Labor Economics of Sports I:

1. Labor Economics of Sports I: Wage Determination

3. 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?

4. What’s the difference between Tara Lipinski

5. And Funny Cide?

6. To see answer: Consider Labor Supply x • Indifference curves • Show desires • Personal trade-off • Goods vs. Leisure L

7. To see answer: Consider Labor Supply x • Indifference curves • Show desires • Personal trade-off • Goods vs. Leisure • Constraint in 2 parts • Exogenous Income (I) • Vertical Segment • Downward sloping • Slope=wage (-w) L

8. To see answer: Consider Labor Supply x • 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 Leisure Work T L L*

9. What happens if I rises • Pure income effect • Moves straight up • What causes this? Leisure Work

10. What happens if I rises • Pure income effect • Can afford more of everything • Moves straight up • What causes this? • Tara v. Funny Cide More Leisure Less Work

11. 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

12. 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?

13. What is LeBron Worth? w • Simplify problem • Fixed Supply” of LeBron • What sets wage? • Demand! D SLJ L

14. 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

15. 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?

16. Monopsony ME $ • 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 S wc wm D L Lc Lm

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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?

24. 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

25. 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?

26. 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

27. 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

28. The Economics of Superstars P • 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 S D’ D Q

29. 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

30. 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

31. 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

32. The Problem with Arbitration • Arbitrator likes job • Doesn’t want to offend either side • Chooses middle • Lose incentive to compromise • Arbitration “addictive” Firm Labor Arbitrator

33. 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

34. 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

35. 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