The Economics of Sports. Chapter 5. Competitive Balance MICHAEL A. LEEDS PETER VON ALLMEN FIFTH EDITION

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1 The Economics of Sports FIFTH EDITION Chapter 5 Competitive Balance MICHAEL A. LEEDS PETER VON ALLMEN

2 Competitive Balance The term means different things to different people Close competition every year, with the difference between the best and worst teams being relatively small Regular turnover in the winner of the league s championship More generally, it means degree of parity within a league Copyright 2014 Pearson Education, Inc. All rights reserved. 5-2

3 Learning Objectives Understand why owners and fans care about competitive balance Be able to use and interpret the different measures of competitive balance Describe and compare the tools that leagues use to promote competitive balance and the limitations of those tools. Copyright 2014 Pearson Education, Inc. All rights reserved. 5-3

4 5.1 Desire for Competitive Balance Fans and owners alike have a conflicted relationship with competitive balance On any given day, seeing one s team win is preferable to seeing it lose But an uninterrupted string of wins is dull Copyright 2014 Pearson Education, Inc. All rights reserved. 5-4

5 The Fans Perspective A game with an uncertain outcome is much more exciting than a foregone conclusion Table 5.1 shows that from 1950 to 1958 attendance for both the Yankees and the entire American League either stagnated or fell because of Yankees dominance Evidence suggests that in many sports, fans prefer a game where the home team has a 60-70% chance of winning Copyright 2014 Pearson Education, Inc. All rights reserved. 5-5

7 The Owners Perspective Competitive balance matters to owners because it matters to fans Leagues adopt policies to promote competitive balance because they enhance fan demand Leagues restrict team behavior if it leads to teams that are too strong or too weak (see Table 5.1) Balance is hard to achieve if some teams maximize wins while others maximize profits Copyright 2014 Pearson Education, Inc. All rights reserved. 5-7

8 Effect of Market Size There is considerable debate over the impact of market size on competitive balance There are three primary sources of disagreement How to measure of success During playoffs or regular season? How to characterize market size Market size has become more important with the advent of broadcasting Copyright 2014 Pearson Education, Inc. All rights reserved. 5-8

9 Effect of Market Size (cont.) The third point of disagreement is how to measure the impact of policies, such as revenue sharing Profit-maximizing leagues do not want total balance they want big-market teams to win more At minimum, more populous locations will win the league championship more frequently Figure 5.1 shows an additional win is more valuable in a larger market, so the optimum number of wins is greater Copyright 2014 Pearson Education, Inc. All rights reserved. 5-9

11 The Effect of Diminishing Returns The impact of another unit of a variable input (when added to a fixed input) eventually falls This effect limits the desire of teams to stockpile and pay star players And promotes competitive balance Drew Brees has limited value to a team that has Tom Brady Brees adds little to wins, attendance, or revenue The added cost exceeds the added benefit Other teams can use him more effectively Copyright 2014 Pearson Education, Inc. All rights reserved. 5-11

12 Is Perfect Balance Profit Maximizing? Winning has a bigger impact in a larger market It adds more to gate, media, and venue revenue MR wins higher in big cities Profit-maximizing leagues and competitive balance may be incompatible Big cities will win more unless MC wins is also higher MR, MC MR small MR large Wins MC Copyright 2014 Pearson Education, Inc. All rights reserved. 5-12

13 A History of Competitive Balance Yankee dominance of MLB is not new Appeared in 15 World Series between 1947 and 1964 The LA Lakers and San Antonio Spurs won 9 of 13 NBA championships between 1999 and 2011 The Montreal Canadiens won 10 Stanley Cups in the NHL between 1965 and 1979 They were succeeded by NY Islander and Edmonton Oiler dynasties in the 1980s The NFL is more balanced, but the Browns and Lions have never been in a Super Bowl Copyright 2014 Pearson Education, Inc. All rights reserved. 5-13

14 Competitive Balance in Soccer from to In England s Premier League Manchester United, Chelsea, and Arsenal have won 11 times In Germany s Bundesliga Bayern Munich and Borussia Dortmund have won 9 times In Italy s Serie A AC Milan, Inter Milan, and Juventus have won 11 times In Spain s La Liga FC Barcelona and Real Madrid have won 10 times Copyright 2014 Pearson Education, Inc. All rights reserved. 5-14

15 5.2 Measuring Competitive Balance Within-Season Balance (Variation) Compares teams within a season across a league A low dispersion of team winning percentages means that the teams are evenly matched Between-Season Balance (Variation) Compares winners (champions) across time Some leagues have the same champions year after year Regular turnover is preferred Copyright 2014 Pearson Education, Inc. All rights reserved. 5-15

16 Within-Season Variation (1) We could use the standard deviation of winning percentage The standard deviation gives the dispersion of performance by teams It is the square root of the average squared deviation from the mean See formula on p. 159 The mean performance is always.5 as there are a winner and a loser in every game Copyright 2014 Pearson Education, Inc. All rights reserved. 5-16

17 Application In 2011, the standard deviation in the American League was The typical winning percentage varies by from the mean The standard deviation in the National League was 0.054, about three-fourths that of the American League. The National Leagues was more balanced Copyright 2014 Pearson Education, Inc. All rights reserved. 5-17

18 Within-Season Variation (cont.) We cannot compare the standard deviation across leagues or across seasons with a different number of games As the number of matches rises, winning percentages cluster around the mean If teams are evenly matched, then the probability of success in any game is close to.5 We can apply the binomial distribution In a short season, a lucky team can have all wins and an unlucky team no wins The league can look unbalanced in a short season Copyright 2014 Pearson Education, Inc. All rights reserved. 5-18

19 Within-Season Variation (cont.) We need a better measure We compare a league s standard deviation to the standard deviation that would result if teams were evenly matched The ideal standard deviation occurs when each team has a 50% chance of winning a given game The better measure is the ratio of the actual to the ideal standard deviation R = s A /s I Copyright 2014 Pearson Education, Inc. All rights reserved. 5-19

20 Computing Within-Season Balance The ratio of actual to ideal standard deviation N = # Teams G = # Games WPCT i,t = Winning percentage of team i at time t R sa / si 1 N N i 1 WPCT 0.5 G i, t Copyright 2014 Pearson Education, Inc. All rights reserved. 5-20

21 Interpreting the Ratio The ratio R gives a standardized measure Actual and ideal standard deviation fall as G rises We can now compare leagues and seasons with a different number of games The formula appears on p. 161 As a rule, R > 1 If R = 1, the league is completely balanced Outcomes are effectively randomly determined As R rises, balance worsens Copyright 2014 Pearson Education, Inc. All rights reserved. 5-21

22 How Do Leagues Compare? English Premier League was the most balanced in The NFL, NHL and MLB have similar balance NBA is by far the least balanced This has been true in most years See Table 5.3 for the actual statistics Copyright 2014 Pearson Education, Inc. All rights reserved. 5-22

24 Between-Season Balance We can use the standard deviation of each team s winning percentage Unlike the within-season measure, there is no ideal measure It is unclear what is a good or bad value We can use the frequency of championships It is hard to compare this across leagues See Table 5.4 Copyright 2014 Pearson Education, Inc. All rights reserved. 5-24

26 The Herfindahl-Hirschman Index HHI measures the concentration of championships In industrial organization, it measures monopoly power Let c i = #championships by team i T = #teams; N = #Years HHI T i 1 If HHI=1, one team always wins If HHI=1/N and N>T, complete competitive balance If HHI=1/T and N<T, complete competitive balance See p. 164 for computations; What if the league had 10 teams? c i N 2 Copyright 2014 Pearson Education, Inc. All rights reserved. 5-26

27 Applying the HHI to Sports See Table 5.4 the HHI for the Premier League is far greater than for any other league the HHI for the NBA is also large the HHI for the NHL, NFL, and MLB are substantially smaller the HHI for the NHL is the smallest, indicating that the league was most balanced in the first decade of the 21st century Copyright 2014 Pearson Education, Inc. All rights reserved. 5-27

28 Illustrating Competitive Imbalance The Lorenz Curve measures inequality in a population It is typically used to measure income inequality We use it to measure inequality in winning Line up NBA teams by wins in (p. 164) 1230 games were played, so population = 1230 The 3 weakest teams (the lowest decile) won 58 games 58 games correspond to 4.7 % of 1230 Thus, the bottom 10% accounted for 4.7% of wins The next 10% accounted for 5.8% and so on The top 10% accounted for 14.7% of wins Figure 5.2 presents the results Copyright 2014 Pearson Education, Inc. All rights reserved. 5-28

29 The Lorenz Curve for the NBA Red line shows perfect balance Adding 10% more teams adds 10% more wins Blue line shows reality Bottom 10% wins less than 10% Sags below red line As we add better teams, blue curve catches up At 100% of teams, we account for 100% of wins The farther the blue line sags, the greater the inequality Copyright 2014 Pearson Education, Inc. All rights reserved. 5-29

30 5.3 Altering Competitive Balance All the major North American sports leagues have developed policies to promote competitive balance Revenue sharing Salary caps and luxury taxes Reverse-order draft Players claim that the policies merely depress overall salaries This section explores the policies effect on competitive balance Copyright 2014 Pearson Education, Inc. All rights reserved. 5-30

31 The Invariance Principle Free agency allows a player to go to the team that offers the best employment terms Players sell their services to the highest bidder Owners claim that free agency is incompatible with competitive balance Economic theory suggests otherwise Markets direct resources to the most productive uses Property rights do not affect the flow of resources They affect only who gets paid for them Simon Rottenberg (1956) first applied the principle to sports Copyright 2014 Pearson Education, Inc. All rights reserved. 5-31

32 How the Invariance Theorem Works In 2012 Albert Pujols was more valuable to the LA Angels than to the St. Louis Cardinals in terms of revenue With free agency The Angels paid Pujols to move to LA Without free agency The Angels would pay the Cardinals for the rights to Pujols Pujols moves in both cases the use of the resource is unaffected The only difference is who gets paid The reserve clause did not prevent player movement In 1920 Red Sox sold Babe Ruth to Yankees Connie Mack twice sold off championship teams in Philadelphia Copyright 2014 Pearson Education, Inc. All rights reserved. 5-32

33 With Transaction Costs The Invariance principle breaks down if there are large costs to making transactions Benefits that do not exceed transaction costs are not realized Transactions costs could have prevented the Angels from pursuing Pujols Copyright 2014 Pearson Education, Inc. All rights reserved. 5-33

34 Revenue Sharing MLB, NBA, NFL, and NHL share network TV revenue equally NFL extensively shares all sources of revenue Teams keep only 60% of home gate revenue Huge TV package dwarfs other sources MLB shares 31% of local revenue (minus expenses ) Central (non-local) revenue also goes disproportionately to teams in 15 smallest markets They will have to spend this revenue on players Copyright 2014 Pearson Education, Inc. All rights reserved. 5-34

35 Revenue Sharing (cont.) The NBA is expected to vastly increase sharing Teams will share up to 50% of local revenue (minus expenses ) The NHL transfers income to teams In bottom 15 smallest media markets If the market has a base population under 2 million Copyright 2014 Pearson Education, Inc. All rights reserved. 5-35

36 Revenue Sharing (cont.) Revenue sharing equalizes revenue across teams Goal is to reduce incentive of big teams to pursue talent This will not work if Sharing shifts down MR of a win for all teams equally bigmarket teams still have higher MR Teams that receive revenue do not spend their added revenue on talent Some teams might pursue profit over wins Copyright 2014 Pearson Education, Inc. All rights reserved. 5-36

37 Salary Caps NBA, NFL, and NHL all have salary caps (not MLB) Salary caps are neither a salary limit nor a cap They set a band on salaries: both upper and lower limits to payrolls (not individual salaries) Take qualifying revenue (QR) of league Not all revenue qualifies Definition varies from league to league Players get a defined share of the QR Divide total player share by # of teams Add & subtract a fudge factor (5-20%) to get the bounds Copyright 2014 Pearson Education, Inc. All rights reserved. 5-37

38 NFL Example Players receive 55% of national broadcast revenue 45% of NFL Ventures (merchandising) revenue 40% of aggregate local revenues Each team must spend at least 89% of the cap Overall, players must receive at least 95% Copyright 2014 Pearson Education, Inc. All rights reserved. 5-38

39 Hard Caps and Soft Caps The NFL has a hard cap Sets a firm limit on salaries without exceptions The NBA has a soft cap with many exceptions Mid-level exception Team can sign 1 player to the league average salary Even if it is over the limit Rookie exception Team can sign a rookie to his first contract Even if it is over the limit Larry Bird exception Named for former Celtics great who was its first beneficiary Team can re-sign a player who is already on its roster Even if it is over the limit Copyright 2014 Pearson Education, Inc. All rights reserved. 5-39

40 The NBA and Soft Caps All the exceptions have undermined the cap This has led to further rules The NBA now caps individual salaries as well The NBA has a luxury tax to prevent teams from abusing the exceptions This has nothing to do with luxury boxes Teams pay a tax that increases for every $5 million over the cap A team $15 million over the cap must pay a $37.5 million tax Copyright 2014 Pearson Education, Inc. All rights reserved. 5-40

41 MLB s Luxury Tax Tax starts at 17.5% for first-time offenders Threshold is $178 million in Rises to $189 million in 2014 Tax rises with the number of abuses NY Yankees have paid the tax every year Copyright 2014 Pearson Education, Inc. All rights reserved. 5-41

42 The Reverse-Order Entry Draft Ideally, it levels out talent over time Teams select new players according to their order of finish in the previous season Weakest teams get the first choice of new talent Strongest teams get the last choice Copyright 2014 Pearson Education, Inc. All rights reserved. 5-42

43 What Was the Point of the Draft? Did teams just want to keep salaries low? Was is a cynical move by weak teams? Eagles owner Bert Bell proposed the draft The Eagles happened to have the NFL s worst record Was it an idealistic move? The NY Giants & Chicago Bears agreed to the draft They were the dominant teams & had the most to lose Tim Mara (Giants owner): People come to see competition. We could give [it to] them only if the teams had some sort of equality. Copyright 2014 Pearson Education, Inc. All rights reserved. 5-43

44 Weaknesses of the Draft It can lead to tanking Teams lose intentionally to improve draft position That is why the NBA has a draft lottery Under a lottery The weakest team has the best chance of choosing first But it might not It works only if teams can identify talent Copyright 2014 Pearson Education, Inc. All rights reserved. 5-44

45 Identifying Talent: Moneyball Billy Beane, the Oakland A s general manager, found underrated players He saw that teams Overrated physical skills Underrated on-base percentage Using different criteria in player selection kept his small market team competitive Other teams eventually caught on A s have fallen on hard times as a result Copyright 2014 Pearson Education, Inc. All rights reserved. 5-45

Markets for Sports. Robert M. Coen. Professor Emeritus of Economics. Northwestern Alumnae Continuing Education. January 26, 2017

Markets for Sports. Robert M. Coen. Professor Emeritus of Economics. Northwestern Alumnae Continuing Education. January 26, 2017 Markets for Sports Robert M. Coen Professor Emeritus of Economics Northwestern Alumnae Continuing Education January 26, 2017 William Hurlburt, 1832-1882 Founded National Baseball League, 1876 Ban Johnson,