The Peculiar Externalities of Professional Team Sports

Beginning of article

The economics literature has long been divided regarding whether competing sports teams can achieve the same, efficient allocation of playing skills that a revenue-maximizing league monopolist would choose despite the external effects the teams impose on each other in their pursuit of athletic talent. In this article an explicit consideration of the arbitrage incentives that underlie the marketing and pricing of playing skills indicates that decentralized franchises generally fail to allocate talent efficiently. For fans concerned about the championship prospects of their preferred team, the popular complaint has merit: "Big-city teams win too much." (JEL L83)

I. INTRODUCTION

Twenty years before the end of Major League Baseball's comprehensive reserve clause, which assigned to team owners the exclusive right to market player contracts, Simon Rottenberg (1956, p. 255) observed that "a market in which freedom is limited by the reserve rule such as that which governs the baseball labor market distributes players among teams about as a free market would." The subsequent economics literature has been divided regarding whether the distribution of players under the reserve clause and free agency is not just identical but also efficient. My analysis suggests that it is not.

The typical popular view is that competitive balance is achieved when teams, at least over time, perform equally well as measured by winning percentage or championship frequency. Economic analysis suggests instead that if team revenues uniformly reflect fan satisfaction, then competitive balance is optimal when talent is allocated so as to maximize revenues for the league as a whole. The two notions of competitive balance match only when team markets are of equal size, either by coincidence or because of freedom of entry and relocation of team franchises. Under the prevailing circumstances in which market sizes differ, superior on-field performance by large-market teams does not in itself indicate to economists that the existing level of competitive balance is suboptimal. The question of interest is whether the dominance of large-market teams is excessive, thereby reducing total league revenues.

The next section reviews the debate about the efficiency consequences that result from the external effects that teams impose on each other through their competition for athletic talent. The following sections then establish three key points. Section III shows that teams generally fail to achieve the league revenue-maximizing allocation of talent when the teams acquire players from an external market with a perfectly elastic supply of playing skills. Section IV turns to the internal marketing of athletic talent, for which Quirk and El Hodiri (1974) have demonstrated that decentralized franchises reach the same allocation of playing skills as a league revenue-maximizing monopolist as long as internally marketed skills sell for a uniform price. However, the analysis of section IV indicates that the arbitrage process that drives the internal marketing of talent does not lead to a uniform price for playing skills but only to an equilibrium set of bilateral transaction prices between each pair of teams. As a result, decentralized franchises do not end up with an equal marginal revenue product of playing skills across teams and therefore do not achieve the allocation of talent that a league revenue-maximizing monopolist would choose. Section V examines the nature of the discrepancy between the optimal allocation of talent and the allocation achieved by noncooperative franchises. Linking fan interest to the championship prospects of the fan's preferred team generates an outcome in which unrestricted competition for playing skills by decentralized franchises results in excessive domination by large-market teams whose incremental acquisitions of playing skills impose negative externalities on third-party rivals. Appropriate per unit taxes and/or subsidies on playing skills can be structured as a first-best policy to address this inefficiency.

II. THE EXTERNALITIES DEBATE

In "The Peculiar Economics of Professional Sports," Neale (1964) described the distinctive mix of cooperation and competition that characterizes sports markets. With respect to the externalities that teams impose on each other in their competition for athletic talent, not only are the externalities themselves peculiar, so is the economic debate concerning them. For decades, opposing opinions have entered the literature on parallel tracks regarding whether market forces ensure that athletic talent gets efficiently allocated across the teams of a sports league. Closure has remained elusive, despite considerable and continuing research into the closely related issue of competitive balance. As noted by Zimbalist (2002, p. 111) in an issue of the Journal of Sports Economics devoted to the topic of competitive balance: "Competitive balance is like wealth. Everyone agrees it is a good thing to have, but no one knows how much one needs." Lack of closure regarding the fundamental debate impedes the ability of economists to weigh in forcefully on policies ostensibly addressed to competitive balance objectives.

Demmert (1973) articulated the underlying concern that the allocation of athletic talent within a league would likely be distorted by a failure of teams to internalize the inherent external effects that arise from the competition to field successful teams:

   The improvement of a better than average team
   results in diseconomies which are external to the
   club in question but internal to the league. Likewise,
   the improvement of a poor team results in
   benefits to the league as a whole over and above
   those which accrue to that individual club. It cannot
   be expected that the club will consider these external
   effects of its decisions in determining the
   level of its team's quality. (p. 29)

After modeling the situation to arrive at an illustrative competitive equilibrium, Demmert concluded that "the jointly optimal distribution of athletic talent among league members will, in general, differ from ... the vector of optimal level team quality" (1973, p. 46). Daly and Moore (1981) echoed Demmert's concerns. They first summarized Rottenberg's argument that "if both owners and players are wealth maxzimizers (an assumption universal in this literature) the Coase theorem assures us that the ownership of property rights should not alter the allocation [of] resources" (1981, p. 78). They then concluded that the competitive equilibrium under either the reserve clause or free agency would be inefficient under

   the related assumptions that (a) external effects are
   an inherent and important aspect of the production
   process in the team sports industry and (b) transactions
   costs associated with internalizing these
   effects are of such a magnitude that such internalization
   does not, in fact, occur.... The second
   assumption ... implies that sports leagues will systematically
   produce competitions which are less
   equal than that required by considerations of joint
   wealth maximization of team owners. (p. 79-80).

In stark contrast, considerable research reflects the view that competing teams do achieve an efficient allocation of playing skills. Hunt and Lewis (1974, p. 940) proposed an unassailable scenario in which

   in the absence of any other sources of player income,
   the amount that the dominating team must
   offer for the player resources necessary to increase
   dominance is equal to the loss in revenue that the
   other teams would experience due to the resource
   transfer. Unless the dominating team offers more
   than this amount, other teams would meet its bids
   and retain the services of the player resources....
   The profit-maximizing amount of dominance,
   where marginal revenue equals marginal cost for
   the dominant team ... by definition also maximizes
   division revenue since all marginal costs are lost
   revenues.

Note, though, that this …