More on Rising Salaries

There has been a nice discussion on salaries going on across the web. There are two small things I wish to add to the general discussion, and rather than sprinkle them far and wide, I’ll post them here.

1) The term “inflation” should not be applied to salary growth in MLB. Yes, I know what people mean, but inflation has a very distinct definition: a continuous rise in the price level, which reflects the average prices of all goods and services in the economy. The rise in baseball player salaries reflects a relative change in value compared to all other goods in the economy. They are becoming more expensive in relation to other things we purchase. And look, I understand the innocent mis-use of the term, but given the recent passing of Milton Friedman, let’s at least honor his dictum: inflation is always and everywhere a monetary phenomenon. ๐Ÿ™‚

2) In absence of some external force or cognitive bias, teams will pay players a salary equal to their net marginal revenue products (MRP). Non-free agents earn less than their MRPs, because their movement within the labor market is restricted. Free agents ought to earn their projected MRPs (there is a lot of variance in these projections) in the competitive labor market, and no team ought to pay a player more than his estimated MRP value, even if it has room in the budget. To do so would be a violation of everything we have come to know in labor economics. Might some team make mistakes based on past rules of thumb? I’ll grant room for some small mistakes, but owners and GMs are pretty smart. I think it’s important to start from the premise that owners know what they are doing (even though it’s not always the case, and we should be on the lookout for mistakes) and try and interpret what is going on.

Given what Tangotiger points out about salary growth in MLB, I’m inclined to think these salaries aren’t as out of whack as I first thought. Furthermore, I believe the potential mistakes that are being made are in regard to projecting players—Soriano and Matthews look like panic moves to me—but that’s me as a fan talking. I would not be surprised if I am proved wrong in the future, more so about Soriano than Matthews; I still can’t understand what the Angels are thinking…unless revenue growth is going to rise at a rate a good bit higher than 10%.

13 Responses “More on Rising Salaries”

  1. tangotiger says:

    Since MLB has the opportunity (and they invoke it) to pay much less for pre-arb players than they produce, and since they have the opportunity to play somewhat less for arb players than they produce (and they invoke that), and if MLB was run by economic principles on free agents (to pay what they produce), this must mean then that, overall, MLB gets a great bang for their buck.

    Imagine something like half your players are arb or slave players that you get to pay below what they produce!

    But, that’s not what happens. Every win adds about 2% to attendance. Extend that to all revenues, and a team that generates 130 million$ in revenue will see an increase of 2.6 million$ per revenue. But, don’t forget about revenue sharing, and it’s something like under 2 million$ per marginal win.

    So, free agents should get 2 mill per win, arb players should get between 1 and 1.8 depending on years of service, and pre-arb will get between 0 and 0.5 if they’re lucky.

    The overall average should be somewhere around 1 million$ per win.

    The reality is at least double that.

    Why? Because teams start with a budget, allocate slave and arb money, and then spend the rest on free agents.

    I know JC wants to believe that these guys are smart. But, not all smart people always do smart things. When it comes to baseball, through wisdom out the window.

  2. tangotiger says:

    By the way, this is the best-fit equation of payroll to wins, using the cumulative, indexed, 1992-2005 data: (P+1)/(P+3), where P = payroll, indexed to league average (P=1.00=average). Depending where you are, teams pay around 4 million$ per win.

  3. David Gassko says:

    Why isn’t it wise to want to win? If I’m a billionaire and I have a choice between making $40 million and having a 10% chance to make the playoffs and making nothing and having a 60% chance of making the playoffs (numbers obviously made up and unimportant), who’s to argue that there isn’t much more utility for me in making nothing and greatly increasing my odds of winning it all? It’s not like I can spend the billions I already have, anyways.

  4. tangotiger says:

    I would say that even if you factor in the windfall of the playoffs, that economically, it won’t make sense.

    Your last point is exactly what is probably happening, that the owner is collecting his Picasso, and he’ll pay whatever it takes to make sure he owns it.

    There are only 30 MLB teams, and only 8 make the playoffs, and an owner will pay what it takes to win, if he thinks he’s close. Pirates, Royals, etc won’t do that.

  5. Marc says:

    Of course, in the long run, they do make money even if they are losing money on a cash flow basis. Unless it’s a really bad franchise, the value appreciates so that an owner that eventually sells the team (and most eventually do) are going to do well on the appreciation. Of course, I don’t know whether that fully compensates for any losses suffered in the meantime.

  6. tangotiger says:

    The point is that the only reason that an asset appreciates is because it will generate a profit. The price of something is exactly equal to all future profits, discounted to present value.

    Unless that asset is a collectible, in which case, it’s subject completely to supply and demand.

    Sports teams seem to be valued like a, without any hope of getting those 40% margins. They are much more like a consulting firm, with razor thin margins, and a workforce that is the product or service.

    JC, Guy made a great point here, of which I followup:

    I’d be interested to hear what your model would be like.

  7. jpwf says:

    In an ealier post Studes mentioned his belief that the great influx of cheap young talent may be a factor driving up salaries.

    Anyone who plays rotisserie baseball (keeper league) knows the phenomenon- it’s called draft inflation.

    Each team has a set budget to spend- and each teams spends that budget. In real baseball, I get the impression that most teams decide to spend $X and then spend approximately $X- no matter whether the value available is worth more or less than $X.

    In Roto you can pretty much figure out what a player’s “value” is (well his past value anyway- if you really knew his future value you’d never lose). Some players- “keepers” are signed at something less than their real value. Every dollar “saved” is an extra dollar to spend on someone else.

    To oversimplify- if you have 10 $20 players, and 5 are saved at an average of $10, the remaining 5 FAs are going to be signed for an average of $25-30. (It’s not linear- $10 players may go for $11-12, $20 players for $25, $30 players for $40)
    In Rotisserrie this spending is rational.

    Of course in most Roto leagues you can cut the guy after the year rather than being forced to keep him multiple years at $30.

    I think this mechanism may be in play a bit, and would justify overpaying for the top talent in the short term- I think a misapplication of this principle may lead to overpaying for mediocrity (ie: Matthews, Pierre)- which is generally a bad move even in draft inflated roto leagues.

  8. tangotiger says:

    I agree teams spend to their budget.

    Heck, we do it in the corporate world. We actually spend on things we don’t need, just so that we can justify that we need that level of budget next year. You’d think we’d be able bank the surplus, but no!

  9. Phil Birnbaum says:

    I think the Picasso theory is the correct explanation. As I wrote here, it seems like every team owner makes a below-market return on the market value of his team. I think that just reflects the market price of the ego boost and prestige of ownership.

    Some owners don’t just want to be owners โ€“ they want to be *winning* owners. The supply of winning teams is limited, by definition, and so the price gets bid up.

    I think you have to think of a franchise not 100% as a firm, but partly as a firm and partly as a consumer good (consumed by the owner). $2 million might be the marginal value of a win *to the fans*. But if the marginal value *to the owner* is (say) $3 million, he’ll wind up willing to pay $5 million per win.

    It seems to me that the value of the player to a team is his MRP plus the consumer surplus reaped by the owner. This would explain high salaries without having to assume that owners are irrational.

  10. JC says:

    If owners are maximizing something other than profits, then I guess we just have to throw our hands up in the air. If you to develop a model that predicts salaries in a different manner, I have no objection. But once we depart from using money to proxy utility, all decisions become tautological. And that’s just not very interesting to me. Furthermore, if owners are such altruists why do they lobby for stadium subsidies, seek corporate sponsors for their stadiums, charge $7 for a beer, etc. I will grant that owners do care about more than just profits, but I just don’t buy these other motivations as large determinants of their behavior.

  11. Phil Birnbaum says:

    Hi, J.C.,

    I’m not arguing that owners don’t care about profits *at all,* just that there is another factor involved too, the utility of pure ownership.

    I think of it like owning a vintage car. There are two sources of return from the car — the utility gained by driving it, and the increase in market value. If you don’t count both, it looks irrational to buy the car — it appreciates at 3% (say), while a CD earns 5%. But if it’s worth the 2% to you to be able to drive it and elicit stares and fame and pride, it may be worth it.

    And the fact that the owner of the car is willing to accept a lower return (or even a negative return) doesn’t mean that he wouldn’t prefer a positive one — by lobbying the government for vintage car subsidies and the like. I guess at the margin, the owner-for-fun is as eager for an extra dollar as the owner-for-profit. It’s just that the owner-for-fun is willing to pay a certain amount for the experience of ownership, an amount that may (Steinbrenner) or may not (Harold Ballard) be tied to the success of the team.

    You may be right that pride of ownership may not be a large determinant of owners’ behavior … but there should be *some* financial cost to pride of ownership, simply because of supply and demand. There are many more people who would prefer to own a team than a business of equal risk profile, just for the fun and fame.

    And, also, why else would sports teams have such small operating profits compared to their market value? Perhaps owners look into the future and see an explosion of revenue coupled with a lowering of union demands?

    I’m not sure what you mean about not being able to use money to proxy utility … if a team has EBITDA of 6% of market enterprise value, and equally risky investments are available at 10%, can we not estimate the owner’s private utility of ownership at 4% of market value per year?

  12. JC says:

    I will grant that owners do care about more than just profits, but I just donโ€™t buy these other motivations as large determinants of their behavior.

  13. tangotiger says:

    I think the majority of the increase in price valuation is the supply/demand. Teams were selling for 10 million$ 30-40 years ago, which means something like a 16x multiple in valuation (i.e., doubled in valuation 4 times, meaning doubles every 7 to 10 years). That’s a 7-10% increase in valuation, which is also the increase in payroll and the increase in revenue.

    But actual profits have never even approached anything where a DCF would justify such a jump in valuation. And certainly future profits won’t justify it either, if teams keep spending like this.

    The modus operandi is to spend 50-65% of your revenue, and be one of the 30 collectors of an MLB team (or one of the 120 collectors of a major sports team).

    You also try to leverage that into cable deals (MSG, YES, NESN, TBS, WGN, etc). But mostly, you are buying a Picasso, or as Phil said, a vintage car.

    If you can squeeze the players, like the NFL, you get the bonus of also turning profits, and thereby increasing you valuation (i.e., MLB would be 2x revenue, while NFL would be 4x revenue, or whathaveyou).