…just like everyone else. Six years for $40.5 million: what’s not to like? You lock up a young Dustin Predroia whose net worth is tied to a single undiversifiable asset—the ability to play baseball well—for a price well below what the team expects to pay out in a series of one-year contracts. I stated the logic in my analysis of the Evan Longoria deal.
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.
The Red Sox will pay Pedroia a signing bonus of $1.5 million with annual salaries of $1.5 million, $3.5 million, $5.5 million, $8 million, $10 million, and $10 million from 2009 to 2014. In addition, the club holds an $11 million option for 2015. In 2009, the Red Sox could unilaterally renew his contract close to the league minimum. In 2010–2012, his salary would have been subject to arbitration. After that, he would have been a free agent.
The Sox might have been able to get him cheaper in his unilateral renewal and arbitration years, but the team gets an absolute bargain during free agency. Given his past performance, aging, and the historical trends in revenue and salary growth, I estimate that Pedroia will be worth three times his salary in the free agent years. Unless he just tanks, he’s going to be worth more than $11 million in 2015. In addition, I’m not sure that Pedroia wouldn’t have earned much more in arbitration than the typical player. Pedroia’s 2008 MVP gives him a strong argument that he should be compared to the best players in the game—many who have signed lucrative free agent contracts—as opposed to his service-time cohort. Arbitrators felt Ryan Howard’s MVP was sufficient to trigger the “special accomplishment” clause that allows players to be compared to higher-salaried players. Thus, the Red Sox may be getting a break on during his arbitration years as well.
But, let’s add one more wrinkle. Let’s say Pedroia’s MVP 2009 is just the beginning of a series of excellent performances. He’ll be so valuable to the Red Sox, that his presence on the field will be a large determinant of the team’s success; thus, he might threaten a hold-out for a bigger contract. If he’s a $30 million player in 2014, he can say “I’m not going to play until you give me a new deal.” The Red Sox can stand firm on the old contract as much as they want, but they may be in a position that they know they’d suffer tremendously without him. He’ll have a lot of bargaining power, and don’t think his agent doesn’t know this.