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)
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. …