Free Ride, Take it Easy: An Empirical Analysis of Adverse Incentives Caused by Revenue Sharing

Transcription

1 MPRA Munch Personal RePEc Archve Free Rde, Take t Easy: An Emprcal Analyss of Adverse Incentves Caused by Revenue Sharng Danel, Rascher; Matt, Brown; Mark, Nagel and Chad, McEvoy Unversty of San Francsco, Unversty of South Carolna, Unversty of South Carolna, Illnos State Unversty 2009 Onlne at MPRA Paper No , posted 11. October 2010 / 07:37

2 Free Rde, Take t Easy 1 Runnng Head: FREE RIDE, TAKE IT EASY Free Rde, Take t Easy: An Emprcal Analyss of Adverse Incentves Caused by Revenue Sharng Abstract A fundamental belef n professonal sport leagues s that compettve balance s needed to maxmze demand and revenues; therefore, leagues have created polces attemptng to attan proper compettve balance. Further, research posts that objectves of professonal sport teams owners nclude some combnaton of wnnng and proft maxmzaton. Although the pursut of wns s a zero sum game, revenue generaton and potental proft makng s not. Ths artcle focuses upon the Natonal Football League s potental unntended consequences of creatng the ncentve for some teams to free rde on the rest of the league s talent and brand. It examnes whether an owner s objectves to generate ncreased revenues and profts are potentally enhanced by operatng as a contnual low-cost provder whle makng money from the shared revenues and brand value of the league. The present evdence ndcates that, overall, beng a lowcost provder s more proftable than ncreasng player salares n an attempt to wn addtonal games.

3 Free Rde, Take t Easy 2 Free Rde, Take t Easy: An Emprcal Analyss of Adverse Incentves Caused by Revenue Sharng The ownershp of the Cncnnat Bengals has broken the unwrtten contract between a team and ts fans. The ownershp of ths organzaton has actvely pursued a course of acton whch has materally ndebted tself to the people of Cncnnat yet has faled to delver a compettve product The ownershp of ths organzaton s causng a lack of balance n the AFC Central and the NFL as a whole. (Msson Statement of MkeBrownSucks.com [Cat, n.d., para.1]). Durng the 1990s, the Cncnnat Bengals of the Natonal Football League (NFL) were the worst team n the league, averagng just fve wns per season ( Standngs, 2008). Mke Brown, owner of the Bengals, s notorous for hs unwllngness to spend money to provde fans wth a decent on-feld product (Daugherty, 2008). However, despte ther poor on-feld record, the Bengals were the league s ffth most proftable team. Further, addtonal teams consstently performng poorly on the feld n ths tmeframe, such as the Tampa Bay Buccaneers and the Chcago Bears, were also among the NFL s most proftable teams ( NFL team valuatons, 2005). Dallas Cowboys owner Jerry Jones noted hs dspleasure wth teams who may be underperformng on the feld, whle overachevng (compared to league averages) fnancally due to revenue sharng (Helyar, 2006). Achevng the optmal level of revenue sharng has been a dscusson n owners meetngs as well as n collectve barganng negotatons wth the players (Wesman, 2006). Smlar concerns and anecdotal evdence of greater profts from nferor team performance exsts n other major North Amercan sport leagues. Under Donald Sterlng s ownershp, the Los Angeles Clppers of the Natonal Basketball Assocaton (NBA) has consstently been one of the worst on-the-court teams n the league, yet s reportedly one of the

4 Free Rde, Take t Easy 3 most proftable (Rovell, 2003). Pror to re-sgnng Elton Brand n 2003, the Clppers had usually ether traded or allowed ther best players to leave va free agency nstead of payng huge salares to retan ther servces (O Sullvan, 2002; Rovell). Despte more than half of the NBA teams makng the playoffs each year, the Clppers has only had four playoff appearances snce Donald Sterlng bought the team n In 2004, Major League Baseball s (MLB) Tampa Bay Rays, though rankng near the bottom of the league n payroll, home attendance, and wnnng percentage, were the second most proftable team behnd the Baltmore Oroles, generatng $27.2 mllon n operatng ncome (Snel, 2005). The Rays 2004 proftablty was largely due to a $20 mllon subsdy provded by MLB s revenue-sharng program. Further, revenue sharng may actually dscourage on-feld success and hamper proftablty. In 2001, 13 of 16 MLB clubs that were requred to contrbute to the revenue-sharng pool lost money at the end of the season. The St. Lous Cardnals fnshed ted for frst place n the Natonal League Central dvson and had ncome from baseball operatons of $1.9 mllon. Under MLB s revenue-sharng model, the Cardnals were requred to pay $8.2 mllon nto the revenue-sharng pool. Ths resulted n a $6.4 mllon loss after revenue sharng (Pappas, 2002). Artcles n the popular press and trade publcatons have specfcally dscussed the recent proftablty problems n professonal sports and ther possble lnk to league revenue-sharng models (Bloom, 2006; Dosh, 2007). In MLB, crtcs have noted that even though revenuesharng dollars are desgned to mprove team performance, smaller revenue producng franchses have spent the money on any set of expenses or even pocketed t as proft rather than mproved ther on-feld performance (Bloom; Kovacevc, 2005; Snel, 2005; Wer, 2002). For some teams, such as the Pttsburgh Prates or Mlwaukee Brewers, t appears that revenue sharng s creatng a dsncentve to compete for top players. Those teams have receved consderable crtcsm for

5 Free Rde, Take t Easy 4 contnung to decrease ther player payroll despte recevng ncreased revenue-sharng payments under the Collectve Barganng Agreement (CBA) and generatng hgher unshared revenues from new facltes (Dosh, 2007). These anecdotal examples suggest that, n North Amercan sport leagues, t mght be possble to ncrease overall net ncome by feldng a less expensve, and often less talented, team. When one franchse n a chan of restaurants, for nstance, can mantan or even enhance proftablty by consstently offerng sub-par servce because the other members of the chan support marketng actvtes that enhance the brand value, free rdng has occurred (Lopatka & Herndon, 1997). In sport, f a free-rder could reap larger profts than other teams n ts league through the decson to decrease operatonal expenses, the overall brand value of the league could eventually decrease. The purpose of ths study was to emprcally test whether free rdng exsts n the NFL. The NFL was chosen for analyss because t shared approxmately 70% of ts overall revenues among ts franchses, a greater percentage than any other major North Amercan professonal league (Alesa, 2002; Bell, 2004). Just as mportant s the avalablty of suffcent NFL data, compared wth other leagues, to test these deas. Lopatka and Herndon (1997) specfcally noted the NFL s revenue-sharng model s potental to encourage mnmal owner nvestments n player payroll; ndeed, NFL owners have a greater nterest n preventng free rdng than do owners of teams n other leagues because of the NFL s unusually hgh level of revenue sharng (p. 760). There s certanly the possblty that other leagues have free-rdng franchses that lower player qualty whle generatng greater profts, but the NFL s revenue-sharng model and sources of shared revenue (prmarly ts natonal televson contracts) spurred ths nvestgaton. Contrary to prevous lterature, ths artcle drectly tests the mpact of free rdng on team profts and the

6 Free Rde, Take t Easy 5 resultng ncentves nvolved. Whle revenue sharng s not necessary to cause free rdng, t can serve to enhance the ncentves for owners to free rde. Ths artcle shows that free rdng does exst n the NFL (utlzng 10 years worth of team level data), and specfcally demonstrates whch teams are free rdng. Specfcally, the artcle s organzed n the followng sectons. Frst, the lterature revew examnes professonal sports league structures as well as the specfc fnancal nformaton pertnent to an nvestgaton of the NFL. Next, the artcle presents the scholarly lterature pertanng to free rdng n professonal sports, followed by a secton that develops a theory nvestgatng why free rdng results from ncentves created by the NFL. The artcle then presents and dscusses data used to examne the theory. Fnally, the artcle provdes data analyss, and presents conclusons and a dscusson of mplcatons for the NFL as well as other professonal sport leagues. Revew of Lterature Franchses wthn professonal sport leagues operate not as ndependent organzatons desrng to completely elmnate ther fellow compettors, but as a quas-socalst franchseefranchsor cartel (Scully, 1995). Whle teams compete on the feld, they collaborate n other busness actvtes n order to mantan the league s overall fnancal vablty. If league owners dd not cooperate, t s lkely that franchses n smaller ctes would not reman fnancally solvent (Fort, 2003; Harrs, 1986; Helyar, 2006). Most North Amercan professonal sport leagues have adopted certan actvtes such as jont marketng campagns, pooled-debt nstruments, and revenue sharng as methods to prevent smaller market teams from beng unable to compete wth clubs n larger markets (Fort).

7 Free Rde, Take t Easy 6 Although all franchsee-franchsor companes retan elements of cooperaton and mnmum standards of performance, professonal sport leagues are pecular n that performance (defned by fans as wns) s a zero-sum game even though proftablty for each franchse s not (Fort, 2003). Whle consstently negatve servce qualty for one franchse n a McDonald s chan wll not negatvely affect every store natonwde, n North Amercan professonal sports, a team whch perpetually loses can negatvely mpact the overall fnancal performance of every other franchse - specfcally by decreasng overall ndustry demand (Fort). In addton, where the nadequately performng McDonald s lcense can be revoked, n professonal sports, contracton of poorly performng franchses can be met wth fnancal as well as legal dffcultes ( MLB at a crossroads, 2002). In North Amercan sport leagues, teams equally share revenue from natonal broadcast rghts, Internet advertsng, lcensed merchandse, and other sources (Brown, Nagel, McEvoy, & Rascher, 2004). Franchses are permtted to keep local revenue whch s typcally assocated wth local broadcast contracts and faclty revenues such as luxury sutes, parkng, and concessons (Foster, Greyser, & Walsh, 2006). The NFL shares a greater share of ts revenues than any other North Amercan league. In partcular, where most leagues permt teams to retan general tcketng mones, the NFL takes 40% of all tcketng revenue and dvdes t equally among every club (Brown et al., 2004). In addton, snce the NFL has no locally broadcast regular or postseason games, all televson revenues - whch averaged $2.8 bllon a year n 2005 and whch ncreased to over $4 bllon a year n are shared equally (Maske, 2005). The NFL generates consderably more money from ts televson contracts than any other source (Foster et al., 2006).

8 Free Rde, Take t Easy 7 Wth such a large porton of shared revenues, many NFL teams have focused ther efforts toward developng local revenues that they can retan for themselves rather than share wth other franchses (Brown et al., 2004). In most cases, the most effectve way to ncrease unshared revenue s to mprove the teams faclty specfcally the unshared revenues that are created through enhanced luxury sute and premum seat sales. Ths has resulted n teams searchng for sgnfcantly remodeled or new facltes, often fnanced by muncpaltes. Even under the latest collectve barganng agreement ( Natonal Football League, 2006), where poorer revenuegeneratng teams are provded a supplement from the top 15 franchses earnng the most from non-televson and tcketng ncome, faclty revenues reman mportant. The $100 mllon total amount of ths new supplement n 2006 was approxmately equal to the dsparty between the hghest and lowest team revenues n the league that year (Bell, 2006). In some cases, the lure of the new stadum and ts unshared revenue sources has resulted n NFL teams movng from larger markets to smaller ones based upon a sweetheart lease arrangement ( Los Angeles Rams to St. Lous; Los Angeles Raders to Oakland; Houston Olers to Nashvlle [Tennessee] Ttans) (Barrett, 2003; Donatell, 2003). However, by choosng to maxmze unshared revenues n a smaller metropoltan area, these teams potentally may hurt a shared-revenue source such as the natonal televson contract. In addton, other league-wde revenue sources may not be as lucratve wthout a team s presence n one of the largest metropoltan communtes (Martzke, 2005). Though there may be attractve optons, NFL teams do not have to move to a new metropoltan area to potentally ncrease revenues and possbly free rde. Throughout the 1990s and nto the early 21 st century the Cncnnat Bengals were consstently one of the most proftable teams because of hgh revenues from the NFL s natonal televson agreement as well

9 Free Rde, Take t Easy 8 as attendance by dehard fans who contnued to purchase tckets despte the team's sub-par onfeld performance (Daugherty, 2008). The Bengals also enhanced ther proftablty by not only feldng an nferor on-feld product but also by lmtng management expenses. For nstance, n 2002 the Bengals had 68 employees (not ncludng players) whle the Buffalo Blls had 142 employees (Monk, 2002). The Bengals small scoutng staff of fve (two of whom were famly members), paled n comparson to the 15 professonal scouts who were employed by the Blls. Moreover, the owner, Mke Brown, doubles as the team s General Manager. Clearly, the ownershp presents the appearance that t s not nterested n spendng money to create a wnnng team (Daugherty). The Bengals frugalty was beleved to be one of the man reasons the NFL Players Assocaton demanded a salary floor when the ntal NFL salary cap was mplemented n 1993 ( Questons and answers, 2006). In addton, the lmted staff and the team's poor performance caused some fans to launch a negatve webste ttled to voce ther dspleasure. In general (see Table 1), about 28% of a team s expenses are not subject to the player salary floor mnmum. In other words, these expenses (team expenses plus General and Admnstratve [G&A] expenses) dvded by player costs plus team expenses plus G&A expenses are avalable for the owner to mnmze. The NFL s extensve revenue-sharng system permts the Bengals, or any other team, to keep only a porton of the revenue that an addtonal dollar spent on marketng generates. Ross (2000) prevously noted that even though revenue sharng creates some desrable outcomes, t may also decrease the ncentves for teams to promote n-person attendance or merchandse sales. Free rdng under an extensve revenue-sharng system may also result n dmnshed player costs, as the ncremental fnancal effect of mprovng the team by sgnng a star player s shared wth the rest of the league. A revenue-sharng system assumes that each team wll

10 Free Rde, Take t Easy 9 maxmze ts fscal endeavors to procure the best players and feld ts best possble team. However, the background and motvaton of each owner s dfferent. For some, the team may have been n the famly for multple generatons wth the team servng as the prmary source of ncome (Harrs, 1986). Other owners have acheved fnancal success n varous ndustres and ther foray nto professonal sports s prmarly drven by glory derved from wnnng rather than the fnancal bottom lne (Werthem, 2007). Even wthn the new breed of sport owners, the tmng of ther purchase nto the league may mpact ther debt servce and, therefore, ther need to generate mmedate fnancal returns. In addton, for some owners, the desred proft margn and/or desre to wn may be augmented by publc relatons consderatons (e.g., gettng the owner s name n the newspaper, on televson). Gven the tremendous dfference n owner motvaton and fnancal backng, t may be dffcult to precsely determne f teams are free rdng or smply mplementng predetermned spendng levels whch wll meet fnancal expectatons. Regardless of the owner s motvaton, the NFL Players Assocaton (NFLPA) has a vested nterest n determnng f free rdng occurs as free rdng may artfcally decrease player compensaton as players receve 59.5% of total league revenues under the current CBA ( Natonal Football League, 2006). NFL owners have speculated that some owners are ganng hgher profts from ther revenue sharng by pocketng money that was desgned to be spent on mprovng overall on-feld qualty (Helyar, 2006). A few large market teams have even expressed frustraton that revenue sharng has resulted n smaller market teams consstently producng greater profts than the hgher revenue clubs that generated the revenue to be shared (Helyar). 1 Ths certanly was a consderaton for the NFL owners delberatons regardng the most recent CBA and s lkely to be an mportant component of the next CBA ( Jerry Jones fned, 2009). Determnng whether

11 Free Rde, Take t Easy 10 ndvdual teams are truly free rdng s dffcult gven dfferent team s analyss of ndvdual player qualty and each team s desre to mplement a specfc team-buldng strategy (e.g., acqure free agents, draft players, trade players). However, dentfyng free rdng across the league could lead to changes n the overall revenue-sharng allocaton as the league would desre to have a plan that optmzes revenue sharng wthout compromsng team ncentves. There have been several studes regardng free rdng and ts effects upon a varety of sport-league operatons. For nstance, Késenne (2000) demonstrated the condtons that allow for revenue sharng to mprove compettve balance, decrease compettve balance, or have no effect on compettve balance. Hs model noted that f the margnal mpact of the vstng team on revenues s mnmal or smlar across teams, then revenue sharng wll worsen compettve balance as home teams wll have no ncentve to mprove ther qualty as ther ncreased revenues wll be mmedately dstrbuted across the league. Other authors utlzed models to nvestgate revenue-sharng ssues specfcally ted to attendance by customers who are purchasng because of the presence of the vstng team (Fort & Qurk, 1995; Marburger, 1997; Rascher, 1997; Vrooman, 1996). These authors found that ncreases n revenue sharng wll ether mprove compettve balance n a league or have mnmal-to-no-mpact on compettve balance. Fort and Qurk noted that addtonal theoretcal and emprcal research regardng compettve balance needs to be conducted. Szymansk and Késenne (2004) demonstrated that revenue sharng makes compettve balance worse. The authors examned gate revenues and the mpact of revenue sharng not only on compettve balance but also on the potental total nvestment n player talent. Ther fndngs contrasted wth earler research related to gate revenue sharng and compettve balance n a league. Smlarly, Palomno and Rgott (2000) showed that revenue sharng lowered the

12 Free Rde, Take t Easy 11 ncentve for a team to put forth the effort (n terms of spendng money to mprove team qualty) to wn. The authors stated, competng hard to wn s wasteful (p. 15). Palomno and Rgott further noted that the optmal level of revenue sharng s dffcult to ascertan. Although free rdng ncentves exst n any franchsee-franchsor relatonshp, the lterature demonstrates that revenue sharng n sport leagues can enhance the effects and thus the ncentve to free rde. Mason (1997) descrbed the prncpal-agent problem nherent n the NFL s structure, notng that nterests are algned qute well because of revenue sharng; however, there are stll stuatons where owners nterests dverge. Mason beleved the NFL could not effectvely merge nto a sngle entty because of the need for contest legtmacy (fan percepton that decsons are made by one owner n order to defeat another owner). Ultmately, sport leagues such as the NFL desre a compettve league wth enough revenue sharng to enable every franchse to mantan compettve balance. However, the movement of teams to smaller markets for unshared revenues - whch may decrease overall shared revenues - combned wth the potental desre of teams wth or wthout new facltes to present a consstently nferor (underpad) on-feld product could create a system where revenue sharng s not the optonal mechansm to maxmze overall league fnancal success. Theory The structure of sport leagues, the NFL n partcular, s complex from the perspectve of ncentves and governance. Most busnesses have a sngle prncpal-agent relatonshp where the owner (prncpal) hres employees (agents) to carry out the owner s objectves. The NFL has a dual-layered prncpal-agent structure, but t s made even more complex by the fact that the prncpal at the top (the league tself) has, as ts ultmate prncpal, the team owners. The Commssoner retans consderable power n the NFL, but stll serves at the dscreton of the

13 Free Rde, Take t Easy 12 league s owners. In ths structure, the league s a prncpal tryng to maxmze the net value of the owners franchses as a whole, subject to some mnmal varaton across teams. Each owner s effectvely an agent servng the league s objectves. At the franchse level, each owner serves as the prncpal and hres employees to be the agents to carry out hs or her objectves. There s not a true prncpal at the league level, but nstead the group of owners act as ther own prncpal. To make a major change n the league, the NFL requres three-quarters of team owners to agree upon the change. As Mason (1997) suggested, an ndvdual owner may fnd t n ther own nterest to relocate to a new cty or (as ths artcle analyzes) to offer a low qualty, nexpensve product. Gven that there are 32 owners n the NFL wth dfferent market szes, stadums, lease arrangements, fan bases, and objectves, t s not surprsng that some owners would be more nterested n proft maxmzaton whle others mght want to pursue on-feld vctores and Super Bowl champonshps. Added to ths structure and owner varablty s substantal revenue sharng across teams. The amount of revenue sharng s an endogenous factor decded upon by the league tself. To the extent that wnnng and proftablty are algned, there should not be a prncpalagent problem of dvergng nterests (see Vrooman, 1996). However, wnnng and proft maxmzaton are not always algned (Gerrard, 2005). Ths artcle examned one prncpal-agent ssue, whether spendng less money operatng a franchse (and beng a low-cost provder of the product) s more proftable. Proftablty s partally based on the brand value and revenue capabltes of the broader league as well as the performance of the ndvdual franchse. A sngle team can spend less money, offer a low qualty product, but stll draw fans and share n the natonal TV contract revenues, all whle lowerng the overall brand of the league (as Jerry Jones contends). Ths artcle does not dscuss the effort of

14 Free Rde, Take t Easy 13 agents (franchse employees) n carryng out a team owner s objectves. An NFL franchse can release a football player who s not performng or fre a front offce employee who s not provdng adequate results. Thus, free rdng n ths context s not about effort, but about the actve decson to spend less money and earn profts based on the brand of the league as a whole and the qualty of the other teams n the league. Gven the structure descrbed above, let be the objectve functon of the NFL. The league s objectves are flud based on the possbly changng objectves of ndvdual owners. However, the requrement that three-quarters of owners must agree to a change tempers the whms of ndvdual owners, yet makes some optmzaton second best. Let the league maxmze π ( α), = ( var( π ( α))), (1) where π s the proft of the th team. Thus, the league tres to maxmze the sum of the profts across the teams (total league proftablty), but also tres to mnmze the varaton n proftablty across the league. The league chooses α (the percentage of local revenues that the franchse gets to keep) n order to allow for there to be enough revenue sharng to keep the league ntact and prevent any falng franchses. The var shows that the league wants to make the varance of proftablty mnmal (whch s equvalent to maxmzng the negatve varance). Ths s a general formulaton of the league s objectve functon and does not specfy a model or how much weght s placed on total proftablty and the mnmzaton of the varance n proftablty. Gven that the league s comprsed of owners and can only make sgnfcant changes wth an affrmatve vote by three-quarters of the owners, the objectve functon for the league s actually qute complcated, and ths s just one method of formulatng t. As an example, n 2001, MLB announced t was consderng the contracton of two of ts franchses. The entre league was not experencng problems, but some ndvdual franchses

15 Free Rde, Take t Easy 14 were beleved to be experencng fnancal dffculty. The contracton opton was eventually tabled due to concerns by the MLB Players Assocaton and other enttes but the ncdent dsplayed how MLB s structure that lmted revenue sharng had a negatve mpact upon some franchses. Therefore, the NFL has multple objectves ncludng maxmzng total league proftablty (or league valuaton), but also upholdng fnancally strugglng franchses. As descrbed earler, there are two levels of prncpals makng decsons n the NFL, the league level and the franchse level (or each team owner). Equaton (1) descrbes the league s decson objectves. At the franchse level, an owner maxmzes hs or her objectves whch are a combnaton of profts and wnnng (Gerrard, 2005; Rascher, 1997). Thus, the owner maxmzes V = δ π + ( 1 δ ) W. (2) V s the value to the owner and s a functon of that owner s profts ( π ) and wnnng ( W ). The parameter δ s bounded by 0 and 1 and t represents the mportance of those two attrbutes to owner s objectves. Wnnng and profts are n dfferent unts, but wthout loss of generalty, they wll both be nterpreted as beng n monetary unts (.e., one could create a transformaton accountng for the amount of wnnng that equals a certan amount of proft). The proft functon for an NFL franchse shows that the ncremental gan from wnnng more games (whch s ted to spendng more money n ths model) s ether postve, negatve, or zero and s thus an emprcal ssue. Let π be team s proft, such that π = N + αl W ) C ( W ) + (1 α) L ( W ), (3) ( j j where W equals annual franchse wns for team, N equals natonal revenues that the franchse receves (and s not based on ts own number of wns), L ( W ) s local franchse revenues for team (and s based on the number of wns for the team), α s the percentage of local revenues

16 Free Rde, Take t Easy 15 that the franchse gets to keep, and C ( W ) s franchse expenses (whch are based on team wns under the assumpton that wnnng more games costs more money). Moreover, L j ( W j ) are revenues receved from the opposng team when team travels to team j s stadum to play. In summary, team profts from the natonal TV contract (largely ndependent of team s performance), the share of ts local revenues that t gets to keep, the share of the opposng teams local revenues (here desgnated as the sngle team j), and team pays a cost to feld a team. Revenue sharng rules durng the 1990s n the NFL put α at approxmately 0.60, mplyng that for each dollar created at the local level, the team shared 40 cents wth the league or opposng team drectly (Rascher, 1997). As n Gerrard (2005), let C = C 0 + γ Q + λw, (4) where C0 represents the fxed costs of runnng the franchse and γ s the ncremental or margnal cost of purchasng talent ( Q ). In other words, γ captures the addtonal expendtures a franchse needs to spend n order to purchase more talent (.e., player salares). There s also an ncremental cost to wnnng ( λ ), such as bonuses for wnnng and advancng nto the playoffs, etc. Equaton (5) s W = W (Q ). Thus, wnnng wll depend on team qualty. Smlarly, let L = L 0 + β, (6) W wth L representng local revenues that are not ted drectly to wnnng, and β capturng the 0 margnal revenue from wnnng a game. An nterestng aspect of the NFL (and other sport leagues) s that dvergng nterests between the league and each franchse (or dvergng nterests across owners as t were) can occur at the hgh and low ends of expendtures. A free-rdng owner would spend as lttle as possble n

17 Free Rde, Take t Easy 16 feldng a team and maxmze profts by savng on costs and sharng n the revenues from the opposng teams. Ths owner would place a low valuaton on W n hs or her objectve functon. Ths can harm other owners because they wll receve less revenue through revenue sharng (and the brand may begn to be harmed). Alternatvely, a hgh spendng owner (who may be relatvely more nterested n wnnng than other owners) maxmzes hs or her objectves by feldng a wnnng team. However, ths can also dverge from the nterests of the league and other owners because n spendng more money, t can rase the cost of talent by ncreasng player salares. Ths s smlar to rasng rvals costs as dscussed n the ndustral organzaton lterature. An owner maxmzes hs or her objectve by choosng the quantty of talent ( team gven the fxed parametersα, β,γ, and λ. The frst order condtons are below. It s Q ) for the ' solved by takng the dervatve of V wth respect to Q (labeled ) n Equaton (2) and settng t equal to zero n order to ensure that the maxmum V has been acheved. Let V V ' ' ' ' δ αβw γ λw + (1 δ ) W = 0. (7) = Rearrangng t as n (7 ) below, one can see that the left-hand sde s the margnal beneft of hrng an ncremental unt of talent. That s, one more unt f talent causes wnnng to rse accordng to Equaton (5), multpled by the amount that the owner cares about profts ( δ ), the percentage of local revenues kept (α ), and the mpact of wnnng on revenues ( β ). That s the effect on the proft porton of the value functon. An ncremental unt of talent also mproves wnnng (agan as n Equaton (5), and wnnng tself s valued by the owner accordng to ( δ ). Equaton (5) s assumed to be upward slopng, but wth dmnshng returns (a standard assumpton). 1

18 Free Rde, Take t Easy 17 δ αβw + +. (7 ) ' ' ' ( 1 δ ) W = γ λw The rght-hand sde of Equaton (7 ) shows the margnal cost of purchasng one more unt of talent. The drect cost (γ ) s added to the cost that s based on wnnng (e.g., performance bonuses or payments for makng the playoffs). Before conductng the statc analyss, t s useful to consder some specal cases for comparson. Frst, f owner was a proft maxmzer who dd not care about wnnng, then δ ' would be 1 and Equaton (7 ) would reduce to αβ W = γ + λ ' W (7 ). Further, f the conventon n Fort and Qurk (1995) s followed, where talent s defned such that one ncremental unt of talent equals one addtonal wn (volatng the non-lnearty assumpton above), then we have αβ = γ + λ (Equaton (7 ). Fnally, f we assume that there are no bonus payments for wnnng, then αβ = γ (Equaton (7 ). The emprcal secton wll test ths fnal equaton along wth drect tests of expendtures on proftablty. The more general equatons cannot be examned wth the emprcal data because there s no way to dstngush between the talent level of each team and ts number of wns wth the data set beng utlzed. For a sport-focused owner (one who strongly desres to wn), the margnal cost of purchasng more talent rses as more talent s purchased. Thus, total player payroll and payroll per unt of talent s hgher for sport-focused owners. The mplcaton s that there s a tradeoff between maxmzng profts and wnnng, so a free-rdng owner (whose prmary concern s not wnnng, but makng profts) wll hre less talent than a sport-focused owner or one who cares about both wnnng and profts. Ths s mportant because the optmal actons taken wll vary across owner type. If t were such that wnnng as much as possble concded wth proft maxmzng, then there would not be a free rdng problem because all owners would try to wn (and thus maxmze profts) as much as possble. Ths proposton can be seen by notng that as

19 Free Rde, Take t Easy 18 δ decreases (meanng the owner cares more about wnnng), the LHS of Equaton (7 ) rses (because αβ 1), causng the RHS to rse (whch s an ncrease n margnal cost caused by ncreasng the level of talent). Therefore, beng a sport-focused owner s consstent wth makng less than maxmum profts. A second proposton s that sportsman owners, n ther quest to wn more games, cause the ncremental cost of hrng playng talent to rse for all team owners (not just themselves). Ths follows from the same analyss above for the sport-focused owner, only that the margnal cost of hrng talent s faced by all team owners. The league chooses the level of revenue sharng accordng to ts optmzaton problem (Equaton (1)). Hgher levels of revenue sharng (lower α ) correspond to a decrease n the margnal beneft from wnnng (LHS of Equaton (7 )), so owners purchase less talent, lowerng ' W (whch keeps the LHS equal to the RHS). Further, for proft-maxmzng owners, ths s even more pronounced. Comparng Equatons (7 ) and (7 ), a fxed decrease n α lowers the LHS of Equaton (7 ) more than Equaton (7 ). Proft-maxmzers react more strongly to ncreased revenue sharng by lowerng ther talent purchases than do sport-focused owners. In fact, n the extreme f all owners were wn maxmzers, then α drops out of Equaton (7 ) and revenue sharng has no mpact on the decsons of the owners. They all try to buy more talent, bddng up ts prce. Sport-focused owners decsons ncrease the costs for proft maxmzng owners, but s the opposte true? Do proft maxmzers who free rde harm sport-focused owners' profts? Ths s a cross effect of the change n profts for team from a decrease n talent purchased by team j. ' Usng Equatons (3), (5), and (6), the dervatve of π wth respect to s 1 α) βw, whch s Q j ( j

20 Free Rde, Take t Easy 19 postve. Therefore, a decrease n playng talent by team j (the free rder), lowers the profts of team. Addtonally, t s exacerbated by ncreased revenue sharng (lower α ). In summary, the key theoretcal fndngs are (a) that there s a trade-off between sportfocused owners wantng to wn and maxmze profts, (b) free rdng by one owner wll harm the profts of sport-focused owners, (c) hgher revenue sharng wll cause owners to want to free rde even more than they normally would, (d) f teams are proft-maxmzng, then the senstvty of wnnng on revenues ( β ) wll be equal to the senstvty of wnnng on costs (γ and λ ), and (e) f the NFL s structured n order to create ncentves to free rde or keep costs down, then lowered expenses (from player talent acquston) wll rase profts because the revenue effect wll be outweghed by the expense effect (from wnnng). Substantal revenue sharng and the exstence of dfferent owner types across the spectrum of profts and wnnng causes some owners (those who care more about profts than wnnng) to free rde on the league s brand and talent n the NFL. Two testable hypotheses are summarzed n (d) and (e) above. Methods Subjects Annual NFL team fnancal data were gathered for the years 1989 to 1999 to determne whether free rdng exsts n the NFL. Data were collected from the conformng fnancal statements sent by each team to the Commssoner s offce and released durng The Oakland Raders v. Natonal Football League (2001) case. Team-specfc fnancal data ncluded local revenues, operatng revenues, player payroll, team expenses, G&A expenses, and operatng proft. Of the 319 avalable observatons, 309 (97%) were useable. More recent data from the NFL are not publcly avalable. There were some crtcs of the accuracy of the fnancal data (Zmbalst, 2001); however, ths nformaton was sent from each franchse to the Commssoner

21 Free Rde, Take t Easy 20 and the NFL Board of Governors (made up of some of the team owners) and was used to set NFL polcy. As well, ts accuracy was not dsputed durng the tral. Varables Two categores of profts and four categores of expenses were developed. The categores were: Operatng profts proft reported n the league documents Calculated profts operatng revenue mnus summary expenses Player costs player payroll reported n the league documents General and admnstratve expenses G&A expenses reported n the league documents Team expenses drect team-related expenses such as salares and other costs assocated wth coachng, scoutng, and tranng Summary expenses the sum of player payroll, G&A expenses, and team expenses. In order to compare data reported over the tme frame, a second set of fnancal varables was created by transformng the fnancal data nto 1998 dollars. Comparsons could then be made across years and across teams, not just across teams for a gven year. The annual number of wns, home game total attendance (ncludng pre-season games), the age of the stadum, stadum capacty for football, the number of major professonal sport teams (MLB, NBA, Natonal Hockey League (NHL), and NFL) n the local area, and the local MSA (Metropoltan Statstcal Area) or CMSA (Consoldated Metropoltan Statstcal Area) populaton were used as control factors n the analyss. These data were collected from sportslne.com, ballparks.com, the U.S. Census Bureau, and ndvdual team webstes. The

22 Free Rde, Take t Easy 21 populaton entry was created by nterpolatng data from the 1980, 1990, and 2000 censuses. Table 1 outlnes the summary statstcs for these data, and Table 2 provdes correlatons. Insert Table 1 and Table 2 about here Procedures The data were graphcally analyzed across the varous combnatons of profts, revenues, and expenses. Gven that there are two forms of proft (operatng and calculated) and four types of expenses (player, general and admnstratve, team, and summary), eght plots representng all combnatons of the data were created. To account for control factors that may skew the graphcal results, locally-weghted least squares (LOWESS) regressons were completed. LOWESS regressons essentally run a separate lnear regresson for each data pont usng some of the other data ponts rght around t. It then plots a lne from that regresson, sldes over, and does t agan wth the next data pont, untl all of the data ponts have been analyzed. Gven that t s a non-parametrc method, there are no coeffcent estmates produced, but nstead a graphcal representaton of the regresson curve s created. The sze of the group used for each data pont and how much weght s placed on the closer versus further ponts wthn that group s chosen by the user. Ths analyss used bandwdths between 0.4 and 0.8, meanng that 40% to 80% of the data are used, centered on the specfc data pont that s beng estmated. Addtonally, the weghtng mechansm chosen s the standard one developed by Cleveland (1979), who frst ntroduced LOWESS. It s called the tr-cube weght functon and gves no weght to ponts that are a gven dstance from the data pont n queston. The result of LOWESS s a non-lnear regresson lne that shows small varatons n the data. Because LOWESS uses standard regresson technques over small subsets of the data, t s good at handlng outlers by mnmzng ther effects on the fnal LOWESS regresson lne.

23 Free Rde, Take t Easy 22 It s possble that there s a varable that s correlated wth both proft and expenses, such as market sze, that s mssng from the graphcal analyss (.e., a specfcaton problem). To nvestgate ths, a seres of regressons, both lnear and polynomal, were completed as well. Generally, only reduced form models wth statstcally sgnfcant varables were reported (not the full models wth nsgnfcant varables). Separately, the parameters β and γ were analyzed from Equatons (4) and (6) by regressng summary expenses on team wns to getγ, and regressng local revenues on team wns to get β. The reasons for conductng numerous analyses around the same queston s that nonlnear regressons (LOWESS) allow one to see any specfc curves or knks n the data that lnear regresson smoothes over. However, the non-lnear regressons are not nterpretable n terms of ncremental mpacts (.e., they do not produce coeffcents). Besdes understandng what the parameters are, ths s the frst analyss that drectly compares proftablty n professonal sports to expendtures. Hypotheses It s mportant to note that compared wth the NBA and NHL, the NFL has exhbted lower fttng models of fnancal varables. Mller (2009) created emprcal models of franchse value for the NBA, NHL, and NFL. Hs goodness-of-ft for the NBA and NHL models were around 0.68 and 0.50 respectvely. However, for the NFL models, t was less than One of hs reasons gven s that there s extensve revenue sharng (drven by the natonal TV contract) that flattens out revenues across teams regardless of the underlyng fundamental dfferences across wnnng and populaton. Smlarly, Alexander and Kern (2004) found a postve and sgnfcant relatonshp between franchse values and populaton for the NBA and NHL, but not for the NFL. Low goodness-of-ft for the proft regressons of NFL franchses s not surprsng

24 Free Rde, Take t Easy 23 gven the prevous fndng related to the NFL and related to estmatng proft functons as opposed to revenue functons. Ths noton s related to one of the ponts of ths artcle, that the NFL purposefully shares revenues regardless of the nature of each team s market or wnnng prospects n order to mnmze the rsk for franchse owners. The league realzes that each owner s n busness together (not compettors) n many ways and t s n the nterests of the league as a whole to mnmze the fnancal rsk. Statstcally, ths causes the dependent varable to have low varance, thus there s not much varaton for the explanatory varables to explan. As dscussed n the theoretcal secton, t s expected that β γ because the fnancal gan from wnnng ought to be at least as hgh as the fnancal cost (under the assumpton that λ = 0, or that the playoff payments to players s de mnms). Addtonally, t s expected that αβ γ wll be near zero relatve to the sze of α and β (based on proft maxmzaton) or negatve n order to keep league costs down. Ths wll also be nvestgated drectly by consderng the relatonshp between expenses and profts (s that relatonshp negatve, as expected n order to mnmze league-wde costs or s that relatonshp postve?). Analyss and Results Free rdng n a sport league occurs when a team s able to generate ncreased profts by offerng a lower qualty on-feld product. An NFL owner s potentally able to free rde because of the NFL s brand value and ts substantal revenue-sharng polcy. Fgures 1A 1H contan scatter plots of the two proft measures versus the four expense categores usng the nflatonadjusted varables. They also contan a lnear ftted lne from a lnear regresson along wth 95% confdence ntervals. Insert Fgures 1A 1H about here

25 Free Rde, Take t Easy 24 As can be seen n the fgures, franchses wth lower player payrolls, lower team expenses, or lower summary expenses typcally have hgher profts. There does not appear to be a relatonshp between G&A expenses and profts. Ths s not surprsng gven that the varance among teams for G&A expenses s mnmal. Fgures 2A 2H contan LOWESS graphs of the nflaton-adjusted proft versus expenses. Snce LOWESS s a non-parametrc analyss, nstead of an equaton, graphs of the ftted relatonshp are created. The relatonshps are relatvely lnear ndcatng that a lnear regresson s a reasonable approxmaton of the true relatonshp between the varables. However, the graph of adjusted operatng profts versus adjusted summary expenses s U-shaped. The U- shape ndcates that proft can be made by ether free rdng va lower expenses or by spendng enough money to mprove wnnng and attendance so that revenues are ncreased at a greater rate than costs. Ths s accounted for n the correspondng lnear regressons n Tables 3 and 4. Insert Fgures 2A 2H about here As a varable could be correlated wth profts and expenses, a seres of regressons, both lnear and polynomal, were completed. The two nflaton-adjusted calculated profts models n Table 3 demonstrate that player payroll and summary expenses are negatvely related to proft at the.01 level of statstcal sgnfcance. The results are economcally as well as statstcally sgnfcant. A $1 mllon ncrease n player payroll s assocated wth an $820,000 decrease n calculated proft. Ths s not surprsng snce nearly 70% of all revenues are shared n the NFL, but no player costs are shared. Thus, purchasng a talented player for $1 mllon mght generate over $1 mllon n revenue. However, most of that wll be shared wth the league, makng net franchse profts decrease. Insert Table 3 about here

26 Free Rde, Take t Easy 25 An ncrease n summary expenses by $1 mllon s assocated wth a $460,000 decrease n adjusted calculated profts (see Table 3). In the regressons, annual number of wns and annual attendance were not ncluded snce they are ntermedate outcomes stemmng from player costs or summary expenses. Player costs and summary expenses were both postvely correlated wth wns and attendance. Populaton and the number of major professonal sport teams were not statstcally sgnfcant. Instrumental varables regresson and lnear regresson wth nteracton terms were nvestgated wth the results beng smlar to those reported here. The Ramsey RESET test for omtted varable bas was negatve. The Cook-Wesberg test for heteroscedastcty was also negatve. Varance-nflaton factors were low, showng no multcollnearty ssues n Table 3 except for the polynomal (last column). However, the CMSA dummy varable was sgnfcant and postve n the full regressons. Fnally, as a stadum gets older, adjusted calculated profts decrease by about $160,000 per year. As expected and mentoned above, the R-square only explans about 20% of the varaton n profts. The goodness-of-ft for the adjusted operatng profts regressons (columns 3 and 4) s hgher wth R-square of An nterestng fndng s that the regresson examnng operatng expenses (last column) s U-shaped (as suggested by the correspondng LOWESS regresson). It has a mnmum at about $115,000 (whch s on the hgher end of adjusted summary expenses across the teams). Table 4 depcts the analyss of the varables whch were not adjusted for nflaton. Multcollnearty was sgnfcant n Table 4. Ths s not surprsng gven the many varables ncreasng over tme (smply because of nflaton) that would be correlated together n Table 4. Table 3 accounted for that by usng nflaton-adjusted varables. The fndngs n Table 4 were somewhat smlar to those n Table 3, but t appears that multcollnearty ssues caused the

27 Free Rde, Take t Easy 26 coeffcents to be dfferent than those n Table 3 (because multcollnearty causes t-statstcs to be artfcally hgh, makng t appear that a varable s sgnfcant, when t mght not be). As a result, the coeffcents, whle techncally unbased, have a very broad confdence nterval. Yearly ndcator varables were used to account for the annual growth n overall franchse expenses n the NFL, wth each beng statstcally sgnfcant (p. <.001), wth 1989 as the comparson year. The varables of nterest, player costs and summary expenses, both had negatve mpacts on operatng profts and calculated profts and were statstcally sgnfcant (p. <.01). The full models were all statstcally sgnfcant and had R-squares rangng from 0.36 to The results n Table 3 statstcally have a stronger ft, but Table 4 s ncluded n order to show how the raw data (.e., not adjusted for nflaton) performed. Insert Table 4 about here There was a clear negatve relatonshp between proft and summary expenses (Table 4). Stadum characterstcs and a measure of market sze appeared to affect proftablty, but the mpact of expenses on profts was greater. An analyss of nteracton terms and an analyss of polynomals of the dfferent expense categores revealed no sgnfcant fndngs, except for a quadratc on Summary Expenses for the Operatng Profts model n Table 4. Solvng for the mnmum pont on the quadratc leads to a mnmum Operatng Profts where Summary Expenses equals about $93 mllon. Ths s consstent wth the Fgure 2C. An examnaton of lnear regressons and LOWESS by year showed smlar results. In 100% of the 44 annual lnear regressons contanng operatng profts or calculated profts versus player payroll or summary expenses and control factors, the coeffcent on the expense category was negatve, wth 57% beng statstcally sgnfcant. In all 11 of the LOWESS regressons of annual operatng proft versus player payroll, the slope of the non-parametrc relatonshp was

28 Free Rde, Take t Easy 27 negatve. In sx of the analyses of annual operatng proft versus summary expenses, the relatonshp was negatve, whle n the remanng fve analyses, t was U-shaped. Smlar results were obtaned usng calculated profts. An analyss of the parameters β and γ s shown n Table 5. The smple unvarate regressons (wth constant terms) yelded sgnfcant results for both the model and the ndependent varables. However, the models for revenues and expenses have low R-squared goodness-of-ft parameters. Ths s partally because these are sngle varable models wthout other explanatory varables. The dependent varables were expressed n thousands of dollars; therefore, nterpretaton of the coeffcents needs to be adjusted. For nstance, durng the 1990s, an addtonal wn yelded $1.14 mllon dollars of local revenue but also cost a franchse $752,685. Gven that 60% of local revenues are kept by the franchse (wth 40% beng shared wth other teams), the net revenues from an addtonal wn ( α * β) were $685,573. An analyss of equaton (4) showed that the ncremental change n profts from wnnng one more game (and havng to share some of those revenues and ncur the full cost of creatng them) was -$67,112. Ths was consstent wth the fndngs n Fgures 1 and 2 and Tables 3 and 4. Insert Table 5 about here Dscusson Across NFL teams, there s a wde range of player payroll costs and summary expenses. Based upon the current data analyss, t appears that some NFL owners choose to free rde whle others do not, wth some spendng more on players than maxmzng profts would warrant. Overall, the purpose of the multple methods used to nvestgate varous defntons of expenses and varous defntons of proft show that spendng less produces hgher profts (other than the U-shaped regresson between adjusted operatng profts and adjusted summary expenses).

29 Free Rde, Take t Easy 28 Emprcally, the NFL s structured n order to slghtly create the ncentve to keep costs down by spendng less. Theoretcally, ths s consstent wth the noton that some teams wll maxmze profts (and spend less) whle others wll maxmze wns (or some combnaton of the two) causng the relatonshp across the league to be downward slopng between profts and expenses. The hgh spendng owners are presumably sport-focused owners. Another possble explanaton for ths behavor s the characterstc of a team s market. Owners n larger markets, more so than owners n smaller markets, may spend more to create hgher qualty teams because t s n ther economc nterest (Gerrard, 2005; Késenne, 2000; Rascher, 1997). Yet, the LOWESS graphs and regressons results show that ths s not actually proftable, but nstead only produces more wns. Only n one case s the proft versus expenses functon U-shaped ndcatng that spendng a lot or a lttle s most proftable, but beng n the mddle between the extremes s not. Ths concdes wth the general fndng n sport economcs research that populaton s an mportant factor n determnng demand. Therefore, an addtonal unt of qualty for the product beng sold wll ncrease the actual demand for tckets (and related merchandse, concessons, etc.) by a larger number n a market wth a hgher populaton. Thus, there are more potental fans to be acqured by ncreasng team qualty n a larger market. Whle market characterstcs do mpact NFL proftablty, these characterstcs do not completely explan the fndngs that some teams spend less on team qualty but reap hgher profts. The correlaton between populaton and team expenses s postve and sgnfcant, but small (e.g., the correlaton between populaton and summary expenses, team expenses, and player costs s 0.13, 0.30, and 0.14, respectvely). Also, hgher costs n larger populaton centers mght smply result from the hgher cost of dong busness n more urban areas.