This is a guest article from Steve over at the baseball blog, Baseball Rethought. The insightful articles ask you to change your perception on the classic sport by taking a logical look into fantasy and real-life baseball operations. We hope you enjoy this guest post from Steve, and encourage you to visit and bookmark his blog.
If you have been under a rock for the last year, the Los Angeles Dodgers have made some substantial pick-ups in salary recently. Last year they made a trade with the Boston Red Sox, taking on the contracts of Carl Crawford, Adrian Gonzalez and Josh Beckett, which accounted to nearly a quarter of a billion dollars in salary. In addition to this, the Dodgers signed up superstar Matt Kemp to an eight-year, $160 million dollar contract on November 18th, 2011. Their offseason acquisitions also haven’t been quiet, as they’ve signed Zack Greinke to a six-year contract worth roughly $147 million dollars. They’ve also signed J.P. Howell to a $2.85M contract, Hyun-Jin Ryu to a six-year $36M contract, and extended $22.5M for Brandon League. They’re also still on the leash for Manny Ramirez at $8.3M and Andruw Jones for $3.2M.
According to The Associated Press, this puts the Dodgers on the books for $214.8M as of their writing on December 13th. This surpasses the Yankees payroll, knocking them out of the lead for the first time in years. So why did the Dodgers decide to spend this much money and how were they able to do it?
How They Were Able to Do it
The answer to this one is known by most individuals: their lucrative television contract. The Dodgers signed a new $6-$7 billion dollar television deal which is going to last over twenty-five years. Calculated out, that’s about a quarter of a billion dollars per year. When you add a quarter of a billion dollars per year to any team’s revenue stream (keep in mind these aren’t pure profits of course) they will definitely have more money to spend.
But the question here shouldn’t be “how”, it should be “why” they chose to spend the amount of money they did: specifically, why did they choose to spend the amount they spent and not say, $250M or $180M? Why not even $450M?
The Why: An Economic Look
We can all come to the agreement that the amount of money you spend in baseball usually has a relatively high correlation with how competitive you are. Yes, there are exceptions (see the Rays for success, see the 2012 Phillies for failure), but overall, it definitely does assist (see the Yankees and Red Sox postseason appearances over the last ten years). Now of course I’m not arrogant enough to suggest that spending money frivolously is the answer – a $50M contract to Jerry Hairston Jr. isn’t a good move no matter what. If we are to assume some rationality in decision making, we can come to an agreement that, for the most part, having more money to spend usually guarantees you better capabilities of fielding a competitive team.
Now, we can also come to a relatively accepted conclusion that fielding a competitive team is good for business revenues. Sure, figuring out the exact correlation between level of competitiveness and attendance is difficult (and how do you even quantify the overall skill of a team to begin with besides the ultimate wins and losses record?) but we can definitely see that there is some correlation and value there. For an example, see the Houston Astros, who last year totaled 1,607,733 fans. In relation, see 2009, in which they posted a 74-88 record (5th in the NL Central), which is by no means a ridiculous demonstration of skill, but they were able to pull in 2,521,076 fans. That’s a difference of 913,343 fans. If we are to come to the conclusion that a ticket costs, on average, $20 a game, that’s a difference in revenue of $18,266,860. Then let’s say that each fan spends on average, $5 in concessions, that’s another $4,566,715. Then throw in merchandise, say at an average of $3 for fan, that’s $2,740,029.
And then that doesn’t even quantify the harder to figure out things. Consider advertising: do you think advertisers would pay more money to have their ads seen by a larger audience at the ballpark? Of course! This is where the Dodgers were able to leverage their brand.
The Dodgers drew 3,324,246 fans last year for 5th in attendance (and have drawn up to 3,761,653 in 2009). They are Major League Baseball’s 2nd largest media market, with a population of 3,819,702 in just Los Angeles (which we know is not the only city they broadcast to). Now let’s compare that with say, the Milwaukee Brewers media market: Milwaukee has a population of 597,867. What do you think this means? It means that on average, more people are going to be watching a Dodgers game than a Brewers game given that the two were equal in skill/marketing/everything else.
What does more people watching mean? It means that more people are going to see every single sponsorship ad that is placed during those games. This makes this more desirable to advertise during a Dodgers’ game (think of like why the “big games” are so desirable to advertise during – it’s a huge audience). If it is more desirable to advertise during a Dodgers’ game, we can come to the conclusion that advertisers would be willing to pay more money for it. This is simple market supply and demand economics – if there is more demand and limited supply, the price point will go up.
If the television company is able to receive more for the advertising space during the Dodgers game, they are in essence receiving a higher profit given that their costs have stayed the same. If the Dodgers are aware of this, as they should be, they can ask for a higher contract price to show the games on television. This is simple economics. If the television provider knows that it can make $10 billion (disclaimer: made up number) over the course of 25 year by showing the Dodgers, they will want to take advantage of that opportunity. And how much exactly should they spend? Classical economics tells us that the television provider will be willing to spend up to the point where marginal revenues equal marginal costs – that is, they would spend up to $10B to show those Dodgers games.
Now this is of course, oversimplified. For one, I hate the idea that they would still pursue the opportunity if there was zero accounting profit, but we use the idea of marginal revenue equaling marginal cost for the sake of simplicity. Additionally, note that I say “they would spend up to”, which means that they don’t necessarily spend up to that point because they wouldn’t want to – any amount that they don’t spend is just added profit as it decreases costs. This is what we could call the “consumer surplus” – the difference between the maximum amounts someone would pay compared to what they actually paid.
Similarly, the Dodgers are trying to reap the benefits of their “producer surplus” – that is, the difference between the minimum amounts they would have sold the rights to compared to what they actually received. Just like the television company, the Dodgers would have sold the rights for where the marginal benefit equaled the marginal costs at the minimum. But, since the market bears for them to sell at a higher cost, they try to take advantage of this. When these two forces come together, the group that usually gets the worse deal is the one that has multiple competitors – I know there are more television providers than there are teams with the rights to the Dodgers. Say there were two television providers interested in broadcasting the Dodgers: one aware that they could make $10B over the 25 year contract and one aware that they could make $6B over the 25 year contract. Theoretically speaking, the second group would bid up to $6B for the rights to broadcast the games. Thus, the first group would have to bid at least $6B for indifference ($6.01B for assurances). Since the Dodgers are the only ones offering the product, they can sit back and wait for the best offer (again, simplified).
But I’m getting off on a tangent here; the question is now, why did the Dodgers choose to spend as much as they did? In simplest terms, they believed that the amount they spent must have maximized their revenues by creating a more competitive team. Simplistic examples are usually best for illustrating these realities. Let’s assume there are only two teams in baseball: the Brewers and the Dodgers. Let’s also assume that the amount of money spent is the only determining factor in whether a team succeeds. As I’ve pointed out, the Brewers have a much smaller market to draw from both for attendance and media. Let’s say that the Brewers realize that the maximum possible revenue they could get was $5B if they were to spend absolutely nothing fielding a team that won every single game. Let’s then say that the Dodgers realize that the maximum possible revenue they could get was $7B if they were to spend absolutely nothing fielding a team that won every single game. How much will each team spend? Well, theoretically, the Brewers would spend up to $5B, at which point the Dodgers would spend $5.00000001B and win every single game and reap all the rewards. In fact, if the Brewers knew this was a losing proposition, they actually might only spend up to the point in which they know they can recoup their losses (say they make $2B no matter what just from “die hard fans” attending the game). No matter what, the team that stands to make more money would be willing to spend more money.
As I said, that was simplified, as we know that the amount spent doesn’t necessarily translate into absolute victories (otherwise the game of baseball would be a predetermined outcome), but I’m sure you can at least see the point I’m trying to make. In the context of reality, all the Dodgers should have theoretically done was realize the minimum they had to spend in order to reap the most rewards. Let’s say that the Giants stand to gain $3B from winning the pennant and the Dodgers stand to gain $4B. The Dodgers should theoretically spend $3.0001B to attract the better talent and win more games to receive that pennant. This can also be determined for winning a World Series as well, though that takes into consideration many more teams.
In reality, the Dodgers believed that they spent the amount they had to spend to field a better team than the Giants (just marginally better) so that they could win the pennant. They may have also spent enough to where they believe they will win a World Series too. There are a lot of variables that have to come into play here that have to be accounted for – figuring out the exact skill level of your opposition and the skill level of your current players being perhaps the most important, as well as the amount of extra revenue to be gained from winning specific things.
Finally, my last caveats. Firstly, it’s possible that the Dodgers didn’t actually spend the amount that they spent because they believe it’s what’s going to make them win, but because they believed that the amount they spent built up the brand more in intangible value than in actual cost; that is, perhaps they feel that the publicity they received from such deals and the brand power they created was worth a quarter of a billion dollars while the competitiveness is just a nice side-benefit. That’s very possible, but these intangibles and external benefits should also theoretically be considered in the amount of “gross potential revenue” to be created. It’s also possible that the contract between the Dodgers and the television contractor was done in good faith that the Dodgers would try to field a competitive team to retain a wider viewing audience – again, a deal they only would have made if the benefits met the costs. If say, the contract somehow stipulated that the Dodgers must spend at least $200M a year in payroll, then that could be one of the factors at play (that is, if the television provider has come to the same conclusion as me, that spending more money usually creates a more competitive team, causing a little bit of circular logic here). There is some uncertainty in this situation and I won’t pretend I understand all the variables.
Additionally, a moment to take a pause here for the idea of “rationality” – although I present things here in a hopefully logical way that you can follow, it doesn’t necessarily mean that all individuals in the process are following the most rational paths – people tend to act predictably irrationally in fact. We also need to realize that the metrics that each team values are different and thus although each may be acting rationality as independent entities, this is because there is uncertainty. Finally, there is the reality of “risk”, which is especially true of baseball players; thus, the Dodgers might have spent an extra $10M or so to decrease the risk of their investment even though they could have spent slightly less (say, they bought a better bench player than necessary just in case he has to step in for a regular). Quantifying risk is exceptionally difficult.
I hope you enjoyed reading my article on the Dodgers and their payroll and were able to follow along. I know that these arguments were often simplified and without absolute conclusions, but perhaps it has made you think differently about the game of baseball as an economic entity. If you enjoy articles like this, please feel free to visit my blog at http://baseballrethought.com. I’d also like to extend credit to ESPN for some of these specific numbers as well as baseball-reference.com.