Economics and Public Policy

Economics has a profound influence on the world of sport. This influence is especially felt in the most popular spectator sports where the players are paid professionals and the teams are firms. Researchers have conducted the majority of economic research in three areas of investigation: the organization and structure of sports leagues, the labor market in sports, and the issue of public subsidies to sporting franchises. In each of these areas economic issues have driven public policy decisions, and public policy decisions have affected the economic choices of individuals and firms.

In each of these issues important distinctions exist between sports institutions in Europe (primarily European football—soccer) and “the big four” professional sports leagues in North America—the National Football League (NFL), the National Basketball League (NBA), Major League Baseball (MLB), and the National Hockey League (NHL).

Peculiar Economics of Professional Sports

Sport exhibits a number of characteristics that distinguish it from other fields of economic endeavor. Notable among these characteristics is the applicability of one of the fundamental assumptions of economics, namely that the driving motivation behind any business is the desire to maximize profit. However, the application of this assumption to sports firms has been criticized as inaccurate given the social status that accompanies ownership of such a culturally important asset. Owners may be motivated to own teams as a means to boost their ego, increase their public profile, or even (as with basketball’s Dallas Mavericks owner Mark Cuban) to relive their childhood dreams of playing professional sports. The realization of any of these motives is dependent on the playing success of the team. Therefore, some owners might be willing to sacrifice profits in order to have a team that wins more games.

ECONOMICS OF TEAMS AND LEAGUES

In most industries cooperation between competing firms is called “collusion” and is prohibited. Antitrust legislation exists to enforce this prohibition. However, in the sports industry cooperation between competing teams is standard business practice. All professional sports teams cooperate by forming into leagues. Originally this cooperation was done in an effort to formalize the rules. Teams in different regions often operated under vastly different rules, making competition difficult. In England the debate about whether handling the ball was legal resulted in the division between soccer and rugby.Teams also quickly realized that fans would be much more interested in sports that culminate in an ultimate victor being declared, creating a need to cooperate to formalize a league schedule and championship.

In marked difference with other industries, every business or team in a sporting league depends on the other businesses or teams with which it competes. Ford can produce a car without any assistance from Chrysler, but no sports team can put on a contest by itself, creating a unique interdependence between the teams in a league.

This interdependence is reinforced by the importance of uncertainty of outcome. Because few people will show up to watch a game in which the result is a foregone conclusion, both teams must have some chance of winning the game. The success of the Cleveland Browns, who won fifty-one of fifty-seven games and all four championships in the history of the All American Football Conference (AAFC), reduced interest in all of the other teams to such an extent that the conference folded.

The practical consequence of this interdependence is that each team or firm has an interest in the performance of its rivals. This peculiar economics of interdependence has given rise to a host of cooperative rules within leagues that goes well beyond what is strictly necessary to coordinate league play.

COOPERATION IN LEAGUE STRUCTURE

In North America all of the professional sports leagues maintain tight control over both the number of teams in the league and their location. In general, each franchise in a league is given monopoly rights to a given region (in the NFL the region is 120 kilometers around the franchise’s home stadium), meaning that no other team in that league will be allowed to locate in that market. Exceptions to this rule exist where some large markets have more than one team in each sport, but a new franchise must compensate the existing franchise for the lost revenue caused by the competition. For example, the NHL Anaheim Mighty Ducks had to pay the Los Angeles Kings $25 million for encroaching on their exclusive rights in the Los Angeles region.

Owners also determine the number of teams in a league. In considering the optimal size of a league, the existing teams will weigh the costs and benefits of permitting an additional team.The benefits include any expansion of revenue that is shared among the teams in a league (such as national television revenue) and the expansion fees that are charged to new franchises.The costs include the dilution of any future shared revenue by the addition of a franchise and increased competition for the closest existing team to the proposed new franchise.

Control of league size is much less of an issue in European soccer, where leagues include far more teams that are organized into divisions. For example, the English league contains ninety-two teams divided into four divisions, and below these is a pyramid of nonleague clubs. Unlike in North American sport, where no mobility of teams exists between the “big leagues” and the minor leagues in each sport, at the end of every season in Europe the top teams in each division move up, and the bottom teams move down.With almost every population center represented by a team at some level, and with the opportunity for every team to play in the top division, decisions about league expansion are something of a moot point.

Cooperation in Revenue Sharing

Revenue sharing is another economic anomaly that is peculiar to sport and related to the issue of interdependence. Team owners argue that revenue sharing is important because equalizing revenue between teams helps improve competitive balance within the league by allowing small-market teams to compete financially with large-market teams. The most common form of revenue sharing is a leaguewide national television broadcast contract, which is distributed equally between all teams. Negotiating as a unit rather than as individual sellers also allows teams in a league to earn more revenue from the broadcast networks. The shared revenue from national TV broadcasts varies widely between the professional leagues. Between 1998 and 2005 the NFL will receive $2.2 billion a year for its four national contracts with ABC, Fox, CBS, and ESPN. At the other end of the spectrum, the NHL contract with ABC/ESPN that ran from 1999 to 2003 was worth only $120 million per year.

Revenue sharing is not without its problems from an economic standpoint. It creates an incentive system that penalizes success and rewards failure. For example, the Oakland Raiders sell more NFL merchandise than any other team. However, because revenue from merchandising is shared equally among all of the teams in the NFL, the Raiders do not benefit from their marketing skills any more than the team that sells the least amount of merchandise. The corollary of this fact is that teams with weaker sales have little incentive to improve.

A second issue is that not all revenue sources are shared, creating an incentive for teams to concentrate on expanding nonshared revenues more than shared revenues. For example, in the NFL, gate, TV, and merchandising are shared, whereas luxury box revenue is not. As a result, owners have been building stadiums with more luxury boxes and less general seating. This situation has also contributed to the seemingly strange movement of teams from large to small markets (for example, the Rams moved from Los Angeles to St. Louis). Smaller markets have been able to attract teams by constructing stadiums that maximize nonshared revenue such as luxury boxes.

Without revenue sharing one of the major benefits of locating in a large market is the revenue from contracts with local media outlets. Movement from large to small markets is more likely when this benefit is diluted, which is the case when media revenue is shared, as is the case in the NFL, which has a national, shared TV contract and prohibits local TV contracts.This situation creates a problem for the league as a whole because leaguewide revenues (such as a national TV contract) would increase with more teams in larger markets.

Revenue sharing also reduces spending on players. Profit-maximizing teams will hire additional players only if the revenue generated is greater than the cost of the players. With revenue sharing the benefits of improving the team (measured, for example, by increased gate revenues) are shared among all of the teams in the league. However, the entire cost of that improvement (in terms of spending on players) falls on the individual team. As a result, teams are unwilling to spend as much on wages as they would if they were able to retain all of the additional revenue.

Cooperation and Public Policy

Antitrust laws in the United States stipulate that firms cannot conspire to increase joint profits or restrain trade. In addition, firms cannot monopolize or attempt to monopolize trade. However, the application of these laws to professional sports teams has been uneven. A 1922 court case granted MLB the only blanket exemption from antitrust law. The case was brought to the Supreme Court by Ned Hanlon, owner of the Baltimore Terrapins of the rival Federal League. In a unanimous decision the Supreme Court ruled that baseball should not be subject to antitrust laws because baseball is a public exhibition rather than a business.This ruling has never been adequately justified, especially since the Supreme Court has not allowed this ruling to set a precedent and has denied other sports a similar exemption.

These court decisions have had a significant impact on the power of the leagues in the marketplace and on their constituent franchises. Baseball has not faced the challenge of a rival league since the Federal League, whereas all of the other three major North American leagues have had to fend off competition. As a league, baseball also has more power over its team owners’ location decisions. Few would argue that given the paltry attendance figures for the Expos in Montreal that the team needed to move at the end of the 2004 season. Prior to this, no baseball team had changed cities since 1972 when the Washington Senators moved to Texas to become the Rangers, and the league has been able to prevent other team owners who were interested in moving their franchises from doing so. The NFL, by contrast, has not been able to prevent teams from relocating since Al Davis successfully sued the league for attempting to prevent him from moving the Raiders to Los Angeles from Oakland in 1980 (they moved back in 1996).

Antitrust laws have been applied only sporadically to other leagues. For example, the rival United States Football League (USFL) successfully sued the NFL for restraint of trade (although the damage award was only $1) based on the pressure tactics applied by the NFL on the broadcast networks to keep the USFL from gaining a television contract. However, courts have consistently granted leagues the right to collude in negotiating collectively for national television contracts. In fact, the NFL was granted a limited exemption to antitrust legislation explicitly to allow it to negotiate a league-wide TV deal.

Europe has less need for antitrust policy, however inconsistently applied, because open entrance into the existing league creates much less incentive to start rival leagues. In addition, with the exception of league-wide TV contracts, little in the way of revenue sharing exists in Europe. However, the European Union (EU) has been threatening to prevent leagues from negotiating nationwide TV contracts, although this prohibition has not yet come to pass.

Labor Market

Researchers have applied most economic analysis of the labor market in sports to determining the impact of changes in the structure of the labor market on both player wages and competitive balance in league play.

Historically, labor market restrictions have been prevalent in both Europe and North America.The main restriction on the labor market in all of the North American leagues used to be the reserve clause, which stated that at the end of a player’s contract, owners could unilaterally extend the terms of the previous contract for an additional year. Unless players were willing to take the extraordinary step of sitting out a year, this clause effectively bound players to their existing team for their entire playing career, eliminating bidding for players by other teams in the league.

In Europe three labor market restrictions were in place: the maximum wage, the retain and transfer system, and import restrictions. The maximum wage stipulated the maximum amount that a player could be paid and was abolished in 1961.The retain and transfer system, like the reserve clause, bound players to one particular team for their entire career. Players could move between teams only with the payment of a transfer fee from the new team to the old team.The purpose of this payment was to provide compensation from the wealthy buying teams to the more modest selling teams for the loss of a valuable playing asset. Finally, European leagues contained import restrictions stipulating the maximum number of foreign players permitted on each team.This stipulation was designed to both foster the development of domestic talent, which is important in a sport in which competition between national teams (such as the World Cup) is prestigious, and to prevent wealthy teams from stocking up on foreign superstars and dominating a league.

Current Labor Market

Under pressure from individual players, who challenged leagues in court under restraint of trade, and player unions negotiating in the collective bargaining process, the reserve clause in North America was gradually eliminated and replaced with free agency, which allows players to negotiate with any team at the end of their contract. By allowing a more competitive labor market to develop in sports, free agency has stimulated an increase in player salaries as teams vie with each other to attract talented athletes.

In an effort to control salaries in the era of free agency, the NFL and the NBA have implemented salary caps, a maximum amount that can be spent on all of the players on a team. Although caps do reduce spending on players’ salaries, salary caps create some important problems. First, the maximum payroll makes it difficult to keep successful teams together. Players on successful (especially championship) teams are more likely to command higher salaries, which makes it unlikely that teams will be able to re-sign their free agent status and stay under the salary cap. In 1983, for example, the Boston Celtics of the NBA discovered that re-signing Larry Bird would use up most of their salary cap, forcing them to sell off much of the rest of their team. In an effort to avoid this problem, the NBA permitted teams to re-sign their own free agents without regard to the salary cap, which came to be known as a “soft cap.” Of course, omitting the salaries of re-signed players from the cap limit severely compromises its ability to constrain salaries.

The second difficulty is that teams often have an incentive to cheat on the salary cap.Teams that are caught going over the cap incur a fine. However, because of the complex financial arrangements in players’ contracts, detecting teams that have cheated is difficult. In addition, some team owners may be willing to accept the fine if they can attract more talent and win more games than teams that obey the cap. This situation is quite likely if owners are not profit maximizers, willing to compromise profits for playing success. However, even if owners were strictly profit maximizers, going over the cap is still rational if the additional revenue from signing a player is greater than the cost.

Another peculiar aspect of the labor market in sports is the draft, which exists in all four North American leagues. Drafts are designed to improve long-term competitive balance by having teams select entry-level players in reverse order of the teams’ playing performance during the previous season. For example, the worst team during the previous season gets the first choice of entry-level players. Of course, eliminating competitive bidding between teams on entry-level players also reduces the cost of recruiting new players.

Players object to the elimination of bidding, as well as to the possibility of being compelled to play for a team, or in a city, that they do not like. Under pressure from players and their unions, the number of draft rounds has been gradually reduced. For example, in the NBA it has been reduced from seven rounds to only two. Players who are not drafted are free to attempt to make any team they choose.

In Europe the retain and transfer system was dramatically altered when a Belgian soccer player, Jean- Marc Bosman, challenged it before the European Union. Unhappy at his original team, F. C. Liege, Bosman wanted a transfer to French team Dunkirk, but the deal foundered on the large transfer fee requested by Liege. In 1990 Bosman sued for damages based on restraint of trade, and, after numerous appeals, in 1995 the EU ruled that transfer fees contravene Article 48 of the EU Treaty of Rome, which states that residents of EU nations must be free to ply their trade in any country of the EU.This ruling forced European soccer clubs to cease the practice of charging transfer fees after a player’s contract is over, although it is still permitted for the duration of the contract.The Bosman ruling also encouraged the EU to force the various soccer associations in Europe to abandon their restrictions on the number of imported players that are permitted on a team.

Salaries of Professional Athletes

In both North America and Europe the reduction of labor market restrictions has paved the way for rapidly increasing salaries for athletes. For example, salaries in the NHL increased by 400 percent between 1990 and 1999.This increase was not unique to North America. Between 1994 and 1999 wages in the Premier Division in England increased by 200 percent. In 2002 average player salaries were $4.5 million in the NBA, $2.5 million in MLB, $1.6 million in the NHL, and $1.3 million in the NFL.

Without question major league athletes are generously paid. However, economists distinguish between being well paid and being overpaid. The most frequently used definition of a “fair” wage in economics is to compare workers’ earnings with their contribution to their firm’s revenue, termed the “marginal revenue product” (MRP). If earnings are below MRP, then players are being paid less than they are contributing to the firm and are being “exploited,” whereas if the opposite is true, players are overpaid. Evidence from the NHL and MLB suggests that when the reserve clause was in place players were badly exploited, earning as little as 10–20 percent of their MRP. In the era of free agency, however, the opposite has occurred. Players are, on average, being paid more than their MRP.

Economists argue that no firm that is attempting to maximize profits should ever pay a wage in excess of a worker’s MRP.The most straightforward explanation of why this argument does not appear to be heeded in professional sports is that owners are not profit maximizing and are willing to sacrifice profits for success. Another possible explanation is the winner’s curse, which occurs when a number of bidders are in an auction-type setting with a degree of uncertainty about the value of the subject of the auction, as is the case when a number of teams are bidding on a free-agent athlete.The successful bidder will inevitably be the one with the most optimistic evaluation of the athlete, creating a tendency for the winning bid to overestimate the value of the athlete.

Economists also have asked whether the relaxation of labor market restrictions has had an impact on the distribution of playing talent in professional sports. Empirical evidence, in North America at least, suggests no impact has occurred. Two studies have demonstrated that no change has taken place in the distribution of winning percentages in any one season after the move from the reserve clause to free agency in baseball. Economists explain this fact through the “invariance principle,” which holds as follows. Assume that the same player has a higher value in a larger market than in a smaller market. Under free agency the team in the larger market will offer the player more money than will the team in the smaller market, and the player will go to the larger market team.With the reserve clause in place, the larger market team cannot negotiate with the player, who is contractually bound to the smaller market team. However, the larger market team can negotiate with the smaller market team, who will agree to sell the player if the larger market team offers more than the player can contribute to the smaller market team. Because the player can generate more revenue in the larger market, the player will be sold.

Notice that although in either case the player ends up with the larger market team, under free agency the player keeps all of the benefits from being able to sign with the larger market team, whereas under the reserve clause the smaller market team receives the payment from the larger market team. Therefore, although the distribution of playing talent remains the same, the reserve clause does redistribute income away from players and toward small-market teams.

Subsidization of Professional Sports Teams

The third important area of economic research in the sports realm emerged when governments became involved in the economics of sports by subsidizing teams. This involvement is particularly common in North America. In an extreme example, the NFL Baltimore Ravens pay nothing to play in a publicly funded facility. Two questions arise from this practice. First, does an economic justification exist for this subsidy? Second, if no justification exists,why is subsidization so prevalent?

The use of public money to support what is essentially little more than grownups playing children’s games at first seems to defy rationality. However, at least in theory, some potential justifications exist for subsidization, assuming that in the absence of the subsidy, the team would leave for another city. If no threat of a team leaving exists, then no economic rationale for subsidization exists.

The presence of a team may bring several types of economic benefits that could justify subsidization. First, a team can increase spending in the local economy, both by increasing tourism and by capturing more of the discretionary spending of locals. For example, purchasing season tickets instead of a foreign vacation reduces spending that would have otherwise “leaked” out of the region. Second, sports teams are considered by some to be a cultural amenity that attracts businesses and workers who would not otherwise locate in a region, thus contributing to general economic expansion. Third, sports teams have an “existence value,” which is the value that residents derive from the mere presence of the team in their city. Unfortunately, existence values are difficult to quantify. As far as the more tangible economic benefits are concerned, a number of economic studies have found no connection between the presence of a professional sports team and a variety of economic indicators such as economic growth, income, or employment.

The explanation for the seemingly perplexing political decision to subsidize teams with so little economic justification rests partially on the ability of wealthier and more organized groups to exert greater influence on the citizenry and on political decision makers than can disorganized and poorly resourced groups. For the team itself and those groups (such as the construction industry) who stand to gain considerably from the subsidy, dedicating considerable resources to a campaign to curry the favor of the public and politicians is rational. On the other hand, the costs of the subsidy are spread thinly across the entire taxpaying public, meaning that it is not economically “rational” for people to invest much time or money in a countercampaign. The prosubsidy camp has both the resources and the incentive to dramatically outspend its opponents in a political system in which money can purchase results. This unequal contest in the political system can result in government subsidies even when the majority of the public would not reasonably support the policy.

The greater incidence of public subsidies of teams in North America compared with teams in Europe is caused in part by the tight control over the number of teams exercised by North American leagues. This control ensures that not all major markets contain teams, making threats of relocation highly credible. As noted earlier, in Europe the number of teams in a league is not similarly restricted. London, for example, had five teams playing in the English Premier division in 2003–2004 and numerous others toiling away in the divisions below.Virtually all major centers already contain teams with a strong traditional fan base, making it difficult for a team to pack up and move to another region and remain viable. Indeed, the only instance of such a move occurring in England in recent history was the move of Wimbledon to Milton Keynes. Not only was this move greeted with horror across the country, but also the team became known derisively as “Franchise FC,” and has attracted few fans in its new location, incurred massive debts, and was relegated from the first division in 2004.The limited possibility of team movement in Europe would make any owner’s relocation threat, on which most subsidy decisions in North America are based, quite hollow.

Economic Crisis?

Professional sports are going through something of an economic crisis. In both Europe and North America the easing of restrictions in the labor market has paved the way for dramatic salary escalation. Owners have responded in two ways. First, they have sought to convince, with varying degrees of success, fellow owners and players that new restrictions in the form of salary caps and revenue sharing are necessary.This effort has been truly successful only in the NFL, which is both the most profitable league and has the strongest salary cap and most revenue sharing. Second, teams have attempted to expand all of their revenue sources.This attempt has resulted in efforts to expand the sales of league merchandise around the globe (most aggressively by the English soccer team Manchester United, which has opened club superstores in several Asian locations) and pressure on governments to increase team revenues through publicly subsidized facilities. Despite these revenue increases, team owners still claim that they are losing money and are placing increasing pressure on player unions to reduce wages and on politicians to increase subsidies. Unsurprisingly, both strategies are being met with increasing resistance, making some people question the ability of these strategies to restore profitability.

Ian Hudson

See also Franchise Relocation; Sport Politics; Unionism

Further Reading

• Cairns, J., Jennett, N., & Sloane, P. (1986). The economics of professional team sports: A survey of theory and evidence. Journal of Economic Studies, 13, 3–80. 
• Danielson, M. (1997). Home team: Professional sports and the American metropolis. Princeton, NJ: Princeton University Press. 
• Dobson, S., & Goddard, J. (2001). The economics of football. Cambridge, UK: Cambridge University Press. 
• El-Hodiri, M., & Quirk, J. (1971). An economic model of a professional sports league. Journal of Political Economy, 79, 1302–1319. 
• Fort, R., & Quirk, J. (1995). Cross subsidization, incentives and outcomes in professional team sports leagues. The Journal of Economic Literature, 33(3), 1265–1299. 
• Hudson, I. (2002). Sabotage versus public choice: Sports as a case study for interest group theory. Journal of Economic Issues, 36(4), 1079–1096. 
• Jones, J., & Walsh, W. (1987). The World Hockey Association and player exploitation in the National Hockey League. Quarterly Review of Economics and Business, 27(2), 87–101. 
• Leeds, M., & von Allmen, P. (2002). The economics of professional sports. Boston: Addison Wesley. 
• Neal,W. (1964). The peculiar economics of professional sport. Quarterly Journal of Economics, 78(1), 1–14. 
• Noll, R. (1974). Government and the sports business,Washington, DC: Brookings Institution. 
• Noll, R., & Zimbalist, A. (1997). Sports jobs and taxes.Washington, DC: Brookings Institution. 
• Quirk, J., & Fort, R. (1992). Pay dirt:The business of professional team sports. Princeton, NJ: Princeton University Press. 
• Quirk, J., & Fort, R. (1999). Hard ball: The abuse of power in pro team sports. Princeton, NJ: Princeton University Press. 
• Rottenberg, S. (1956). The Major League Baseball player’s labor market. Journal of Political Economy, 64, 242–258. 
• Scully, G. (1974). Pay and performance in Major League Baseball. American Economic Review, 64, 915–930. 
• Scully, G. (1995). The market structure of sports. Chicago: University of Chicago Press. 
• Siegfried, J., & Zimbalist, A. (2000).The economics of sports facilities and their communities. Journal of Economic Perspectives, 14(3), 95–114. 
• Szymanski, S. (2003). The economic design of sporting contests. The Journal of Economic Literature, 41(4), 1137–1187. 
• Vrooman, J. (1995). A general theory of professional sports leagues. Southern Economic Journal, 61, 971–990. 
• Zimbalist, A. (1994). Baseball and billions. New York: Basic Books.