cost of capital) is inconsistent with profit maximization

8. 7 Team and League Objectives • (5) Charging prices for tickets below the marginal cost of providing the product infringes the profit maximization rule • Teams often have a waiting list for season tickets for many years, which would be strong evidence of behavior against profit maximization • Also setting prices on the inelastic part of the demand curve, unless this generated sufficient ancillary sales to cover the implied reduction in total revenue

9. 8 The Nature of the Product • Neale (1964) referred to the ‘peculiar’ economics of professional team sports since it is not possible to produce any output without the assistance of other producers • The essence of such sports leagues is mutual interdependence • i.e. individual producers (teams) have a vested interest in the economic viability of other teams in order to maintain the interest of their fans and in turn the revenues generated from the sale of the product (the joint game) • Neale, W.C. (1964), ‘The Peculiar Economics of Professional Sports’, Quarterly Journal of Economics, 78 (1), 1–14.

10. 8 The Nature of the Product • The nature of the product thus creates a requirement for uncertainty of outcome (a.k.a. competitive balance) • This is the uncertainty of outcome hypothesis: fans pay more for this than having their team always winning or a lot of absolute quality in the game

11. 9 The Nature of the Product • Competitive balance can have several meanings: • (1) Event or game uncertainty which increases as the probability of either side winning approaches 0.5 • (2) Seasonal uncertainty over which team will eventually win the championship • (3) Absence of long-run domination by one or two teams, in the sense that the same or one or two teams win the league championship over a number of seasons

12. 10 Cartel Behavior • Neale (1964): professional team sports are natural monopolies and teams simply individual plants in a common enterprise • Others see leagues as cartels constraining activities of individual teams by various rules required to organize the league

13. 10 Cartel Behavior • leagues as cartels: • E.g. sporting rules to determine how games are conducted, and rules about the selection and employment of players by teams • Rules required to determine shares of revenues from games, TV and other activities • Rules designed to influence market structure and conduct such as controls on league size, on the distribution of league franchises and various forms of labor market controls

14. 11 Cartel Behavior • Standard defence of these restrictions: without controls the wealthier teams would acquire so much player talent that they would become too dominant and kill spectator interest in the league as a whole • Economists such as Rottenburg (1956) have used the invariance principle to argue that such restrictions will have no effect on competitive outcomes • Rottenberg, S. (1956), 'The Baseball Players' Labor Market', Journal of Political Economy64. Seminal paper in sports economics!

15. 12 Cartel Behavior • Invariance principle consists of two propositions: • (1) In the absence of transactions costs, the parties to any contract will settle on the most efficient outcome • (2) The same outcome will be achieved regardless of the distribution of property rights (the invariance thesis)

16. 13 Cartel Behavior • Implication: the distribution of talent would be identical regardless of whether leagues imposed limitations on the free mobility of labor • The best players would still end up in the wealthiest teams • However, this takes no account of externalities, the fact that a team signing up the best players will not likely take into account the negative effect of such as signing on other teams

17. 14 Cartel Behavior • A further problem is that a player’s talent maybe team-specific (irreversibility proposition) • Thus, it may be reasonable to assume that a team for whom a player has performed over a number of seasons will be better informed about the player’s potential than any other team interested in signing him (the lemons phenomenon) • The possibility of a winner’s curse operating seems much more likely in a situation in which the maximization of playing success dominates over profit maximization considerations • winners’ curse: information asymmetries and uncertainty may imply that the team which values a player’s worth correctly has less chance of signing him than a team which overestimates his value (Sloane 2006)

18. 15 Salary Caps in Professional Team Sports • Cartel interpretation: one of the main functions of the leagues is to effect rules to further the collective interest of their member teams • E.g. in 1983 the National Basketball Association (NBA) introduced a salary cap • It limits each team’s expenditure on players’ compensation to 53 per cent of gross league revenues divided by the number of teams in the league

19. 16 Salary Caps in Professional Team Sports • By equalizing expenditure on players’ wages throughout the league, the NBA salary cap is intended to enable small-market teams to compete on equal terms with the large-market teams

20. 16 Salary Caps in Professional Team Sports • In practice, however, the exemption clause is invoked regularly by the large-market teams and the cap has not succeeded in equalizing expenditures • Consequently, total wages regularly exceed 60% of revenues, and the high-spending teams’ wage bills are typically more than twice those of the low-spending teams

21. 17Salary Caps in Professional Team Sports • In theory, if all teams are required to spend exactly the same on wages, and it a reverse-order-of-finish draft allocates the best new players to the lowest-finishing teams, the long-term equilibrium allocation of playing talent implies perfect competitive balance • The large-market teams would like to spend more on players and the small-market teams would like to spend less, but both are prevented from doing so by the rules of the salary cap • The equilibrium is also inefficient since total league revenues are not maximized (Fort and Quirk, 1995)

22. 18 Cheating in Professional Team Sports • Major difficulty with attempts to restrain players’ salaries: possibility of cheating on the part of individual teams • This can be illustrated using the prisoner’s dilemma game-theoretic model

23. 22Cheating in Professional Team Sports • Other issues • Why do sports stars make so much money? • Why do amateurs do sports? • How do we model the demand for sport activity?

24. Further reading • Gratton, Chris and Peter Taylor (2000). Ch. 1 Sports and Economics, Ch.11 Professional Team Sports • Neale, W.C. (1964), ‘The Peculiar Economics of Professional Sports’, Quarterly Journal of Economics, 78 (1), 1–14. • Sanderson, A. R. (2002), 'The Many Dimensions of Competitive Balance', Journal of Sports Economics 3, 204-228. • Rottenberg, S. (1956), 'The Baseball Players' Labor Market', Journal of Political Economy64. • Jones, J. C. H. (1969), 'The Economics of the National Hockey League', Canadian Journal of Economics2(1), 1-20. • Sloane, P. (2006), 'Rottenberg and the Economics of Sport after 50 years: An Evaluation'(0608), Technical report, International Association of Sports Economists; North American Association of Sports Economists.