The Economics of the Longoria Deal

The Tampa Bay Rays have just signed top prospect Evan Longoria to a long-term deal only a few games into his first major league season. The deal guarantees Longoria $17.5 million over six seasons, and it includes team options for three more years.

This deal is interesting in that it locks in his purely-reserved and arbitration-eligible years for a price that is similar to what Longoria would make if he signed a series of one-year contracts for the next six years. The Rays then have two sets of options. In the seventh year, the Rays can pick up his option for $7.5 million or terminate the deal with a $3-4 million buyout (depending on service time). The second option would pay Longoria $11 and $11.5 million for his eighth and ninth seasons, and includes a $1 million buyout.

What does each party get out of this deal? Longoria gets stability: if he suffers an injury or never develops into a quality major-league player, he still ends up a wealthy man. As for the Rays, it seems that Longoria’s rewards for good performance would have been capped by the CBA rules, but if he ends up not fulfilling his promise the Rays are now locked into his salary and cannot dump him. Longoria’s stability is the Rays liability.

The real deal for the Rays is in the options. If Longoria becomes a good player, he would command well more than $7.5 million on the free agent market. If MLB salaries continue to rise at a 10% annual rate, as they have over the past two decades, then in seven years player salaries will double. For example, if Longoria projects to be a $15-million player today, he could be a $30-million player in 2014 (gulp!). The point isn’t that he is that good of a player—I really don’t know what he will become—but that Longoria is going to have to be pretty bad not to be worth $7.5 million in 2014. Even the $11 and $11.5 million option may not be too pricey even if he becomes a sub-All-Star regular player.

If this is such a good deal for the Rays, why would Longoria agree to it? Professional athletes have most of their net worth tied up in a single asset: their athletic ability. Once that goes, the player’s main source of income disappears. Individuals tend to be risk averse, meaning that they are willing to sacrifice income to reduce risk. Just ask Marcus Giles about what it’s like to go from an All-Star to waiver wire fodder before he even finished his arbitration years. Thus, it’s not surprising to see a player trade away higher probabilistic income for lower guaranteed income.

But don’t the Rays face the same risks? What if he never lives up to his potential and is out of baseball in three years? Then the Rays are on the hook for a player whom they could have waived for free. This is true. But, unlike individuals, firms tend to be risk neutral, and price assets equal to their expected value. Baseball teams are firms that invest in many assets, many of which are players. Teams can diversify risk to minimize losses in a way that players cannot by investing in a bundle of assets. If a player stinks, he stinks; and there is not much he can do about it. Teams have many players. Some players signed to long-run contracts will exceed expectations while others will fail. On average, the successes and failures ought to average out.

By taking advantage of players’ risk aversion, teams can sign several players for less than their expected value and come out ahead in the long run. For example, assume we have two players who are expected to be worth $10 million/year for five years (total salaries of $100 million). Let’s say that one player ends up being worth $5 million/year, while the other is worth $15 million/year, the team still ends up getting $100 million in value. However, this is not where the big savings come in. Had the team gone year-to-year with the players, paying each of them their exact annual worth, the team does not save any money. Because players are willing to trade income for financial security, teams can sign players for less than their expected value. Therefore, the team in our example ought to be able to sign the players for less than $10 million per year each.

As an alternative to signing discounted deals, players could chose to protect their financial security by getting outside insurance, but I think that teams are the best position to insure players. Guaranteeing a player financial security creates an incentive for the insured player to slack off. Why work out or watch your weight when a relatively big payday is coming your way no matter what? Private insurance companies can include some contract provisions designed to limit shirking, but the cost of monitoring is high. Thus, third-party insurance suffers more from a moral hazard problem than teams.

Teams, on the other hand, are in a fantastic position to monitor and affect player behavior. It is probably quite difficult for any insurance agency to tell a player to get into shape. A manager can just say, “hey tubby, it’s time to lay off the patty melts and hit the weight room.” Also, trainers and medical professionals can quickly catch and report any misbehavior. Thus, the discount that teams are willing to offer players for stability are probably a better deal than available third-party insurance.

I have often wondered if some agents offer their clients insurance in order to negotiate better overall deals. Like teams, agents can diversify across many players.

Overall, I like the deal. From the team’s perspective, I might have waited a year or two before locking up Longoria, because free agency is still a while off and I expect the team still may have been able to get a similar discount in the future. Ryan Howard’s arbitration victory may have scared the team to act now, maybe it’s a gesture of good will to fans and players, or maybe it’s a discount that Longoria wouldn’t have accepted down the road.

6 Responses “The Economics of the Longoria Deal”

  1. jfalk says:

    Two questions: 1) How does this deal compare with the McCann deal? 2) More importantly, though, isn’t there a huge moral hazard problem with this deal in that the player is given an implicit option to shirk and capture the upside. Suppose Longoria turns out to be a $30 million player. What’s to stop him him from striking out every time up until the club lets him go or ponies up the difference? Aren’t there examples of literally dozens of players who renegotiate salaries to capture the upside? I know I’d be willing to be categorized as someone with a “bad attitude” to earn a few million dollars more someplace else.

  2. JC says:

    My take on the McCann deal is similar.

    Tanking to earn your release has a few problems.
    1) It’s easy to spot, and will probably allow the club to void the deal while placing the player on the restricted list.
    2) If a player does such a good job at tanking that the team decides to release him, then no other team will be waiting to offer a big payday.
    3) Who wants to sign a guy who will shut it down when he’s not happy?

    Holdouts of major leaguers baseball players happen rarely. The last one I recall was Roger Clemens in 1987. There have probably been a few others since then that I do not recall.

  3. Dan says:

    Will there ever be a market for players to insure their risk? That is, if a pool of young players were to group together (or a market acting for the players) and agree to each contribute x% of their future revenues in case of the collapse of any one of them, it seems to me there would be a way the players could then get the best of both worlds. They can guarentee they will be rich, even if they have a terrible injury, but still can hold out for the big bucks.

    Just a thought. Given the dollars involved, would any agent consider offering this kind of insurance to a pool of talented young players?

  4. kosmo says:

    JC,

    I believe that Sheffield tanked when he was with Milwaukee in order to force a trade. I don’t know if he ever actually admitted it, but I seem to remember that a lot of folks thought he did. Nearly two decades later, I still hold it against him (and I’m not even a Brewers fan)

    You are correct that tanking and salary holdouts are uncommon in baseball.

  5. jfalk says:

    I agree that they are uncommon, but that’s at least partially because long-term deals like this are uncommon. As to whether or not shirking is easy to spot, I frankly doubt it. Slow returns from injuries, lackadaisaical play, a period where you just can’t seem to find the plate… hard to determine against the background, no? Sheffield, Dick Allen, Garry Templeton come to mind. I agree that there have been few holdouts, but there have been lots of players who asked to be traded, and it seems to me the difficulty of monitoring shirking is why they get accommodated. Longoria will, I assume as part of this contract, not be allowed to waive his CBA rights to approve trades if he has enough seniority… something else he can use as leverage as well….

    Overall, I grant there is an arbitrage opportunity to strike a bargain around players’ risk aversion, but there are monitoring costs which go strongly in the other direction. You may be right that the balance favors these sorts of deals… I’m less sure.

  6. Sam says:

    Firms are also risk averse. In fact, to a large extent, firms are more risk averse than individuals (see investment decisions and gambling). This, obviously, is only on average. However, what I think the author meant to say (and touched on briefly) is that teams are able to reduce their risk through diversification, which means that they have a different risk/reward scale than individuals.

    E.g. You are the Rays, and you have 10 good young players. Each one has a 50% chance of being worth $5 million over the next 6 years, and a 50% chance of being worth $25 million. That means the expected value to the team of each player is $15 million, which is the same as the expected salary. A player may be willing to take a guaranteed $12 million, reducing their expected payment by $3 million, becuase 50% of the time this will pay them $7 million. To the team, this $12 million per player is an increase in expected value of $30 million ($3 million savings * 10 players). However, the chances of them realizing a $70 million loss (the same proportion to the individuals gain) is only .098%.