by Daniel A. Rascher, Ph.D.
SportsEconomics

In sports antitrust cases such as Mackey, McNeil, Williams, Raiders I, Bulls II, Silverman, and many others, the economics of salary caps, revenue sharing, the amateur draft, no-cash trades, exclusive-franchise territories, the reserve clause, and free agency have all been viewed through the critical rule-of-reason prism.  However, whether a given rule is pro- or anti-competitive will hinge on matters beyond the control of decision-makers, i.e., what economists call exogenous factors. Any analysis of the economics of rules that leagues use to promote on-the-field competition must recognize a critical potential exogeneity, namely whether sports leagues are natural monopolies.

This discussion will focus on: (1) the formation and importance of competitive balance, (2) the exogenous factors that tend to make incumbent sports leagues difficult to compete with, and (3) an analysis of the two most common tools used to affect competitive balance, revenue sharing and team salary restrictions.

Importance of Competitive Balance

The on-field dominance by the New York Yankees baseball teams of the 1920s led to attendance problems for the Yankees and for many of the other Major League Baseball (MLB) teams. Fans grew tired of lopsided, predetermined affairs, instead preferring uncertain outcomes and balance.  Current MLB critics point to similar dynamics, with the 2000 World Series between the two New York teams (having two of the highest player payrolls in MLB) serving as the most recent piece of evidence that baseball has still not solved the problem of competitive balance.

In 1964, economist Walter Neale recognized the uniqueness of competitive balance to sports in noting the peculiar economics of professional sports.  Neale’s work pointed out that while other companies may seek less competition in the industries which they operate, such as Coca-Cola wishing Pepsi would disappear, in baseball teams benefit when competitors are more viable.  For instance, the Yankees benefit financially when the Oakland As are of high quality. Thus, the nature of competition was infused with a need for cooperation, which has itself been the core of the argument that MLB teams constitute a joint venture or perhaps even a single economic entity.

Twenty years later, the Court in the Board of Regents case recognized the special economic forces at work in sports leagues in its decision that the rules of the NCAA (namely the joint sale of television rights), which would otherwise be illegal per se in other industries, needed to be evaluated using the rule-of-reason weighing the net anti- or pro-competitive effect of the rules in question.[1]

To some extent, the courts have turned the focus away from the economics of sports leagues in their reliance on the formalistic corporate structure of a league such as the NFL (ruled not to be a single entity in cases such as Raiders I and CVC) compared to Major League Soccer (MLS), found recently to be a single entity in MLS.[2]  From an economic standpoint, it has been argued that what matters is the function of the league, not its formal structure.  To this end, it has been maintain that sports leagues should be treated as joint ventures regardless of their organizational form (e.g., single entity or separate entities).[3]  However, current precedents have shaped the landscape such that for the foreseeable future Section I rule-of-reason logic will apply when determining the economic competitiveness of any given league rules regarding on-field competitive balance.  Thus leagues must craft their rules with an eye on developing and maintaining an optimal degree of competitive balance, but may need to do so under the auspices of the rules of reason, weighing the pro- and anti-competitive effects.

The Exogenous Structure of Sports Leagues

Critical to making informed economic judgments on competitiveness is the question of whether a particular sports league has significant brand equity from a first mover advantage.  Football fans may prefer to have the very best athletes concentrated in a single league rather than spread across numerous competing leagues. If this is true, then sufficient support may not exist for multiple top-level leagues.  Moreover, the seemingly high switching costs for fans to change their allegiance to a competing football league complements the desire for concentrated talent.  The common experience that bonds fans of the same team may mean that, for another league to start up and be successful, it would have to compensate fans (presumably through higher enjoyment) for the cost of learning the new teams and players and tossing out the history of the NFL.

Further, it can be argued that leagues such as the NFL exhibit positive consumption network externalities.  As the size of the fan base increases, there are more opportunities for sports-based conversations, and increased attendance typically adds to the excitement of a given game.  For a rival to be successful, it may have to make an all-or-nothing move for primacy. These three factors help explain why a single U.S. professional football league exists and why rivals have had such minimal success in toppling the NFL from its position of dominance.  In fact, the rapid decline in television ratings for the NFL’s most recent rival, the XFL, may show how hard it can be for a second league in this or another major sport to become popular even with the backing of a major television network.

Sports leagues also produce a very high fixed cost, low marginal cost product, similar to what is produced by actors, singers, and software writers.  This may enhance the tendency toward one brand of the particular sport (e.g., there is one major professional baseball league, MLB, not more than one).  Once a league is created and a season of competitive play is in progress, the cost of selling an extra seat or of having one more fan tune in is quite inexpensive. Moreover, consumption by one television-viewing fan does not inhibit another fan from consuming the product on TV, which when combined with low marginal costs, enables a sports league to sell its product simultaneously to millions of fans around the world.  Unlike a carpenter who can only sell his/her services to one construction project at a time, a sports league can remain the only firm in an industry and still satisfy 100% of the market. Additionally, the low marginal cost allows an incumbent league to engage in limit pricing to prevent the entry of a competitor leading to a version of a winner-take-all market. In short, if fans only want to see the best, and the best can be purchased for about the same price as the second best, the market may not support the second best at all.

The extent to which the NFL and other sports leagues have a fan-driven first mover advantage is extremely important for policy decisions. It may be that consumers demand only one league, so efforts by the Courts to encourage competition by leagues of the same sport will be in vain or contrary to consumers’ interests.

The Rules that Sports Leagues Use to Maintain Competitive Balance

Sports leagues have developed numerous rules to enhance competitive balance (e.g., salary caps, revenue sharing, amateur draft, no-cash trades, exclusive-franchise territories, reserve clause and free agency).  This section will focus on the two that are most often heralded as the solution to competitive balance problems  salary caps and revenue sharing.

Team Salary Restrictions

In the NFL for instance, player salaries represent more than 50 percent of the total operating costs of running a team.  The salary cap for each season is a function of the upcoming seasons expected average league revenue.  The salary cap rules attempt to limit each teams total player salaries to approximately 63 percent of the average teams defined gross revenues (DGR), while it cannot go below 50 percent of DGR.

A salary restriction is generally regarded as the most effective method for maintaining or improving competitive balance because it forces teams to spend similar amounts on player payrolls.  An effect of a binding salary maximum is that it puts a restriction on the average salary of a player, thus decreasing the wage per unit of talent.  On the other hand, the salary minimum effectively raises the pay per unit of talent, if the floor is binding.  Another result is that revenue for some large market teams may decrease because they are forced to field a less talented team than would otherwise be the case.  The opposite may occur for small market teams  namely the team might produce quality in excess of the optimal level associated with profit maximization.

In Williams, the District Judge granted declaratory relief stating that even if Section 1 applied to this collective bargaining situation, the pro-competitive benefits of promoting on-court competitive balance made the salary cap, rookie draft, and first-refusal rights restraints reasonable and lawful under Section 1. The Court determined that the effectiveness of the salary cap restriction outweighed any anticompetitive effects, such as the decrease in competition for player services.

Revenue Sharing

In 1962, when the first NFL national television contract was negotiated, revenue sharing was enacted. While revenue sharing prevents the lowest revenue-generating teams from becoming insolvent, it can also cause a problem in which a team may enhance profits by fielding relatively lower-talented players to keep costs down, while reaping large profits from sharing revenues with the rest of the league.  Much of the value of a sports team comes from being a member of the league, not just fielding a competitive team.

 

Revenue sharing might have the following effects.  First, revenue sharing may lower the wage paid to players if it decreases the incentive to bid high for a talented player given that part of the financial return on that player will be shared with the league.  Judge Sotomayor, in Silverman, recognized this effect, noting that it was not simply a harmless exchange of dollars between owners, and prevented the owners from unilaterally imposing revenue sharing rules without the consent of the players association.

 

Second, the effect that revenue sharing has on competitive balance is currently under debate.  The popular notion is that small-market teams will use the net excess revenue that they receive from large-market teams through the national media and licensing contracts and through gate sharing to improve the quality of their team, therefore increasing competitive balance.  In Bulls II, the NBAs justification for its restriction of Bulls broadcasts was the need to maintain competitive balance.

However, it is possible that an athlete will play for the team for which he/she generates the most revenue, regardless of who owns the rights to that revenue. Under this conjecture, small market teams without a mandatory salary minimum will simply pocket their portion of shared revenue as profit, leaving unsolved the “small-market problem” which plagues some sports.  If small-market teams are currently choosing the optimal talent level, a transfer of cash will, by itself, provide no incentive for investments in individually sub-optimally higher levels of quality.  In other words, unless the team does not have access to enough capital to pay more for that next player, it would have already hired the player.  Receiving shared revenues will not make that player more valuable to the team  the better investment is somewhere else, not hiring new talent.

 

This is not merely a theoretical concern.  Recent remarks by former Senator George Mitchell, George Will (both part of an economics team hired by MLB to investigate solutions to business problems in baseball) and others, point out that small-market teams in baseball (where the effective salary minimum is close enough to zero to be inconsequential) may currently be bringing their revenue sharing to the bottom line instead of spending it on improving team talent.

 

Profits may increase from revenue sharing if there is a decline in player costs combined with no or minimal changes in player distribution and hence revenues.  Again, player distribution will not change if the shared revenues are not spent on new players.

 

Moreover, both the revenue-sharing and salary-cap rules create incentives for owners to generate revenue from sources, such as stadium revenues, that are excluded from revenue sharing.  An owner may invest in stadium improvements simply because he or she gets to keep all of the return on that investment, as opposed to investing in a new team logo from which any new revenues from national merchandising would be shared with the rest of the league.  One example from the NFL is luxury suites, which tend to remain outside of the revenue sharing/salary cap structure.  This may help raise the incentive to invest in team improvements, and counter possible effects of profit maximizing by keeping costs low.

Conclusion

Economic analysis plays an important role in understanding the special structure and economic forces inherent in sports, and in analyzing the competitiveness of league conduct. Allegations of wrongdoing need to be viewed through the correct economic prism before a proper evaluation can occur.  This analysis requires an understanding of the exogenous factors inherent in sports leagues, and the rules that leagues use to affect competitive balance.

 

Because of high switching costs, a positive consumption network externality, fans desire to see the very best athletes compete against each other, high fixed costs coupled with low marginal costs, and non-rival production, sports leagues may tend towards one brand for each sport.  This may also be a consumer welfare improvement over multiple leagues of lower quality play within the same sport.

 

Moreover, the economic factors that sports leagues control, e.g., revenue sharing and team salary restrictions, may superficially appear to be anti-competitive, but may instead promote competitive balance, and hence be pro-competitive.  On the other hand, restrictions designed to address competitive balance may merely lower average cost without improving competitive balance, and may have unintended side effects as teams and leagues incentives diverge.  Policy decisions made without the proper understanding of the economics of sports leagues may prove to be detrimental to consumer welfare.

About SportsEconomics

SportsEconomics is a professional services firm that provides a broad range of consulting services to the sports business and entertainment communities. Over the past eight years, SportsEconomics has provided economic, financial, and marketing research analysis to clients in a wide variety of fields associated with sports. SportsEconomics is based in the San Francisco Bay Area, but serves clients throughout the United States and the world. Contact:  Daniel Rascher, President, 110 Brookside Drive, Berkeley, CA 94705; (510) 387-0644; daniel_rascher@sportseconomics.com

 

---

[3]As argued by Richard Gilbert and Michael Flynn in The Analysis of Professional Sports Leagues as Joint Ventures