DRI-290 for week of 5-18-14: The Role of Economics in Sports

An Access Advertising EconBrief:

The Role of Economics in Sports

It is a commonplace that sports today is “just a business.” Once upon a time, so the thinking goes, sports was a magical realm, a “kid’s game” in which everybody played for fun and decisions were motivated by “the love of the game.” Now, though, it’s “all about the money.” From this, we might draw the inference that sports were once an economics-free zone.

The cliché applies: Nothing could be further from the truth. Indeed, sports today are ruled less by economic considerations than formerly. That isn’t quite the same thing as saying that money plays a smaller role. It doesn’t; the role of money has been distorted by the introduction of non-economic factors.

By applying the logic of economics to baseball, the national pastime, we can appreciate the historical role played by economics and understand how this role has been misshapen in recent decades.

Profit in Baseball

Baseball began as a game played for fun. Its origins are shrouded in mystery but date to before the Civil War. (Thus, the celebration of Abner Doubleday, Civil War general in the Union army, as baseball’s inventor is undoubtedly misplaced.) Professional baseball began in 1869 with the first professional team, the Cincinnati Red Stockings. Since then, profit has been inseparable from the game of baseball as a commercial enterprise.

Until recent decades, owners of baseball teams earned revenue from one primary source – the admission of baseball fans to watch games in person. The calculation of profit was quite straightforward: an admission price was charged to games and collected – either from advance ticket sales or at the gate prior to game time – and the revenue from the sum of all such sales was weighed against the costs of owning the team. The costs varied with circumstances, but less in true economic terms than might be supposed. For example, a team that owned its stadium would not pay rent according to a lease, but an economist would still reckon that rent as an implicit cost, since the team is foregoing the rent it could earn by leasing the stadium out to somebody else. Salaries paid to players and administrative staff, wages paid to low-level employees, travel costs, marketing costs – these comprise the standard costs of operating a baseball team and are subtracted from revenue in reckoning profit.

Like so many things in life, though, even this simple calculation has its complications. Revenue always has been, and remains today, a function of market size. The larger the potential number of fans, the greater is a team’s revenue potential. But for most of its history, revenue was also a function of stadium size. The Philadelphia Phillies have been a National League mainstay for over a century. For the first third of the 20th century, they played their games in the Baker Bowl, a tiny stadium whose capacity never exceeded 20,000 people and was typically less. The New York Yankees, on the other hand, played in a stadium befitting the nation’s largest city, as New York City was for nearly the first century of professional baseball’s existence. Yankee Stadium, built expressly to house the Yankees in the early 1920s, could hold around 70,000 people. Even the Polo Grounds, home of crosstown National League New York Giants, held over 60,000. Cleveland’s Municipal Stadium held over 80,000. If that seems incongruous, given the city’s comparatively modest size, our later discussion will rectify that impression.

Economists have developed a theory of the firm. They teach it to students in microeconomics courses. It is designed to apply broadly to business firms of all kinds, shapes and sizes. Given the tenuous connection traditionally made between sports and business, that attitude might seem arrogant. It turns out to be well-justified confidence.

The traditional formula for profit maximization in the economic theory of the firm requires equality between marginal revenue and marginal cost. But in order to apply the theory, we must have a measure of output. Businesses exist in order to produce goods and services. What do baseball teams exist to produce, anyway? In the ultimate sense, they produce satisfaction by entertaining fans. But this feeling of satisfaction is subjective; it is a non-operational definition of output. Is there something hard-edged and quantitative that we can measure as a source of this satisfaction?

Yes. It is winning games. If this doesn’t make baseball fans happy, it is hard to think of something else that does. Now all we have to do is identify the process by which the wins are produced – what economists call the production function. Inconceivable as it seems, it is only in the last 15 years that any real headway has been made in quantifying this formula. For over a century, professionals and amateurs alike were content to apply more or less subjective criteria to this concept.

Everybody always knew that good players and athletic talent were the raw material from which the production function sprang. But exactly how did they interact to produce winning baseball? Everybody had their own pet theories. Owners and their administrative staffs applied the theories to the selection and grooming of talent. Really, all that was done was to throw money at the problem. The amount of money and the direction of the throw varied widely from team to team and owner to owner. And baseball fans throughout America developed a time-honored set of prejudices, educated guesses and conventional thinking about the subject.

Bigger Market = More Revenue = Larger Expenditure on Player Salaries = Better Team

Even without a clear theoretical idea of the production function, though, we can still say a lot about how economic logic influenced the conduct of baseball operations and the course of baseball history. Regardless of how you go about calculating the marginal revenue associated with an additional win, it will be larger for a (say) New York City than (say) a Kansas City. (That is true even though New York City has two baseball teams to Kansas City’s one.) That an owner in New York City will find it profitable to expend a larger amount on player salaries than will an owner in Kansas City. All other things equal, this should produce better teams in New York City. In the broader context, that means that larger-market teams should tend to be better teams.

“All other things equal” (or “ceteris paribus,” as economists prefer to disguise it) is the great weasel phrase joining theory to reality. As we will see in the second installment of this discussion, those things became unequal indeed when a few wise guys cracked the code for the production function in baseball. But this generalization certainly worked well for over a century of baseball history.

No baseball team has come within a country mile of the Yankees’ 27 world championships. The St. Louis Cardinals hold second place, and for most of baseball history St. Louis was among the most populous cities and metropolitan areas in the nation. The New York Giants and Brooklyn Dodgers also rank among the most successful teams in history despite vacating New York in the 1950s. The Los Angeles Dodgers picked up the mantle doffed by their Brooklyn predecessor.

Chicago might seem a conspicuous exception to this rule of thumb, but even there it held good in the early days of the modern era. The Chicago White Sox and Chicago Cubs were two of the most successful teams in the first two decades of the modern era beginning in 1901. The Cubs set the all-time record for wins in a season in 1906 and appeared often in the World Series until 1918. The White Sox vied with the Philadelphia Athletics and Detroit Tigers for American League supremacy during that era and upset the Cubs in the 1906 Series. The Cubs enjoyed periodic success until after World War II, their final World Series appearance to date being 1945.

“Free Agency Will Be the Death of Baseball”

Much has been made over the years of the fact that major-league baseball enjoys exemption from the anti-trust laws, thanks to a federal-court decision in 1922 (Federal Baseball Club of Baltimore v. National League et al). While it is technically true that “major-league baseball” constitutes a combination of businesses that restricts its membership via the issuance of franchises, this exemption means very little in practice.

Over the course of baseball history, various competitive leagues have arisen. The American League itself was once one of those, just as the American Football League once competed with the National Football League. And major-league baseball has often reacted to its competition by absorbing it, as the NFL did the AFL. At other times, the Federal League (in 1915) and the Mexican League (in the late 1940s) briefly constituted significant threats to the major leagues.

Even more significant, though, has been the very substantial inter-industry competition provided by competing forms of sports and entertainment generally. Today, pro football and pro basketball have supplanted major-league baseball in the attraction of athletic talent. Insofar as the antitrust exemption applies to the product market in which major-league baseball operates, it has become a dead letter.

By far the most important antitrust issue faced by baseball concerned its input market. Economists have traditionally contended that baseball teams should compete with each other for players in the labor market. Until 1975, labor-market competition for players was severely restricted by the reserve clause. That clause granted exclusive bargaining rights to a player to the team first to sign that player. In recent years, a draft has assigned initial bargaining rights in baseball, as in football and basketball. It is still true that the right of players to initiate transfers to different teams is restricted in various ways.

The first economist to publicly question this arrangement was Gerald Scully in 1974 in a pathbreaking article in the American Economic Review. Scully maintained that competitive bidding normally drives a worker’s wage at or close to marginal revenue product – the value of additional output created at the margin by the input. In the case of uniquely talented inputs such as athletes – the antithesis of homogeneous unskilled labor – a player should earn his incremental contribution to revenue. By allowing freedom of player movement, players would naturally move where they would earn the most money.

Owners and baseball administrators spoke with one voice in response to this theory. They hated it. They loathed it. They reviled it. Almost unanimously, they proclaimed that to allow players the freedom of movement, or “free agency,” would be the death of organized baseball. Owners would be unable to recoup their “investment” in players. They would be unable to make enough profit to stay in business – the result would be carpetbagging teams moving from city to city in an effort to skim the cream of popularity off the top before moving on to the next city. Most of all, fans would lose their sense of identification with players who rented their services to the highest bidder rather than establishing loyalty to a city and its fan base.

An often-repeated fallacy is that the higher salaries associated with free agency would cause ticket prices to skyrocket upwards. Economists often use this as a case study in their microeconomics classes. Assuming owners want to maximize the revenue earned from ticket sales, they will choose the ticket price (or range of prices) that accomplishes that objective – with no regard whatsoever for what players are paid. The profit maximizing price depends on fan tastes, incomes and the substitute forms of entertainment available, which are the parameters of what economists call the demand curve. It is unrelated to supply-curve considerations such as player salaries.

But don’t fans pay player salaries ultimately, through ticket payments and various other means? Indeed they do. In fact, it is useful to employ the framework of the late, great Nobel laureate Ronald Coase from his classic article “The Theory of the Firm.” A business firm is a middleman between the players and fans. It is too costly for fans to contract directly with players for entertainment, so the team acts as a business intermediary. Free agency settles the question of how the fans’ payments are divided between players and team, not how much the total payment will be. The reserve clause allocated more to the team (e.g., the owner) than was economically efficient; free agency changes the division to favor the players more.

Of all these predictions, the least likely was the one that was most widely subscribed. Most people believed that free agency would cause players to move between teams much more freely and often than before. But economists like Scully contended that this would not happen. And years after the case of outfielder Curt Flood set in motion the eventual destruction of the reserve clause, they produced studies showing that player movement was no more rapid or frequent after the reserve clause was gone than in its heyday.

Although Scully and his colleagues thought they needed econometrics to persuade the public, simple logic should have sufficed. On second thought, a glance backward at baseball history should have been enough. This is how Scully put it in his contribution to the Fortune Encyclopedia of Economics: “When players are not free to move, does a small city that acquired a star player… keep him? …A small-city franchise…holding the contract of the player expects him to contribute, say, $1 million in incremental revenue to the club. In a large city that same player’s talents might contribute $3 million. Since the player is worth more to the big-city team…the big-city team will pay more for him [so] the small-city franchise has an incentive to sell the player’s contract to the big-city team and thereby make more money than it could by keeping him. Thus, players should wind up allocated by highest incremental revenue, with or without restrictions on player-initiated movement.”

There are countless examples of this principle in operation. The most famous example involved baseball’s greatest player.

“The Curse of the Bambino?” No, Just Economics at Work

In 1920, Boston Red Sox owner Harry Frazee was in trouble. His trouble wasn’t baseball-related. The Red Sox had won the World Series in 1912, 1915, 1916 and 1918. They had baseball’s greatest player, Babe Ruth. He was the American League’s best left-handed pitcher who had lately taken to playing the outfield in his spare time – and had led the league in home runs in 1919 and 1920.

No, Frazee’s troubles were related to his main business, which was bankrolling Broadway shows. Financing shows was and still is a high-risk business. Now Frazee was in debt up to his ears. He was contemplating selling baseball’s best and most popular player, Babe Ruth, to the New York Yankees, in spite of the pleading of his general manager, Ed Barrow.

Eventually, Frazee did just that. He got $100,000 (the tax-free equivalent of several million today) plus a $300,000 loan. And Babe Ruth went on to set a flock of records in a Yankee uniform and earn more in a single year than the President of the United States. Frazee went on to sell numerous other players to the Yankees in the next few years for another $305,000 in sale proceeds. And he produced successful shows such as “No, No, Nanette.”

According to baseball history, Frazee was an idiot who sacrificed his fans to his personal bank balance. But economics tells us that the Red Sox could never have paid Ruth anywhere close to his maximum potential salary. Only the Yankees, with their tremendous geographic and demographic reach, could have paid Ruth the salary he later commanded. It is no coincidence that Barrow, who criticized Frazee so sternly at the time, later went to work for the Yankees himself, became baseball’s most famous general manager and entered the Hall of Fame in his own right. Barrow also became rich by working for the Yankees.

Is it a coincidence that all the great power hitters, the players who commanded the biggest salaries and drew the most fans to the park, played for large-market teams? Lou Gehrig played alongside Ruth on the Yankees. Joe Dimaggio joined Gehrig in the 1930s and flanked Mickey Mantle in Mantle’s formative years. Roger Maris dueled teammate Mantle on his way to hitting 61 home runs in 1961. Yogi Berra was their teammate. Willie Mays played for the New York Giants, then moved with them to San Francisco, finishing up his career back in New York with the Mets. Duke Snider’s glory years were spent in Brooklyn before he, too, ended up with the New York Mets. Jimmie Foxx’s two primary teams were the Philadelphia Athletic and Boston Red Sox. The exceptions, Harmon Killebrew (Minnesota) and Ralph Kiner (Pittsburgh), were one-dimensional players who were slow runners and mediocre defensive players; thus, their value was limited by their liabilities.

Misers? Or Profit-Maximizers?

Connie Mack was one of baseball’s most beloved figures. Prior to that, he was a well-known and skillful major-league catcher. He owned and managed the Philadelphia Athletics for 50 years, from 1901 to 1950. He managed his teams to 8 World Series appearances and 4 championships. He retired as manager at age 87 and died at 95. Late in life, he was universally revered as the “grand old man” of the game.

Yet on three separate occasions he created furious controversy by selling his star players wholesale or (less often) trading them. He didn’t merely trade away one popular, talented player. He either sold or traded all his stars and started all over again with young players. At the time, he was not much more popular in Philadelphia than Frazee had been in Boston. He was even accused of being “no better than a miser, selling the contracts of players to line his own pockets.”

In order to have meaning, the word “miser” must denote inordinate stinginess. It must imply actions of thrift and economy that exceed in intensity those of ordinary men. But when we examine Connie Mack’s actions by the standards set by Scully and the principles of economics, they resemble instead the same kinds of profit-maximizing actions that any businessman would take.

In 1907, pitcher Rube Waddell was arguably the best pitcher in the American League, certainly the best left-handed pitcher. He had just set a season record for strikeouts (349) that was to last for over half a century. His off-the-field behavior was just as fast and even less controllable than his blazing fastball and wicked curveball. His drinking and carousing gave Mack the excuse for selling his contract to the St. Louis Browns, where he set a single-game league record for strikeouts (16) in 1908. Mack also disposed of Waddell’s batterymate, catcher Ozzie Schreckengost. The sale of the popular duo was highly unpopular with the public, although team members were more willing to bid goodbye to Waddell’s eccentric antics. The players had been instrumental in the two American League pennants won by the Athletics in 1902 and 1905.

Mack set about rebuilding his team. He produced a group of players – Frank “Home Run” Baker, Jack Barry, Eddie Collins and Stuffy McInnis – who became known as the “$100,000 Infield” because of their defensive positions and their aggregate salaries. They spearheaded pennant-winning seasons in 1910, 1911, 1913 and 1914. The first two of those were also World Series championship years.

Yet following the Athletics’ stunning upset loss to the Boston Braves in the 1914 World Series, Mack broke up this winning team through sales and trades over the course of the next three years. At the time, this action was explained by Mack’s financial troubles caused by competition from the new Federal League, which raided major-league teams for players and reportedly drove up player salaries with their competitive forays. But Mack’s actions caused a furor throughout professional baseball and were front-page news in Philadelphia, where he was bitterly criticized in the press.

Once more, Mack slowly and painfully rebuilt his team. Despite having to play in the American League against the powerful New York Yankees of Babe Ruth, Lou Gehrig, Bob Meusel, Herb Pennock and Waite Hoyt, Mack eventually assembled a powerhouse squad that included future Hall of Famers Jimmie Foxx, Lefty Grove, Al Simmons and Mickey Cochrane. They won consecutive American League pennants in 1929, 1930 and 1931 against the “Murderer’s Row” lineup from New York and took two World Series titles in 1929 and 1930.

And once again, Mack pleaded financial exigency – this time citing the Great Depression – as his justification for selling or trading away all of those great players and others. This succession of transactions was nearly as unpopular as the previous one, and this time there was no comeback. Mack’s Philadelphia Athletics won no more American League pennants and mostly occupied the lower rungs of the league rankings until Mack’s retirement as manager at age 87 in 1950.

In retrospect, the citation of financial necessity was flimsy and unnecessary. Mack’s philosophy of player management and development was well-known and documented. He believed in using young players in preference to older ones. He was convinced that maximum value could be extracted from a player by trading or (preferably) selling him before his abilities declined markedly. Sure enough, players such as Waddell, Baker, Collins, Grove, Foxx and Cochrane produced productive years with their new teams. Collins and Grove went on to have unexpectedly long careers; the rest declined in ability and retired or became benchwarmers within a few years after leaving the Athletics.

Mack was obviously following the philosophy of profit-maximization to the best of his knowledge and ability. He used his formidable contacts throughout the baseball industry to scout and develop young talent. He could hardly be accused of stinginess when he paid the impressive talent he developed the high salaries that eventually made the team payroll a financial burden to him.

Economist James Quirk did voluminous research into the financial history of major-league baseball and found that only in the major-market cities like New York City did owners typically earn large profits from their teams. It is also important to note that the large-market owners, like Jacob Ruppert of the Yankees, were already independently rich before entering the baseball business. This enabled them to undertake any investments necessary to capitalize on the opportunities presented by their market size. The norm was represented by hardscrabble owners like Connie Mack, who worked with small- to medium-size stadiums circumscribed by downtown urban environments. Mack played the game better than most of these lower-class owners, which explains his amazing longevity.

Connie Mack borrowed the money he used to buy part-ownership in the Philadelphia Athletics in 1901. He remained part-owner until 1937, when he was 75 years old. Yet he was able to hand on through difficult business and economic circumstances for a half-century as both owner and manager of a leading major-league team. He was a classic example of economics at work in major-league baseball during its first century.

The Changeover

The great manager Casey Stengel is famous for remarking, upon viewing the lack of talent assembled by the expansion-team New York Mets, “Can’t anybody here play this game?” There is no doubt that for baseball’s first century it was a business, not just a game. The problem was that most of its practitioners lacked the acquired skills and natural talent to play the game of baseball from a purely business standpoint. A baseball genius like Connie Mack was able to exist and earn a comfortable living for over fifty years without stacking up the fortunes earned by today’s moguls.

The watershed came when baseball owners started treating the game less like a hobby – as it was viewed by rich, large-market owners – or just a way of earning a decent living – as the lower-level owners experienced it. A man came along with the marketing skills, business acumen and love of the game to take the business of baseball to a new level. That paved the way for the ascension of baseball – and professional sports generally – to the economic level it now occupies. The man’s name was Bill Veeck. His story will be told in our next EconBrief.