Competitive Balance and League Revenue:

Transcription

1 An Analysis of the Effects of the 1993 NFL Salary Cap on Competitive Balance and League Revenue: Has anticompetitive behavior led to better competition? Charles N. Baschnagel A thesis submitted in partial fulfillment of the requirements for the Degree of Bachelor of Arts with Honors in Economics Williams College Williamstown, Massachusetts May 23,2005

2 Acknowledgments: I would like to take this opportunity to thank my thesis advisor from first semester, Professor Alan de Brauw who steered me in the direction of my topic, and my Winter Study and second semester thesis advisor, Robert Gazzale who guided me through the growing pains of maturing in my academic life. I would also like to thank my second reader, Professor Kaye Husbands Fealing for providing many helpful comments and for nudging me in the right direction on the interpretation of my results, J.J. OBrien for his assistance in data collection, Matthew Steding '07 from the writing workshop, Professor Bernhard Klingenberg for assistance with data analysis, Jodi Psoter Schow Science Librarian for everything, Professor Victor Matheson for providing my introduction to the field of Sports Economics, Professor Ralph Bradburgh for instilling the fear of failure, the Williams College Men's Basketball team, the Williams College Security Department, Professor Stewart Johnson, the Jesup All-Nighters and my Parents Norbert and Beverly Baschnagel, all of whom provided moral support. Special thanks goes out to Matt Weisbrot '08 whose ipod playlists kept me going during those long cold days of data analysis during Winter Study.

3 Abstract: Following the advent of free agency in the National Football League (NFL), the 1993 Collective Bargaining Agreement (CBA) between NFL owners and the players' union instituted a salary cap to maintain competitive balance on the field and financial strength and stability off the field. Previous research has shown that the CBA was successful in maintaining intra-season competitive balance. I confirm these find finding, but also find that inter-season parity-the degree to which unsuccessful teams from one season are successful the nextsignificantly increased following the 1993 CBA. I also find that NFL revenue growth has been greater than rival professional sport leagues, suggesting that the salary cap, by increasing competitive balance, has actually increased player salaries.

4 Table of Contents Acknowledgements... p ii... Abstract... pul Table of Contents... p iv Chapter 1 Introduction... PI Chapter 2 History of the Reserve Clause P13 Chapter 3 History of Free Agency in the NFL P21 Chapter 4 The NFL's Theory of Fan Interest... P26 Section 1 The NFL... ~ Section 2 The NBA and MLB P3 1 Chapter 5 Measurement of Parity... P35 Chapter 6 Data... P41 Chapter 7 Results... P43 Section 1 Parity... ~ 4 3 Part 1 Intra-season Parity... ~ 4 3 Part 2 Inter-season Parity... ~ 5 3 Section 2 Fan Interest... ~ 7 1 Section 3 Financial Strength... ~ 7 5 Part 1 Revenue... P75 Part 2 Franchise Value... ~ 8 0 Part 3 Player Salaries... ~ 8 3 Chapter 8 Policy Implications... P87 Chapter 9 Further Research... P93 Bibliography... p101 Appendix I

5 Chapter 1 Introduction: In 1993, the National Football League Players Association (NFLPA) accepted a bill of goods. They agreed to allow the franchise owners in the National Football League (NFL) to limit the percentage of total revenue any one team could pay to players in order to sustain a high level of competitive balance. Both parties subscribed to the theory that fan interest is correlated with competitive balance between teams, and thus the maintenance of competitive balance would result in increased league revenues in the long-run. Players, paid a fixed fraction of league revenues, as well as owners would thus benefit. The justification for this bill of goods is based on a theory of fan interest in professional team-sport leagues. This theory contends that a high level of competitive balance' is vital to building and maintaining fan interest in a professional team-sport league. Based on this theory, a decrease in parity would lead to a decrease in a league's revenue growth. Why was the NFL worried about a decrease in parity? After a lengthy court battle ending in 1992, the NFLPA gained the right to free agency. In the negotiations for a Collective Bargaining Agreement (CBA) that followed, the owners argued that free agency necessitated a limit on the amount any team was allowed to spend on players. Without any restrictions, free agency would create a Prisoner's dilemma. Each team would have to choice between cooperating to ' Competitive balance has a broad definition encompassing both intra-season and inter-season parity, but the essence of competitive balance stems from the idea that teams which come together and form a league are of fairly equal strength.

6 sustain a high level of parity in the league and defecting to spend the amount of money on players that would maximize their own franchise's profits in any given year. If teams in the league defected, richer teams from larger markets would spend a large amount of money buying up the best players from the small-market teams who could not match the amount of money large-market teams are willing and able to spend on players. This would decrease competitive balance and ruin the parity the NFL had worked so hard to build and maintain. The NFL contends this decrease in competitive balance would stunt league revenue growth. The solution: ensure "financial" parity through a salary cap. This solution to the prisoners' dilemma would result in greater fan interest, greater revenues, and thus greater salaries in the long run. The implementation of a salary cap is a relatively new solution to a very unique problem facing the leagues in the industry of professional team-sports. The industry of professional team-sports is different from most other industry. Firms (or teams) in this industry rely on one another to create a high-quality product. Firms increase demand for their product by increasing fan interest. One way to increase fan interest is by working together off the field to ensure that the level of competitive balance on the field remains high, for if the outcome of the game or the season is in question, a fan will be enticed to watch the drama that unfolds as well as witness the athletic feats being performed. For this reason, the competition between firms in a professional team-sport league is unlike the competition between firms in almost any other industry. Unlike the competition between Coca Cola and Pepsi, the Pittsburgh Steelers would not benefit if they drove the Dallas Cowboys out of business. The only competition in

7 professional sports that mirrors that of the regular business world occurs when two leagues compete against one another. An example of such competition is that seen between the NFL and the United States Football League (USFL) during the mid- 1980s. Now that the USFL no longer exists, the closest competition the NFL faces is from the three other major sports leagues: Major League Baseball (MLB), the National Basketball Association (NBA) and the National Hockey League (NHL). College football is a close substitute for fans interested in football, but colleges and universities claim that their programs are not profit-maximizing firms. They claim that they are institutions of higher learning and are not competing with the NFL. The NFL schedules its games on Sunday to avoid direct competition with college football, which plays a majority of its games on ~aturda~.~ The NFL owners appear to understand that they are better off focusing on their competition with other sports leagues and not with one another. Their response to the Supreme Court finding the reserve clause illegal in 1957 is a perfect example of the "league-think" mentality introduced by Pete Rozelle, the NFL's commissioner from Prior to 1957, the NFL, like all other team-sport leagues, placed a reserve clause in all player contracts to give individual owners the exclusive right to negotiate with players for their services. This clause enabled owners to keep the players' salaries low by restricting the bidding amongst owners for a player's services. The owners claimed this practice kept competitive balance in the league high. A player was able to negotiate only with his current team for a contract to sell his services while a team could pick from a variety of players giving owners the upper 2 The NFL also benefits from college football. College football provides a service for the NFL by developing player talent. Certainly, few athletes are ready for the physical demands of professional football straight out of high school.

8 hand in contract negotiations. Owners did not have to pay players the value of their marginal product of labor. An owner only needed to pay a player more money than they could earn outside of the NFL to keep them playing in the league. After the Supreme Court struck down the reserve clause, the league instituted the "Rozelle rule" which allowed the commissioner to compensate a team which lost a free agent with players from the team which signed him. This compensation was meant to preserve competitive balance. In actuality, the level of compensation was often much greater than the worth of the original player. The threat of the commissioner stepping in and awarding compensation acted as a strong deterrent for franchises interested in acquiring a free agent from another team. Players could seldom find alternative teams willing to sign them (Fort 1997). Rozelle was also responsible for convincing large-market teams to consolidate their television contracts with the rest of the league to present the product of the NFL on the national level and share the revenue generated from that television policy evenly. Rozelle had to lobby Congress in order to receive a specific exemption from the antitrust legislation so that football, hockey, and basketball would be allowed to negotiate a single, league-wide national television contract. Rozelle consolidated the television contracts of the franchises in the NFL in order to further align the interests of each franchise with the league and consolidate the league's power in negotiating the terms of the television contracts with the networks (Leeds 2002). The current NFL Commissioner, Paul Tagliabue, shares the viewpoint of his predecessor. In the late 1990s, he was called to testify in front of the Senate Judiciary Baseball did not need to be included in this piece of legislation, because it still enjoyed general antitrust exemption extending from the Federal Baseball Club ruling of 1922.

9 Committee. In his testimony, he was asked why the NFL participated in such practices as unbalanced scheduling, reverse order drafting, and a salary cap, all of which the NFL claims is done to increase competitive balance in the league. Tagliabue stated, "it is the way business partners conduct themselves, seeking to compete not with each other, but with other outside independent competitors in the marketplace, including other sports leagues and other non-sport entertainment" (CBA 2004). This mentality is apparently shared by even the NFL owners in large-market cities, who would have the most to gain in the short run if each team is allowed to do as they wished when it came to obtaining and paying players. New England Patriots owner, Robert Kraft, in an interview with PBS, stated his take on things, "here's the bottom line of our league, why I think we're the best sports league in this country, if not the world, is that in the end, we only really compete three hours on Sunday with one other team. The rest of the time, the progressive owners in our league understand we have aligned interests, and we should always be a partnership and put our selfish interests down, so that we can share and do what's in the league's long-term interest" (CBA 2004). If owners are to work together to increase fan interest, then they need to know what factors contribute to increasing fan interest and how they can manipulate these factors. In general, winning teams tend to generate more fan interest than losing teams (Leeds 2002). Surprisingly, however, when it comes to spurring interest in a sports franchise, fan interest is not always positively correlated with winning. James Quirk and Rodney Fort turned to the example of the Cleveland Browns of the late 1940s to illustrate this problem and why it exists. The Browns' dominance of their

10 league during that period made the outcome of the game predictable and thus boring, even to the Cleveland fans (Fort 1997). More recently, various television analysts and executives went on record defending the NFL's policies, which are designed to maintain a high level of parity. Television industry insiders commonly cite examples where the Nielsen ratings for particular sports programming increases with the level of parity in the league for which that program provides coverage. Most analysts and executives in the television industry celebrate the combination of free agency and the salary cap which they believe to be responsible for the apparent increase in parity. They believe free agency allows greater player movement, increasing inter-season parity, while the salary cap maintains intra-season parity (Sandomir 2002). Studies have shown that other factors such as playoff implications can increase the demand for a particular game (Leeds 2002). Europeai~ soccer leagues apply this idea, of making each game more meaningful in order to spur interest, in choosing how to organize their leagues. Not only do the games near the end of the season determine the playoff seeding for the more successful team, but the games for the worst teams are also made important by the interaction of the different leagues. The final season standings of the worst teams determine which teams get moved down to less competitive leagues the following year. The less competitive leagues are usually composed of franchises which are hosted by cities in smaller markets and play in smaller arenas. These two factors mean the revenue-sharing in these leagues is not as fiscally lucrative as the premier leagues. This system increases fan interest in late season games of less successful teams. It also increases the competitive balance in the various professional soccer leagues by picking off the most and least

11 successful teams and moving them up or down the spectrum of leagues accordingly (Leeds 2002). The structure of the European soccer leagues provides added incentives to owners to spend more to improve the quality of their team. Teams in this system of franchise movement between leagues cannot field an inexpensive team and benefit from revenue-sharing agreements with the other teams in the league for long. If an owner chooses to cut costs by trading away players with expensive contracts, she risks having her team perform so poorly that the franchise is moved down a league. The threat of being moved down a league compels owners who participate in revenue-sharing agreements to field competitive teams. Several factors, including parity, contribute to making sports leagues more entertaining for fans to watch. It is this entertainment value that determines the level of fan interest, involvement, and investment in various leagues. The time and money fans spend on watching and following various leagues translate into the million dollar player contracts and billion-dollar television contracts. With so much money at stake it is not only important to know what factors go into increasing league revenues but what can be done to manipulate these factors. The NFL contends that, without a salary cap, free agency would decrease competitive balance in the league and, as a result, total league revenue would not grow as quickly as it could otherwise, causing players as well as owners to lose out in the long run. Even though a bidding war might increase players' salaries in the short run, large-market teams would win the bidding wars for the better players and, as a result, small-market teams would not be competitive. The owners contend that this

12 decrease in competitive balance would decrease fan interest for the league as a whole. As interest in the league as a whole decreased, the money generated from the national television contracts would also experience stunted growth. Some may ask why revenue-sharing alone does not align the interests of owners with the interests of the league. Indeed, revenue-sharing does help solve the problem of financial stability for small-market teams in professional team-sport leagues (Noll 1974), Large-market teams under free agency, however, would overinvest in player talent because they would only consider the effects that increasing their team's level of talent has on their revenue and would not account for the negative effect it would have for fan interest in other league games (Quirk 1974). Sharing gate revenue alone would not be able to internalize this externality fully, because gate revenue sharing is only between the two franchises competing. Even revenue sharing would not incorporate the full league-wide effects of adding player talent into an owner's decision, because this form of revenue sharing only aligns the incentive of the owner with other owners for the games in which her team plays. Only in a two-team league would this form of revenue sharing fully solve the problem. This model predicts that, with a large share of each team's revenue coming from the league itself, as is the case with the NFL's practice of splitting media revenues, the owners have less incentive to over-invest in player talent. On the other hand, if all owners were simply given a share of total league revenue, the incentive to field a quality, high-cost team would be eliminated (Noll 1974). The NFLPA was offered a percentage of league revenue to align the interests of the players with those of the owners and the league. The players were told that

13 they would benefit two-fold from this arrangement. First, the league guaranteed players that teams would be allowed to spend up to approximately sixty-four percent of league revenue on players' contracts for the length of the agreement. This was a larger share of revenue than the players had ever received before in the NFL and a larger share of revenue than the other major team-sport leagues with established free- agent markets were spending on player talent. second, players were told the salary cap would maintain the high level of competitive balance, in the form of intra-season parity, in the NFL and, according to the NFL's theory of fan interest, lead to greater increase in total revenue. This increase in total revenue would be passed along to the players through the share of revenue they were guaranteed. The NFL was not the first professional team-sport league in the United States to institute a salary cap. In 1984, the NBA experimented with a salary cap. However, certain NBA franchise owners, particularly the owner of the Boston Celtics, Don Gaston, were concerned that the salary cap might force owners to break up popular and profitable franchises. The final version of the salary cap included a rule which allowed franchises to exceed the salary cap in order to re-sign up to five "franchise players." This rule came to be known as the "Larry Bird exception" (Leeds 2002). The IWL, on the other hand, was not concerned about the possibility of breaking up popular teams when it instituted its "hard" salary cap. In fact, the NFL believed that if a particular team was too popular, it was probably due to the fact that they were winning too many games and decreasing competitive balance, hurting the 4 The transition from the modified "Rozelle rule" to a salary cap system included one year (1993) in which free agency existed for the players whose contracts ended in that year. In 1993, players' salaries rose to encompass 60 percent of league revenue. It is difficult to say how high NFL salaries, as a percent of revenues, would have been with free agency in the absence of a salary cap (Leeds 2002).

14 league as a whole. The 1993 CBA also stipulated that NFL players' contracts are not guaranteed. This means an NFL franchise can release a player during the off-season at any point in the life of the contract. The only money the player is guaranteed to see is his signing bonus. The rest is at the discretion of the franchise and whether the franchise feels the player is worth their salary for that year (Lackner 2005). This prevents a bad decision in acquiring a player one year from negatively affecting the ability of a team to be successful and still come under the salary cap in the following year. As a result, overpaid players can be released and signed to smaller contracts at the end of the season. This combination of a "hard" salary cap and no guaranteed contracts allows for greater player movement. One such example of the extent player movement has increased in the NFL is to cxaminc the player rosters of the Pittsburgh Steelers of the late 1970s and the New England Patriots of the start of the 21St century. Each franchise experienced winning the Super Bowl more than once during the period of time mentioned. When examining the player rosters for each franchise for the years in which each franchise won the Super Bowl three years apart (In 1977 and 1980 for the Pittsburgh Steelers and 2002 and 2005 for the New England Patriots.) one sees that 63% of the Steelers who were on the roster in 1977 were still on the roster in 1980, (including all nine players who eventually made the NFL Hall of Fame) while only 28% of the players with the New England Patriots in 2002 were with the team when they won it again in Kowalewski and Leeds (2001) show that the advent of free agency and the institution of the NFL's salary cap have dramatically changed the level and nature of

15 compensation for NFL players not just player movement. The authors run different regressions on the available data to compensate for the position-specific nature of the salaries in the NFL. The authors conclude that the 1993 salary cap and free agency have significantly shifted the compensation of NFL players to a more efficient allocation. This shift produced a closer alignment between performance and compensation (Kowalewski 2001). I test what effects this change in the alignment of performance and compensation has on intra- and inter-season parity in the NFL. Previous research suggests that the 1993 salary cap maintained the level of intra-season parity in the NFL. Sommers, Barriger, Sharpe, and Sullivan (2004) use the Gini coefficient for winning percentages of teams in a league in each season to quantify the level of competitive balance in the NFL within each season from ' He runs a regression using a binary variable to separate the Gini coefficients for seasons in which the salary cap is in place. The regression also includes a continuous variable for the year to look for general trends over time. He finds that the salary cap coefficient was not statistically significant (Sommers, et al. 2004). This indicates that the values for this measure of intra-season parity did not change following the 1993 CBA. I argue that the measure of parity in previous research is too narrow and that further measures, including measures for inter-season parity, are needed to quantify the full effects of the 1993 CBA on parity and competitive balance in the NFL. I contend that the NFL is acting responsibly, promoting high levels of parity in all its His paper calculates a Gini coefficient with a Lorenz curve given by the cumulative percentage of wins as each team is arranged from poorest (or worst) to richest (or best) for each season.

16 forms, including inter-season parity, and that these actions are necessary to maximize fan interest and league revenues over time. I analyze, in this paper, how the NFL's policy of a "hard" salary cap has affected the level of competitive balance amongst the teams in the league. The measure of intra-season parity I use confirms Sommers's earlier findings that the 1993 CBA sustained this form of parity at a high level. Various measures of interseason parity indicate an increase in this form of parity following the 1993 CBA. The NFL also experienced exceptional, uninterrupted revenue growth during this period. I use MLB and the NBA as a basis for comparison for revenue and franchise value growth to account for any cultural shifts in the consumption of sports entertainment. The NFL certainly outperformed MLB and the NBA during this period of time. I examine the claim that changes in the structural organizational of in the NFL can have an effect on the level of competitive balance in the NFL and that an increase in the level of competitive balance increases fan interest, which in turn increases league revenue growth.

17 Chapter 2 History of the Reserve Clause Era: The reserve system was created in order to stabilize player movement and reduce player salaries in professional team sports. It was first introduced over a hundred years ago by the owners of professional baseball clubs. It was later adopted by every other professional team-sport league which has competed in the United States. Any player who wanted to start playing in the major leagues had to sign a contract that, in effect, granted a franchise the exclusive rights to that player for his entire career (Fort 1999). Prior to free agency, during the political and legal battles to prevent it from occurring, the owners of professional team-sport franchises argued that the ability to retain the property rights to a player was essential in maintaining competitive balance. Without a reserve clause system, large-market teams would be able to outbid smallmarket teams for the better players and that large-market teams would win a majority of the games played between large- and small-market teams. Unable to afford the players needed to be competitive, small-market teams would be unable to maintain fan interest, decreasing their revenue. Also small-market teams would be less of a draw when they visited large-market teams. This would cause a slight decrease in the revenue for all the large-market teams that small-market teams visited. These decreases, however, would be spread out amongst all the large-market teams, and no large-market team by itself could realize the increase in revenue by cutting player salaries and allowing small-market teams access to cheap playing talent (Fort 1997).

18 In the worst case scenario, the small market teams would go bankrupt and the league would collapse in on itself. Fortunately, this has not yet happened in the NFL, the NBA or MLB, but it appears to be a serious problem for the National Hockey League (NHL). Several of the small market teams have faced serious financial difficulties. The Pittsburgh Penguins, an NHL franchise, despite winning two Stanley cups6 in the 1990s, almost defaulted on outstanding loans in Mario Lemieux, a star player for the Penguins, forfeited over $32 million in salary, temporarily saving the franchise from bankruptcy and becoming the first athlete to own a controlling share of a major league professional franchise (Conrad 1999). The Penguins, as well as a number of other teams, faced serious financial trouble heading into the 2004 season. The owners of the NHL demanded a salary cap be instituted to regulate player contracts and return financial stability to the league. The NHL player's union refused to accept the salary cap and the season was cancelled. The two parties involved do not, at this time, appear to be any closer to resolving this conflict (Boston (AP) 2005). The history of restricting players7 abilities to negotiate contracts freely with owners started with the reserve clause. The formation of the reserve clause system began in Late in the professional baseball season, William Hulbert, the owner of the Chicago White Stockings, acquired four of Boston's star players, causing a great deal of disruption to a franchise which, up to that point, had been having a successful and profitable season. After illustrating how the free market system for player talent could be abused, Hulbert then called for the creation of a new mechanism to prevent a bidding war for players7 services (Leeds 2002). In 1879, The Stanley Cup is the trophy awarded to the NHL franchise that wins the NHL playoffs.

19 Arthur Soden, the owner of the aforementioned Boston Braves, proposed that a reserve clause7 be written into all player contracts in order to restrict player movement and control players' salaries (Fort 1999). Professional baseball operated under the reserve clause system unchallenged for several years. In 1922, the Supreme Court heard a case between the National League of Professional Base Ball Clubs and the Federal Base Ball Club of Baltimore, a team from the recently disbanded Federal League. The Federal Base Ball Club of Baltimore sued the National League (N.L.) claiming that the N.L. engaged in illegal practices under the Sherman Act. The N.L. had lured a number of teams away from the Federal League, thus destroying it. The opinion of the Court stated that baseball was a "public exhibition, not commerce, and that the interstate travel," which made baseball a federal matter and subject to the Sherman Act, was a "mere incident, not the essential thing." For these reasons, the National League was found to be exempt from the Sherman Antitrust Act of Professional baseball would come to exploit this antitrust exemption in a variety of ways in the coming years, particularly when dealing with the issue of player contract negotiation restrictions in the form of the reserve clause (Holmes 1922). A minor league player for the New York Yankees, George Toolson, was the first player to contest the legality of baseball's reserve clause system. This case, held in 1953, was also decided in favor of MLB. The Court stated that MLB was exempt The clause stated that a player was not allowed to play for any other team for the duration of the contract. If, by March lst of the last year of the contract, the team renewed the existing contract, they retained the rights to the player for one additional year. The owners claimed the renewal of the contract includes all of its original terms, including the option to renew again in one year. This recursive system could then be used to prevent a player from selling their services to any other team in the league for as long as his current owner wanted (Leeds 2002). Coincidently, one of the lower court judges who ruled in favor of the N.L. went on to become the first commissioner of MLB five years after making his ruling.

20 from the Sherman Act due to the decision in the Federal Base Ball case. They decided that, since Congress had not acted to clarify the law, Congress did not object to the Court's previous interpretation granting baseball an exemption from the Sherman Act. The dissenters stated that, even if baseball was not interstate trade in the 1910s, it had certainly become so by the 1950s (Burton 1953). The extension of baseball's exemption to other team sports was tested in 1957, when the NFL7s reserve clause system was first challenged by George Radovich. Radovich was once an all-pro guard for the Detroit Lions but switched leagues, leaving the Lions, an NFL team, to play for a team in Los Angeles, a non-nfl team, to be closer to his father who had fallen ill. After some time, Radovich decided he wanted to return to the NFL as a player-coach but found himself blacklisted from the NFL for having played in a rival league. Radovich filed suit under the Sherman Act. The court decided in favor of Radovich, stating that football was not baseball and thus did not benefit from the antitrust exemption that baseball enjoyed (Clark 1957). In 1973, Curt Flood finally brought free agency to baseball, even though he lost his case. Curt Flood was a quality journeyman player who, in 1969, was traded from St. Louis to Philadelphia. He was not consulted about the trade and did not like the fact that he had been traded. He filed suit giving the Supreme Court its third opportunity in 50 years to rule on baseball's antitrust exemption. The court decided in favor of MLB, but the current Justices also conveyed their opinion that the earlier Supreme Courts had made an error when ruling in favor of baseball's exemption from antitrust legislation in 1922 and 1954, and that they did not properly resolve the issue when they ruled on Radovich v. NFL. The court stated that, given the opportunity to

21 start from scratch, they would decide in favor of the Federal Club, Toolson, and Flood. But given the Court's previous decisions and the mess that would be caused by a retroactive decision, the Court decided in favor of MLB but called on Congress to make the appropriate changes, an action which would only be proactive and not affect the previous decisions (Blackmun 1972). MLB baseball read the writing on the wall and changed their practices to prevent the need for congressional action. In 1973, after negotiations between owners and the Major League Players' Association finalized the terms and players were granted free agency (Leeds 2002).~ This marked the end of the reserve clause era and the start of the free agent era in professional team-sport leagues. Owners warned that the Flood ruling would decrease competitive balance in professional baseball. They stated that allowing players to sell the rights to their playing talent to the highest bidder would create a situation were small-market franchises could not afford to keep the players necessary to be competitive. As a result, competitive balance would decrease and the league would suffer (Fort 1997). To address this argument, I present what economic theory predicts will happen in both free agent and reserve clause systems and determine whether the owners' predictions agree with economic theory. The economic tool most commonly used when talking about property rights is the Coase Theorem. The Coase Theorem can be used to predict the distribution of player talent in professional team-sport leagues under both reserve clause and f?ee agent systems. The Coase Theorem predicts that even a reserve clause system Congress did not actually pass the Curt Flood Act, repealing baseball's antitrust exemption with respect to labor, until 1998.

22 produces the allocation of players, such that the team that has the largest marginal increase in revenue from the addition of a player is the team that acquires that player. The Coase theorem predicts that, as long as property rights are "well-defined" and transaction costs are low, the team which generates the largest profits from acquiring a player will still do so and that a reserve clause system will do nothing to prevent this allocation of resources from occurring. The only difference in a reserve clause system would be who receives the surplus from the transaction. As long as property rights are well-defined, the Coase Theorem predicts that the distribution of player talent will be the same and only the allocation of the surplus generated by the players will differ (Leeds 2002). A hypothetical situation illustrates this point. Assume a player generates three million dollars of revenue in Seattle but could generate five million dollars of revenue in Los Angeles. Under a reserve clause system, the Seattle franchise would simply sell the rights of the player in question to the Los Angeles franchise at a price between three and five million dollars minus the player's reservation price of not playing at all. lo Under free agency, the Los Angeles team pays the player three to five million dollars for the rights to his services. The player ends up playing in Los Angeles either way, only the allocation of the surplus from the player's services changes. For this theory to be applicable to professional team-sport leagues, player-forcash trades between franchises would need to take place. The history of professional 'O A player's reservation price is only slightly more than the player can earn outside of the league. 18

23 team-sport leagues is full of such trades under a reserve clause system." Thus, for a reserve clause system to have a chance at increasing competitive balance, leagues have to ban player-for-cash trades. But this alone would not ensure competitive balance. The initial level of competitive balance would have to be high and the acquisition of new player talent into the league would have to be even in order to ensure that a reserve clause system maintained competitive balance (Quirk 1974). The Coase theorem also predicts that players would be underpaid with respect to their marginal product of labor in a reserve clause system. The example of Stan Kostka illustrates the extent to which players were paid less than their marginal product of labor under a reserve clause system. In 1934, Stan Kostka graduated as a talented fullback from the national championship winning University of Minnesota. Two professional football teams, the Philadelphia Eagles and the Brooklyn Dodgers, desperately wanted to lock up the rights to this promising player. Both teams bid against one another for the right to sign Kostka. When the smoke settled, Kostka signed with the Dodgers for $5,000. This matched the highest salary in the league at the time. The NFL instituted a college draft the following year. Other leagues soon followed in instituting similar drafts (Fort 1999). The draft prohibits a team from negotiating with a player who was drafted by another team and the only way to play in the NFL is to enter the NFL through the draft. This marked the last opportunity NFL players had to make franchises in the NFL bid against one another for their l1 Arguably the most infamous example of such a trade is that of Babe Ruth from the Boston Red Sox to the New York Yankees in 1920 for cash and loan advances after the owner of the Red Sox, Harry Frazee, encountered financial difficulties while financing various Broadway shows.

24 services, until players won the right to free agency through the Radovich ruling in 1957 (Fort 1997).12 Following the Radovich ruling, the NFL would need to negotiate with players for the right to place any restrictions on player-owner interaction in the league. These negotiations created a variety of different systems to regulate player-owner interactions in the coming years, the most recent of which was the salary cap instituted in the 1993 CBA. l2 Players actually traded away this right in subsequent labor negations (Leeds 2002).

25 Chapter 3 History of Free Agency in the NFL: The NF'L has a long history of participating in practices aimed at maintaining competitive balance in the league and financial security for its franchises. By the early 1920s, the NFL adopted a reserve clause system almost identical to that of organized baseball. In 1936, the NFL was the first to institute a reverse-order-offinish college draft (Fort 1997). A draft orders the selection of players entering a league to allow only the team that selects a player to bid for the player's services. This prevents other teams from bidding for and driving up the price the team pays for the rights to a new player's services. A reverse-order-of-finish college draft assigns the first pick of eligible players to the team that finished the previous season with the worst record, the second pick to the team with the second worst overall record, and so on. After every team selects a player, a new round of player selection starts with the same team that started in the first round. This type of draft allows the teams that do not perform well one season to have an advantage in acquiring player talent for the following season. In 1957, the Radovich decision brought an end to the reserve clause system in the NFL. Following this decision, the NFL's owners entered into a "gentleman's agreement" not to sign free agents from one another's franchises. There is no record of a player who was offered a contract with another team after playing out the contract with his current team until Carroll Rosenbloom, owner of the Baltimore Colts, signed away free agent R.C. Owens from the 49ers in 1963 (Fort 1997). This

26 opened the door for other owners to do the same and start a bidding war for players, decreasing profits and possibly decreasing competitive balance. At the next NFL owners meeting, Commissioner Pete Rozelle instituted a compensation system that came to be known as the "Rozelle rule," to avoid having owners bid against one another for players. This rule stated that if a player became a free-agent and signed with a different franchise, the Commissioner could then step in and assign the team which lost the free-agent one or more players from the team which acquired the free-agent. This was done to compensate and appease the team who lost the free-agent and maintain competitive balance. The compensations Rozelle awarded were so large that most teams were afraid to sign a free-agent without organizing prior compensation with the other franchise. While the "Rozelle rule" was in effect, from , 176 players played out their existing contracts to test the waters of free-agency. Only 34 players ended up signing with different teams and only four of these signings involved compensation disputes that required enforcement of the "Rozelle rule" (Fort 1997). In the 1960s, under Pete Rozelle, the NFL instituted a revenue sharing program. Currently, the NFL has the most aggressive revenue sharing program. Home and visiting teams split the gate receipts (MLB also splits gate revenue but not to the same extent. The National League teams split the gate revenues roughly and the American League teams adhere to approximately an split.) The NFL evenly splits the national television contracts which make up more

27 then half of each team's total revenue. NFL teams also evenly split licensing income (Leeds 2002). Visa, for example, is a "proud sponsor" of the entire NFL.'~ This type of revenue sharing allows the NFL to increase competitive balance in the league and secure the financial stability of its franchises in small-market cities. By distributing revenue in this fashion, the NFL closes the gap between the incomes of small- and large-market teams. A smaller gap in revenue helps level the playing field even without a salary cap. With a salary cap, this form of revenue sharing helps small-market teams meet their obligations toward paying player salaries. Under the current NFL salary cap, each team is required to spend at least fifty-six percent of the average league income on player salaries, regardless of their individual income level (Lackner 2005). Rozelle may also be responsible for ending player-for-cash trades in the NFL, a practice which allows large-market teams quickly and easily to acquire talented players from small-market teams without replacing that talent with other players. Large-market teams value talented players more then small-market teams because talented players can generate more revenue in large-market cities. With player-forcash trades, large-market teams can simply pay small-market teams an amount of money greater than the increase in revenue a player would make in the smaller market, to acquire the player from the small-market team (Quirk 1974). Without player-forcash trades, teams trading players demand that they receive players which will generate at least the same amount of net revenue as the players they are trading away. l3 Jerry Jones, former owner of the Dallas Cowboys, tried to take advantage of the arrival of unregulated free agency in He outbid teams for their free agents and then attempted to market the Dallas Cowboys as "America's Team." His plan to increase revenues and contracts involved the Dallas Cowboys issuing their own licensing agreements (Leeds 2002).

28 This helps maintain a higher level of competitive balance in the league. Owners in a variety of professional team-sport leagues have claimed that an increase in competitive balance increases fan interest, which then generates more revenue for the entire league. Only one player-for-cash trade has taken place in the NFL since Rozelle took over as Commissioner (Fort 1997). l4 In 1976, a player named John Mackey brought suit against the NFL and the courts struck down the "Rozelle rule" as a violation of antitrust laws. The National Football League Players Association (NFLPA) soon negotiated away its newly granted free agency and replaced it with a modified version of the "Rozelle rule" where the compensation for a team which lost a free agent was determined by a set formula, as opposed to the discretion of the Commissioner. In return, the NFLPA received greater benefits such as heath-care and retirement packages, which were more pressing issues for the players at the time. The players soon realized that the new system was no less restrictive than the old one. Between 1977 and 1988, an average of over 125 players filed for free agency each year. Of the 125 plus players per year, only three players changed teams during that 12-year period. (Fort 1997) In 1977, Rozelle oversaw the start of the NFL's unique scheduling policy which is designed to increase the level of competitive balance in the league. This policy is designed to provide closer match-ups by trying to schedule teams of equal strength against one another. The NFL matches teams by how well they finished in the previous season (Fort 1997) Johnny Unitas was traded from the Colts to the Chargers in 1973 and this was after Johnny Unitas had already passed his prime. 15 Currently, two of a team's sixteen games are determined in this matter. Each team plays two intraconference games based on the prior season's standings. With four divisions per conference, the first-

29 In 1982, unsatisfied with the modified "Rozelle rule" system, the NFLPA demanded change but was unable to win free-agency during a strike which lasted 57 days into the start of the season. Players eventually turned back to the courts to argue that the new rule was illegal according to antitrust laws. The courts, however, stated that antitrust laws no longer applied because the new rules were negotiated in a collective bargaining agreement with the league. The only way around this technicality would be for the Players' Association to disband. The NFLPA did just that in 1988 to give the suits brought against the NFL a better chance of succeeding. In 1992, the decision of McNeil v. ProFootball, Inc. gave the players the legal precedence they needed. In 1993, owners negotiated a salary cap to regulate fi-ee agency. l6 The owners claimed this regulation was needed in order to maintaidincrease competitive balance in the league. The Collective Bargaining Agreement was approved for a six-year extension by the NFL and the NFLPA in 1998 (Leeds 2002). place team in a division will play against two of the other first-place teams from divisions within the same conference. The second place team in a division will play against two second-place teams from divisions within the same conference, etc. (Alder 2005). l6 The NFL experienced one year of unregulated free agency in 1993.

30 Chapter 4 The NFL 's Theory offan Interest: Section 1 The NFL : The NFL7s theory of fan interest is simple.17 Increasing the level of parity in the league increases the quality of the product the NFL produces which, in turn, increases demand for their product. The increased demand for their product increases fans' willingness to pay for the product, leading to higher revenues for the league to distribute between players and owners. The NFL has long held a "league-think" mentality in which increasing parity and selling the idea that, on "Any Given Sunday" or that in any given season, any team could win, is the best way to increase fan interest and league revenue. This theory of fan interest impels the NFL to implement a variety of regulations to level the financial playing field amongst teams bidding for players. The NFL wants even the smallest market teams, such as the Tampa Bay Buccaneers, to have the opportunity to succeed both athletically and financially (Leeds 2002). There is some existing research which already supports the NFL7s theory of fan interest. Welki and Zlatoper (1999) examine the game-day attendance1' for The theory I refer to in this paper as "The NFL's theory of fan interest" is simply my best guess as to what the NFL uses to guide its decisions. I have not found any information explicitly stating what the NFL's theory of fan interest is. I piece together my beliefs from the actions of the NFL and the statements various agents of the NFL have made to the public, some of which I have included in this paper. 18 This distinguishes the number of fans which attended the game as apposed to simply the number of tickets sold.

31 regular season games played during the 1986 and 1987 seasons. The authors perform regression analyses using a range of variables including the home team's winning percentage, weather conditions, ticket prices, rivalry, the day of the week, and arena type. The regressions show rivalries, playoff significance, a higher winning percentage for the home team, a higher winning percentage for the visiting team and the expectation that the final score of a game will be close, all increase game-day attendance (Welki 1999). This last point-that a decrease in the expected difference between the final scores of a game increases competitive balance--supports the NFL's theory of fan interest. The NFL's theory of fan interest predicts that owners will enter into a Prisoners' Dilemma if the market for player talent falls under a free agency system-- simply, think of owners as "brokers" who accept "bids" (revenues) from their local market for winning percentages (Canes 1974). l9 The brokers will only consider the effect that acquiring additional player talent will have on their profits and this will not result in the socially optimal allocation of player talent which would maximize league revenue through higher levels of competitive balance.20 Large-market teams would over-invest in player talent, while small-market teams would under-invest in player talent. If all teams were allocated an even share of total league revenue this Prisoners Dilemma would not exist. However, if all owners where simply given a share of total l9 Higher bids correspond with higher winning percentages. 20 Canes actual disagrees with this last assertion and the restricting owner's ability to broker deals between creates inefficiencies by increasing winning percentage in markets where "consumers are willing to pay relatively less for a winning team and decrease winning percentages in areas where consumers are willing to pay relatively more" (Canes 1974). However, the NFL theory of fan interest would contend that this analysis ignores the full effects increases in competitive balance has on generating increased revenues from increasing interest in the league as a whole.