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.

If we want to model the baseball management decision, we need one that is a bit more nuanced.  Certainly owners enjoy the cash flow that a team can generate, but that isn’t the only source of enjoyment.  Sports franchises with no history of profitability still find wealthy men bidding furiously when they come on the market.  Owners are fans… and like fans they enjoy winning.  In a way, a team is a large, expensive and exclusive toy.  Since they are so exclusive, the value of the team is likely to increase rapidly even if that team doesn’t appear to be a viable business.

So, a better assumption than maximization of profits might be that owners maximize the probability of a championship – but they do so subject to constraints.  Each team will set a budget and spend it to give themselves the best odds they can.  If an owner didn’t care about winning and only about profits, they would probably invest their money elsewhere.  Unless their last name is Loria.  Yes, Warren Buffet does own a baseball team, but it isn’t a major league one.  The baseball franchise itself helps to pay its own cost of competition, but how much each market can contribute is unequal.  This is a part of the budget constraint that each team faces.  The other half is the willingness of owners to accept low or negative profits.

Given the tremendous expense of a baseball franchise, holding on to that team presents a huge ‘opportunity cost’ to the owners.  Before the 2010 season Forbes magazine estimated the value of the New York Yankees at $1.6 billion.  If the Steinbrenner family could have sold the team and invested that $1.6 billion in hedge funds instead – getting an 8% rate of return, holding onto the team represents foregone income of $128 million.  If the team makes less than $128 million in profits – that means that the Steinbrenners have sacrificed some potential income for the joy of owning the team.  Since Forbes estimated the Yankees profits in 2009 at $24.9 that would imply that the Steinbrenners were willing to give up $103.1 million to chase championships.  The same goes for any team… management can spend whatever revenue the team is able to generate plus whatever additional money the owner is willing to contribute to the cause.  The Florida Marlins, on the other hand were estimated to be worth $317 million and had profits of $46.2 million – that is more profit than Mr. Loria and friends could likely have earned in most other investment and it implies that they aren’t interested in contributing anything at all to see parades in Miami.  The odd case of the Marlins is one of the few in the MLB that fits the economists assumption of true profit maximization.