Wake Up People: A lesson in the Economics of Sports
For all those who think the Knicks paid too much for Amar’e… get a clue.
Are you one of those people who can’t understand why pro athletes get paid so much? Do you often ask, “How can a guy get paid millions and a teacher or cop get paid so little”? Well, you’re not alone. Everyday people from all walks of life, who work hard day after day just to make ends meet, are left bewildered and perplexed as a man contemplates his future of millions for putting a ball in a hole. Although some athletes can make more money in one year than some normal Americans make in their life-times, there’s a very real reason for this. Another piece to this puzzle is how the market place dictates these astonishing deals. Does playing in different markets (i.e. L.A. or NY) or during different eras, make a difference? Hopefully I can help answer these questions.
Let’s begin with basic economic principles. Without getting too in depth, we must recognize there are theoretical models that economists use to help gage the market (basically it’s trying to predict the future and explain prices and the past). The most fundamental model is that of supply & demand (S&D).
Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy. Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand.
Supply and demand are not constant and are always fluctuating; as one raises the other usually falls. The changes in the relationship between S&D are theorized to always approach equilibrium- meaning the market is self correcting and prices will usually reflect what the current demand is. Although this isn’t true across the board (say with some luxury items), this is the most constant effect. If there is too much of a supply (depending on the demand), prices will fall. If there is a high demand, usually prices will rise. Of course there are other mitigating factors that are calculated within economics like: is this a good, service, or both? The location of the business (something we will touch on later), is it a necessity, are there any complementary goods used in conjunction (autos and gas), and revenue generation, to name a few. When dealing with pro-athletes we can label them as products (in entertainment), garnered by owners (for their services), that generate revenue (in many ways).
A. The Law of Demand
The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more.
B. The Law of Supply Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at higher price increases revenue.
All the laws of supply & demand are present within sports. More available (demanded) talent means owners can pay less because of the options available. Less available means owners pay a premium for their services as there aren’t many to go around. There are many obvious examples of the S&D relationship. Mercedes Benz’s may cost $20 to 30 thousands more than say some Toyotas, and while they include more luxury features, they both use gas and drive. But the demand for Benz is higher, thus some are willing to pay more even if the performance isn’t that different. The same can be said for say, Tim Duncan or an elite athlete, when factoring reasons for offering them more than others it’s simple, they have statistically proven to be among the leaders and they produce revenues (upwards of hundreds of millions)- which is nothing compared to the contract dollars per year they get. That’s why many say “players are rich, owners are wealthy”. Would you invest $10 to 20 million per year to get back less? I don’t think so.
Now that we’ve cleared that up, let’s steer this discussion towards <?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-comL.A.</st1:City> or <st1:State w:st=" /><st1:State w:st="on"><ST1lace w:st="on">New York</ST1lace></st1:State> sport teams. I’ll start by prefacing this section with this: <st1:State w:st="on"><ST1New York</ST1</st1:State> Teams generate MORE revenues, are in a bigger market (more fans and media), and therefore (according to S&D theory) MUST pay more to their athletes. Looking at the history, and taking the laws of S&D into account, is there any question why <st1:State w:st="on"><ST1lace w:st="on">New York</ST1lace></st1:State> is home to the teams with the highest payrolls? Until recently with the Mets, the Yankees, Giants, and now the Jets and Knicks have the distinction of having the most bloated pay rolls. This is not a coincidence. Additionally, the NBA’s most successful teams reside in the larger markets <st1:City w:st="on">Boston</st1:City> and <ST1<st1:City w:st="on">L.A.</st1:City></ST1Although the league has designed and retooled its draft system and collective bargaining agreement (CBA) to promote parody and give smaller market teams the opportunity to compete, larger market teams especially those willing to breach the luxury tax threshold have circumvented this.
<st1:State w:st="on"><ST1New York
</ST1</st1:State> and other big market teams are actually the minority. They are in non-conventional market situations as compared to others. This dictates they build their franchises in an unconventional manner. The conventional manner, according to consensus is to build through the draft. This holds that a team that finishes near the bottom of the league will be able to add the best young talent entering the NBA the following season and pay a rookie wage (scaled to decrease as the team picks later in the draft). Teams finishing outside of the playoffs can enter a lottery and land a top rookie prospect. As time progresses, this can be repeated, and other players can be signed to surround and build around the rookie star acquired in the draft. Usually the top draft pick helps win more games (Shaquille O’Neal improved <st1:City w:st="on"><ST1lace w:st="on">Orlando</ST1lace></st1:City>’s record by 20 games his rookie year and led the team to the playoffs), but nothing is guaranteed. Note, as better rookies are acquired, usually this translates to an improvement and a less likely chance of getting higher picks. And, drafting is just one tool used to improve teams. The issue with big market teams is simple, if they aren’t [bad] (and lucky) enough to get a young talent, but are producing revenues, how do they get better?
Teams in larger markets, build through trades and free agency. A caveat to the CBA and the salary cap is the flexibility allowed to teams under the cap. In a trade, salaries must match within 105% if a team is over the cap. When franchises realize their player investments aren’t producing desired results, they look to trade. Being that many teams aren’t under the cap, the one’s who are, are in demand as the salaries don’t have to match. When a team is in this enviable position they have leverage. They can acquire players and/or draft picks from teams desperate to shed salary at a discount (or premium). This was the case between <st1:City w:st="on">L.A.</st1:City> and <ST1lace w:st="on"><st1:City w:st="on">Memphis</st1:City></ST1lace> in the Pau Gasol deal, and this happens often.
But this doesn’t really address why larger teams build unconventionally. Well first we must consider the expectations by those providing those high revenues- the fans. Teams in <st1:City w:st="on">L.A.</st1:City>, <st1:City w:st="on">Boston</st1:City>, <st1:City w:st="on"><ST1Chicago</ST1</st1:City>, and NY inherit more, higher per capita payers plus the media, than smaller market teams. The demand for success in these markets is greater as compared to say Tampa Bay<ST1. There is a theory in the sport of business that says; in a business sense, if you can’t spend to win a championship; then at least put butts in the seats. The reality is most teams don’t and won’t win, but the business of sports dictates owners make decisions that bring in revenues but not rings. This is why owners in smaller markets are willing to over pay for more famous stars (even if the performance numbers don’t justify this) - it puts butts in seats. It’s also the reason why a big market team can cherry pick the top drafted talent from smaller market teams looking to stay afloat, a problem the L.A’s and NY’s of the world don’t have. These teams are more than willing to exceed the luxury tax threshold because they produce revenues even when they lose. Smaller market teams have trouble selling tickets in the playoffs. This is how large market semi-competitive teams get better and circumvent building through the draft. Let a small, less successful team draft a player and the larger market teams will but his services when needed if the original team can’t over-spend.
The thing with <st1:State w:st="on">New York</st1:State> is… for these reasons, <st1:State w:st="on"><ST1New York</ST1</st1:State> teams have been forced to over-pay for their athletes by the league. It’s the parody of the big market, and perceived (real) demand for success. Players and agents know this. Big market teams have the cash to offer bigger contracts partly because they produce the most revenue. The equilibrium in the league is approached by players demanding to get paid more in big markets. It makes sense when considering if you had a job say in <st1:State w:st="on"><ST1Ohio</ST1</st1:State> from a local investment bank that is near the bottom in terms of its success and were offered the same position at say Merrill Lynch in NYC- you would expect the pay to be higher right? You would consider the cost of living, the tax differential, and the success and size of the company offering the deal to justify this higher wage. And so would Merrill Lynch. And, if you were in a performance based industry, likewise if you performed better than your counterparts, you would expect to be paid more. Simple.
But, the established culture goes deeper. Players in demand will always use larger markets (and the fact they can pay more) to leverage their deals. The market sets the market price. A player is worth whatever a team is willing to offer him. Performance has nothing to do with the market price and value. Why do you think there were so many players being discussed to come to NY? Was it real, or was it leveraging by players? Well none of those players were acquired so what do you think? Players will always look to get an offer form NY or a large market team. It conveys to potential suitors “look I’m in high demand and this is what I could get, can you match this”? But if the team is part of a losing culture, this is usually just leveraging against the players actual desired location. And it makes sense. Of course players want it all; they want to be the highest paid on the best teams. Unfortunately for 90% of them, there isn’t even an opportunity to do so, so they must decide.
In order to control this situation of players leveraging the big market teams against others, teams like NY have to achieve two things. First, they have to be business savvy and scouting savvy as to not overpay for someone who can’t produce wins. They will always overpay compared to the league, but they must be careful to bring in players that can produce wins. If that happens then they effectively call a players bluff, and those looking to join can be thought of as more sincere. Second, they have to take advantage of those struggling teams that are looking to shed salary. When the Knicks were losing, teams who sensed their desperation made out like bandits by giving NY bloated contracts and players that didn’t produce wins (along with receiving NY’s draft picks), because NY had the cash, picks, and payroll to accommodate. Now that the Knicks have shed salary, they can return the favor by acquiring talent at a discount, but patience is needed.
The bottom line is… <st1:State w:st="on"><ST1New York</ST1</st1:State> will always have to over-pay to win. Not only must fans realize that no one will do <st1:State w:st="on"><ST1lace w:st="on">New York</ST1lace></st1:State> any favors (because of the distain for NY), but teams might actually collaborate to limit NY’s opportunities, why would they not, knowing revenue is generated with wins or loses? The media and fans demand immediate success and are very impatient. The Knicks organization knows building the conventional way takes too much time and luck to rely on. And, they know to surround their picks with players; the market will dictate that they over-pay. It’s the inevitable. If you want success in <ST1<st1:State w:st="on">New York</st1:State></ST1, you will pay.
As demand for success by fans increases, so does the need to bring in players that the market has dictated will be paid more in bigger markets. As bigger market teams lose more, demand will again raise to convey that a bigger market team should have more opportunity to compete and thus aren’t afforded the outlook of say a <ST1lace w:st="on"><st1:PlaceName w:st="on">Tampa</st1:PlaceName> <st1:PlaceType w:st="on">Bay</st1:PlaceType></ST1lace>. Smaller market teams can get by without winning- not so much the major market teams. Ask George Steinbrenner. Players know this, owners know this, and agents know this, now fans need to accept this. Don’t be fooled by the Tampa Bay Ray’s of the world. Yes young, affordable talent is there (every player is a rookie at one point). Yes an organization can catch lightning in a bottle see: Patrick Ewing. But, the championships won by small market teams are miniscule compared to those won by larger market teams. The ancillary effects (like fame and brand recognition) from winning is immeasurable in larger markets, and spans decades for some successful franchises. Incidentally, the brand recognition along with league leading revenues is highest in <st1:State w:st="on"><ST1New York</ST1</st1:State> and they haven’t even sniffed lightning or bottles. <O></O>
Now to build a team do you need the best players ever? No. You need the best players available who compliment and fit the system. And you need financial flexibility, to take advantage of smaller market teams when the time is right. You need scouts and GM’s who can maximize the payroll and get the most for their investments and a coach that can get through to his players with a solid system. Over paying isn’t the issue as that’s the inevitable. Winning while remaining flexible and while overpaying is the problem these teams have. The opposite can be said for smaller market teams, once the winning starts, overpriced players will seek sincere contracts, bloated but with real desire. Once you’re flexible, teams will line up offering their services and deals will be presented at premiums. And, once fans realize this is how the supply and demand in sports works… they will realize why contracts are so high and why bigger markets pay more for success.