The economics that governs how professional leagues operate

From Aguero’s last minute goal to the Cavaliers 3-1 finals comeback, Professional Sports Leagues are responsible for some of life’s most shocking and spectacular experiences. Arguably just as shocking was the day LeBron James announced on live television that he was leaving the Cleveland Cavaliers for the Miami Heat, and in the process won two NBA championships. As we saw amongst the countless jersey burnings and riots over the following days, sometimes we can become too invested in our favourite teams and athletes. However, what is relatively absent from most sporting discussions are the financial and strategic decision-making processes each team undertakes.

If you follow the news, you probably know that economists have an opinion on everything, and sports are no exception. Indeed, complex econometric algorithms and game theory are responsible for almost every tactical decision clubs make. For professional sports economists, however, the most important debates are to do with constructing and enforcing rules to promote competitive balance amongst teams.

Putting on our thinking caps
As you may know from ECON2010, in a perfectly competitive market, workers are hired and fired at the equilibrium wage rate, equal to the marginal product of their labour. But as in many other industries, player signings and trade markets are not very competitive. Athlete’s skills take years of training and impeccable gene pooling to develop and cannot be easily replaced by new players. Likewise, the barries to entry for firms are enormous, giving entrenched teams great advantages over newcomers.

Indeed, Kesenne suggests that in a bidding war between big clubs and small clubs, the bigger club will inevitably have greater demand for top players due to market size having a positive effect on marginal player revenue. Los Angeles (a market with over 18 million people, countless sponsors and an endless supply of Instagram influencers) is always going to have the upper hand in contract negotiations for a player like LeBron James, whilst small market teams like Utah and Memphis will lose out. If unchecked, this process will inevitably cause a “death spiral” as teams like the Lakers buy better players, win championships, increase market share and repeat in a vicious cycle.

The common solution is a salary cap, or in other words, a price ceiling. Yes, the bane of neoliberal economists everywhere. Most major sporting leagues have them – the AFL, NBA, NRL, NFL & MLB all restrict the amount of money teams can pay players, the notable exception being European soccer leagues. A salary cap, if appropriately valued, should have no effect on the small club, but will limit the larger club’s ability to bid for players, ensuring equal competition across all clubs. (Kesenne, 2000) Overall, it should increase profits for both small and large clubs, but it would seem obvious from rudimentary economic analysis that the player’s losses out-balance the clubs gains. In this case, the classic deadweight loss is borne on the athletes.

According to FiveThirtyEight, the NBA’s system of cap restrictions has the overall effect of reducing star player’s salaries. LeBron James, perhaps the most dominant athlete of our time, is paid a third of Neymar’s salary. A conservative estimate of LeBron’s value estimates that through ticket sales, jersey sales and broadcasting deals, LeBron’s actual level of marginal revenue to a club is almost double his current contract of $37.44 million. You’d probably expect that the (admittedly small and austere) field of sports economics would be in uproar as player salaries are sacrificed whilst CEO pay skyrockets.

Figure 1: Salary caps decrease the salaries of star players on the open market

Eat the Rich
But is it the case that most players lose out? Well, if you’re a mid-tier athlete I have good news because current research suggests that salary caps actually make you better off. Indeed, Rodney Fort (the Adam Smith of the sports economics world) showed that payroll salary caps, when set as a proportion of league revenue, could actually achieve a Pareto Optimal allocation of talent and increase most player salaries, by increasing viewership, and as a consequence revenue. This is because managers of large clubs fail to take into account the positive externality associated with competitive balance in the league. Los Angelites are going to watch the Lakers regardless if they are good or bad, but the same cannot be said about the rest of small-town America if their teams are being dominated.

Figure 2: According to Ford, salary caps move the equilibrium win percent from A to C. Over time, the cap increases to B due to increased revenue from enhanced competition.

The effect of this can be derived from rudimentary revenue statistics. The NFL, with constant stoppages, gruelling ad-breaks and a very small international fan-base, is the most successful sporting league in the world, netting over $18.5 billion per year in revenue. It is also incredibly balanced, with the small-town of Green Bay hosting the most historically successful team. Contrastingly, La Liga, considered to have the premier soccer talent in the world, generates less revenue than the American Ice Hockey League, partially because every competition is a two-horse race between Barcelona and Real Madrid.

Further, an argument is to be had that even the highest-paid players who supposedly suffer aren’t necessarily worse off, since teams can offer non-pecuniary benefits to players to subvert salary caps. After LeBron’s move to the Los Angeles Lakers, he became heavily involved in the managerial and operational aspects of the club, whilst his close friend and talent agent Rich Paul purportedly had exclusive access to Lakers practice sessions as a means to scope out new contracts among rookies, in what can obviously be chalked up to pure coincidence and definitely not nepotism.

As a consequence, the preferred option among sports economists is to opt for a hard salary cap without loopholes, which maximises competitiveness and minimises the power of wealthy clubs. In what is perhaps a surprising turn of events, American and Australian sports leagues take the equality approach, whilst Europe lets the rugged free market do its thing, with rapidly increasing star player salaries confusingly coinciding with decreasing viewership and competition with certain teams (Manchester City ahem…) being known to spend their way to titles.

Tanks
The other major tool that most sporting leagues use to ensure competitive balance is revenue-sharing. There are two main points of economic literature on this. First is the “invariance principle”. Considered the holy grail of 1900s Sports Economics, the invariance principle suggests that revenue sharing between teams will have no effect on competitive balance in the league, since home and away games will equal out over time and in-game attendances are roughly similar. The problem with this theory is the advent of television. With games now televised locally and nationally, large city teams have a much greater marginal revenue in the open market and monopolistic control over lucrative TV contracts.

Consequentially, revenue sharing is wielded handily by modern-day sporting leagues to correct these market imbalances. Once again, the NFL is a trendsetter, sharing 70% of all revenue between owners, leading to the league’s reputation as “32 Fat-Cat Republicans who vote socialist on football.” Indeed, Vrooman found that rabid revenue sharing meant NFL teams are simultaneously the highest return and lowest risk investments of all major sporting leagues worldwide, generating overall profits higher than the major 5 European Soccer League’s combined, despite a much more equitable distribution of revenue.

Figure 3: The NFL: America’s Socialist Sports League?

Nevertheless, this system has been found to have some perverse incentives for teams. Szymanski suggests this may incorporate some degree of moral hazard, where rich teams willingly lose talent, or “tank”, with the foreknowledge that they can free-ride off of other team’s revenue and accumulate talent through the draft process in the future. In the NBA, this led to the reviled “Process” in Philadelphia, where over three years they won 19% of their games, acquiring Joel Embiid and our own Ben Simmons in the draft as a result. Left unchecked, the “Process” can have the adverse effect of reducing overall league revenue and athlete salaries, since teams now face reduced incentives for playing well.

However, this phenomenon of “tanking” hasn’t taken off outside America. European football leagues avoid this risk through relegation, whilst Australia’s unique method of club ownership ensures the best of both worlds.

Aussie, Aussie, Aussie!
Most Australian football clubs (NRL and AFL) are member-owned and are thus considered “win-maximisers” and not “profit-maximisers”. According to Vrooman, as win-maximisers, team management is less likely to purposefully lose since the shareholders (i.e. the fans) will hold them accountable. As a result, Booth states that nearly every perverse incentive is eliminated in our sporting leagues. Revenue sharing, player drafts and salary caps all contribute to the competitive balance of our leagues and the AFL in particular is a model as to how a league should be run – with healthy profits, high player salaries and enormous attendance figures. In fact, despite being host to a relatively small consumer market, the AFL generates the 7th highest profit of any international sporting league. So, alongside Vegemite and Crocodile Dundee, can we add Sports Economics supremacy to our list of Aussie exports?

Not so fast.

Our other major sporting league, the NRL, has found itself on the brink of bankruptcy due to the effects of COVID. Indeed, “money” and “profits” are dirty words in the Rugby League community. However, this is largely due to a string of poor financial decisions by clubs and league operators alike, rather than structural and economic issues. For example, the NRL doesn’t own a single asset aside from cash reserves, refuses to undergo competitive bidding processes for contracts and clubs have lost numerous sponsorships deals due to player’s off-field antics (Proszenko, 2020). Clearly, NRL’s management staff could learn a bit from Australia’s sexier (see Figure 4) and more profitable football code.

Figure 4: CHAD Scott

So, why does any of this matter? Well, partly due to the sheer value of the international sports industry. America’s top three sporting leagues combined have a GDP larger than most African nations, and the revenue rights to the AFL alone are worth 1% of Australia’s annual output. But in a broader context, price controls (like we’ve seen with salary caps) can be a simple externality-correcting measure. That’s not to say the government should willy-nilly slap a price control on everything (I’m looking at you, Venezuela). But potentially, price ceilings can be used as easily as Pigouvian taxes to correct an externality, particularly when supply is inelastic. In fact, this is what the government does when necessities such as tap water are in short supply.

So that’s it. Next time you’re watching the local footy match at the pub, take some time to think about the salary consequences of Charlie Cameron’s goal or James Tedesco’s try. And if you want to learn more, you can find me at the Gabba after the Lions hoist the Flag this year.

By Daniel Walton

Sources

Booth, R. (2004). THE ECONOMICS OF ACHIEVING COMPETITIVE BALANCE IN THE AUSTRALIAN FOOTBALL LEAGUE, 1897–2004. Economic Papers: A Journal of Applied Economics and Policy, 23(4), 325–344. https://doi.org/10.1111/j.1759-3441.2004.tb00986.x

Késenne, S. (2000). The Impact of Salary Caps in Professional Team Sports. Scottish Journal of Political Economy, 47(4), 422–430. https://doi.org/10.1111/1467-9485.00171

Fort, R., & Quirk, J. (1995). Cross-Subsidization, Incentives, and Outcomes in Professional Team Sports Leagues. Journal of Economic Literature, 33(3), 1265–1299.

Paine, N. (2015). No Matter How Much They Make, The Best Players In The NBA Are Vastly Underpaid. Fivethirtyeight. https://fivethirtyeight.com/features/kawhi-leonard-like-all-the-best-nba-players-is-vastly-underpaid/

Proszenko, A. (2020). Broken and Almost Broke: How did it come to this for the NRL? Sydney Morning Herald. https://www.smh.com.au/sport/nrl/broken-and-almost-broke-how-did-it-come-to-this-for-the-nrl-20200321-p54cix.html

Szymanski, & Késenne. (2004). Competitive balance and gate revenue sharing in team sports. Journal of Industrial Economics, 52(1), 165–177. https://doi.org/10.1111/j.0022-1821.2004.00220.x

Vrooman, J. (2009). Theory of the Perfect Game: Competitive Balance in Monopoly Sports Leagues. Review of Industrial Organization, 34(1), 5–44. https://doi.org/10.1007/s11151-009-9202-7

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