The Detroit Tigers in Dollars & Cents: part 1

What logic is it that governs baseball management decisions?

The economics profession starts with the ironclad assumptions that all firms seek to maximize profits.  Baseball franchises are firms, and so should they… right?  Economists are therefore somewhat confused when it appears that (with one notable exception) front-office strategy in sports doesn’t seem to have much to do with profitability.  Sure, they’ll raise (or lower) the ticket price if that will bring more money into their coffers… but what possesses a rational businessman to take a long look at a river of red ink and decide that what his business needs most is to pay $8 million for the services Johnny Damon?  Is this what it takes to get him into the black?

This is the first installment in a three-part Sunday series covering how the business of baseball works, where our team stands in relation to the competition and the lens through which we should view off-season decisions.

First, we need to lay a little groundwork.

Many of you out there are already familiar with this, but one important theory of today’s major leagues (and a lot of credit for this needs to go to the crew at Baseball Prospectus) is that fiscal rationality – with both free agency and revenue sharing – should lead to a lack of real competition.  The idea goes something like this:  a lot of team revenues are unrelated to team performance, in fact unrelated to the local market in general.  I’m referring here to revenue sharing, redistributions from the MLB central fund, etc…  Other revenues (ticket sales, merchandise, even television contracts) are related to team performance – and also market size.  Large market teams benefit a lot from winning but small-market teams benefit only a little.  Given the high cost of sustaining a strong baseball team, only large-market teams will find it profitable to win – small market teams maximize profits by conceding defeat before the season begins and paring payroll and player development costs to the bone.

There is nothing wrong with the first line of reasoning – that less of a small-market team’s revenue comes from local sources and therefore less of it depends on the talent on the field.  That’s observably true.  But… the Cincinnati Reds had the best record in the National League this year – and a mid-sized market (the Dallas area) beat the mighty Yankees and made it to the World Series.  The idea of profit maximization is only an assumption, and since we can also observe that baseball has competition and strong teams in small markets this must be the flawed piece of the argument.