NORTHWESTERN BUSINESS REVIEW Friday - Oct 31, 2014

Why Certain MLB Teams Can Afford Star Players and Others Cannot


Major League Baseball’s “Hot Stove” season is heating up.  Former three time National League MVP Albert Pujols recently signed a ten-year contract with the Los Angeles Angels of Anaheim, worth over $250 million.  Even some of the league’s poorer teams have chosen to spend big this winter.  The Miami Marlins committed nearly $200 million so far this off-season, signing shortstop and former National League batting champion Jose Reyes and pitchers Mark Buehrle and Heath Bell to free agent contracts.  The Texas Rangers just paid $51.7 million just for the rights to negotiate with Japanese pitcher Yu Darvish.  How can some teams, such as the Angels and the Rangers, afford to spend enormous amounts of money on star athletes, while others can only pay “scrubs” smaller salaries?  And, more importantly, does the size of a team’s payroll really matter?

Big and Small Market Teams: Why Are Some Team’s Payrolls Larger Than Others?

Sports writers and league employees typically refer to baseball teams as belonging to one of two groups: big-market teams and small-market teams.  Specifically, the “big-market” designation refers to those teams that play in the nation’s consolidated statistical metropolitan areas (CSMAs); “small-market” refers to teams that play in smaller CSMAs.  In Major League Baseball, the New York Yankees, New York Mets, Chicago White Sox, Chicago Cubs, and the Boston Red Sox are undoubtedly “big-market” teams.  The Cincinnati Red, Kansas City Royals, and Milwaukee Brewers are “small-market,” teams while the rest fall somewhere in the middle.

While the size of the market refers only to the population of the respective city, it is also closely correlated, in most cases, to the amount of money that a team will spend on players.  In general, teams in “big markets” attract more fans, allowing them to raise ticket prices. This is a simple principle of economics.  The larger the fan base, the greater the demand for tickets.  Ticket supply is relatively constant; a stadium can only hold so many people.  As a result, prices rise. Larger ticket sales and higher ticket prices together increase a team’s revenue, allowing team owners to reinvest more money into their organization while still turning a profit.

There are notable exceptions, however.  Owners of big-market professional baseball teams may decide, for a number of reasons, to cut payroll and spend more like a middle-market or even small-market teams.  For example, over the past few seasons, Fred Wilpon, the owner of the New York Mets, has lowered the team’s payroll by many millions of dollars.  On Opening Day of the 2009 MLB season, the Met’s total payroll was over $135 million—the second highest in the league.  At the start of the upcoming 2012 MLB season, the club’s payroll is projected to be closer to $100 million.

On the other hand, small market teams sometimes overspend, hoping that a higher payroll—and the signing of marquee talent—will attract a larger fan base.  For example, the Miami Marlines—previously the Florida Marlins—play in one of the leagues smallest markets.  (The team frequently struggles to draw fans and played a game in front of a dismal crowd of 347 this past August.)  The Marlins, however, have rebranded themselves this year.  The team will be moving to a new stadium for the 2012 season and recently released images of its new uniforms.  Considering the circumstances, the Marlins’ owner, Jeffery Loria, has spent a large amount of money so far this offseason; the 2012 Miami Marlins’ payroll will be almost twice the team’s 2011 payroll.  The size of an organization’s payroll is, in the end, completely up to its owner.

The Cost of Winning Games: Does a Larger Payroll Really Matter?

There is a clear gap between the league’s richest teams and the league’s poorer teams.  At the beginning of the 2011 season, the New York Yankees had the league’s highest payroll; an astonishing $202,689,028.  Meanwhile, the league’s poorest team—the Kansas City Royals—had a payroll of only $36,126,000.  (To make the comparison even more shocking, consider this: the New York Yankees highest paid athlete last season was Alex Rodriguez who earned $32 million, almost as much as the entire Kansas City Royal’s payroll.

But does this payroll gap really matter?  Recently, CNBC’s sports business journalist (and Northwestern alum) Darren Rovell reported a study focusing on this very issue.  During the period from 2001-2010, 61.5% of the league’s playoff teams were among the top 10 biggest spenders; 23.1% ranked 11th-20th in total end of the year payroll and 15.4% were among the league’s poorest 10 teams.  The evidence is clear: teams in the top third in overall payroll have almost twice the chance of reaching the playoffs than other teams.

The data is even more startling when examining the payrolls of World Series winners.  Of the ten World Series champions from 2001-2010, six ranked in the top ten in end of the year payroll.  The remaining four teams all belonged to the middle ten.

While a team doesn’t have to be the league’s richest to win the World Series—the New York Yankees had the highest payroll each year from 2001-2010 and won only one World Series (2009)—teams generally benefit from having a higher payroll.

Despite the general trend, there have been examples that defy the common logic.  Rich teams have crashed and burned; the New York Mets, for example, have accumulated a payroll of over $100 million each of the last few seasons, but have not made the playoffs since 2006.  Last year, with a payroll of nearly $119 million, the Mets won only seventy-seven games, and by the end of the season was barely competitive.  Less commonly, poor teams have succeeded, playing over their heads and exceeding expectations.  By example, in the early 2000s, the Oakland Athletics, with one of the lowest payrolls in the game, ranked at or near the top of Major League Baseball in total wins.

Creating Competitive Balance: Major League Baseball’s Collective Bargaining Agreement

Major League Baseball’s collective bargaining agreement (CBA) includes multiple conditions that, when read together, attempt to create competitive balance.  First, the league’s collective bargaining agreement puts in place a system of revenue sharing.  Under the system, the league redistributes wealth away from richer teams towards poorer teams.  Every team is required to deposit a percentage of their local revenues into a pot at the end of each season.  Luxury tax funds and a portion of the league’s “Central Fund”—comprised of monies from television contracts and the like—are also put into the pot.  The pot is then redistributed amongst the thirty different teams, with poorer teams—such as the Oakland Athletics and Pittsburg Pirates—receiving larger portions of the pot.

While the league’s revenue sharing system succeeds in redistributing wealth, it does not significantly improve parity amongst the teams.  Rich teams still spend large amounts of money on team payroll, regardless or revenue sharing.  While it can be argued that revenue sharing is meant to benefit poorer teams rather than penalize richer teams, the system fails.  In many cases, teams receiving large portions of the pot misuse the funds.  Rather than investing in a higher payroll and signing better talent, MLB organizations sometimes use the shared revenue to otherwise increase profits.

More importantly, the league’s CBA implements a luxury tax.  Simply put, organizations that spend over a specified amount of money in total payroll face a monetary penalty for their actions.  The luxury tax threshold varies from year to year and is stipulated in the CBA.  For the upcoming 2012 season, the threshold is $178 million.  The amount paid depends on the offense.  First time offenders must pay 22.5% of salaries above the threshold.  Second times offenders must pay 30% and third (and sequent) time offenders must pay 40% of salaries above the threshold.

While the luxury tax attempts to deter teams from spending huge amounts of money, it has had little effect in increasing parity between big- and small-market teams.  Since the tax was first implemented in 2003, only four organizations have been penalized.  Over the nine-year period, the New York Yankees have paid over $192 million in penalties.  The Boston Red Sox have been penalized approximately $15 million, the Los Angeles Angels of Anaheim $1.3 million, and the Detroit Tigers under $1 million.

Why has the luxury tax proven ineffective?  The most likely answer is that the threshold has been placed too high.  The average team payroll at the beginning of the 2011 season was approximately $93 million, just over half of the luxury tax threshold.  Moreover, only three teams were even close to the limit: the New York Yankees ($202.7 million), the Philadelphia Phillies ($173 million), and the Boston Red Sox ($161.8 million).

Improving the System: What does Major League Baseball Need to do to Achieve Competitive Balance?

Major League Baseball’s current luxury tax has done little to improve the league’s competitive balance, but would the league benefit from a different, more stringent system?  Should Major League Baseball adopt a salary cap?  Of the nations four major professional sports leagues, MLB is the only league without a true salary cap.  The NHL adopted a hard salary cap for the 2005-06 season.  Under the new CBA adopted in the summer of 2011, the NFL also adopted a hard salary cap of $120 million and a salary floor of $108 million.  The NBA’s salary cap is a “soft” cap; teams cannot spend above a certain payroll threshold except in the case of certain “exceptions,” included in the league’s new collective bargaining agreement.  For example, under the “Larry Bird” rule, teams are allowed to spend above the maximum payroll in order to re-sign their own free agents.

While evidence on competitive balance in the NHL, NFL, and NBA is scarce—the NFL and NBA are in the first year of their new CBAs—the systems draw an interesting comparison to MLB’s luxury tax.  A hard salary cap is an interesting option, disallowing teams from spending above a predetermined amount under any circumstances.  However, if MLB were to adopt a hard salary cap with a threshold similar to the current luxury tax threshold—as one might assume—the cap would be ineffective, restricting the spending of only a few teams.  Similarly, a soft cap would also prove ineffective.  In essence, MLB’s luxury tax is a form of a soft cap.  Teams are given a threshold that they are not allowed to exceed.  If teams choose to generate a payroll above the threshold, they are penalized or taxed.  The tax is like the exceptions present in the NBA’s soft cap.

The system currently in place under the NFL’s CBA provides the best solution the Major League Baseball’s concerns.  Not only will teams be disallowed from generating a high payroll, but they would also be banned from spending too little money on major league talent.  The system could be particularly effective in MLB, where astonishingly low payrolls are almost as big of a problem as high payrolls.

Unfortunately, Major League Baseball seems particularly hesitant towards adopting a hard salary cap or a salary floor of any kind.  In the recent labor talks that concluded in early December, team owners and the league’s players’ association debated the institution of a luxury tax in reverse.  Under the proposed system, there would be a threshold at the lower end of the payroll scale.  Teams that spend below the threshold would be hit with a tax, just as teams that spend above the current luxury tax threshold are penalized.  Not surprisingly, the system was not adopted.  Team owners—particularly the owners of the league’s poorer teams—want to ability and opportunity to keep costs down.

With a new CBA adopted only a month ago, Major League Baseball’s luxury tax system will remain in place for at least the next five seasons, effectively ensuring that a competitive balance will not be achieved.

Photo Credit: The Associated Press

About Dylan Kraslow

Dylan is technology editor for NBR. He primarily writes about the start-up space and the business of sports.

2 comments
  1. Chia Golston

    February 25, 2012 at 6:02 pm

    Anyone saw that Dirk’s anticlimactic walk to the locker room as an antithesis to everything about the Miami Heat?

    Reply
  2. Nik

    April 28, 2012 at 4:17 pm

    Should the MLB create a salary cap to make MLB more competitive?

    Reply

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