Advisory Board Notes: Stanford's Roger Noll Takes a Look at the Economics of Major League Baseball's Downsizing

Nov 27 2001
Commentaries

A Stanford Institute for Economic Policy Research (SIEPR) study by AAI Advisory Board Member Roger G. Noll, published with permission. Nov., 2001.

The Economics of Baseball Contraction

by Roger G. Noll

The proposal to reduce the number of major league baseball teams by two raises an interesting issue concerning the financial incentives of baseball owners in contraction. This note examines whether the proposed contraction makes sense financially to both the owners that would fold their teams and the remaining owners who would pay for the contraction. The core question is whether there exists a price at which all or nearly all 30 teams would be made better off if contraction took place.

To address this question the following analysis estimates the benefits and costs of contraction to both the folding and surviving franchises. Baseball releases only selective and incomplete information about team finances, and the most recent year for which even this information was made available is 1999 through the report of the so-called Commissioner's Blue Ribbon Panel (available at www.mlb.com/NASApp/mlb/mlb/official_info/mlb_official_info.jsp). Consequently, the analysis in this essay is based on rough estimates of baseball finances. Nevertheless, the errors are not likely to be so large that they fundamentally alter the results.

The main conclusion from this analysis is that the remaining Major League Baseball (MLB) teams have a powerful financial incentive to eliminate the Montreal Expos; however, to maintain an even number of teams, MLB must eliminate one more franchise, and therein lies the the financial benefit from folding the Expos. Because eliminating two teams is not attractive financially, contraction must be motivated by other objectives, such as collective bargaining strategy, expansion objectives, or the quest for stadium subsidies in cities that have not yet built a state-of-the-art baseball park.

Payments to Folding Teams

According to press reports, the 28 remaining teams plan to buy two franchises. The most prominent candidates are Florida (Miami), Minnesota, Montreal and Tampa Bay, with some mention made of Anaheim and Oakland. The price paid to the folding teams has not been disclosed (and perhaps has not been decided), but published estimates range between $135 million and $250 million. Because MLB's rules require that three-fourths of the teams must agree to a major action such as this, nearly all teams must believe that a price in this range is reasonable. In addition, to avoid protracted and possibly unsuccessful litigation, the teams to be eliminated must also fold voluntarily, which means that they, too, must regard the sales price as attractive.

From the standpoint of the teams that might fold, contraction is attractive only if the price paid is roughly equal to the market value of the franchise if it were sold as continuing enterprise. Even the low figure of $135 million is more than the value of Montreal, the least-valuable current franchise, if the Expos are doomed to stay where they are. The lower number is within the ballpark as an estimate of the market value of the other weak franchises in baseball, including Kansas City as well as Florida, Minnesota and Tampa Bay. A few other teams are in slightly better shape but probably worth less than $200 million, including Oakland - again, assuming no relocation. Nevertheless, the market price of all of these teams would be substantially greater if the teams can relocate.

The market price of the weakest teams is not easy to estimate because it depends not only on whether the teams would be permitted to move, but the magnitude of relocation benefits, such as a subsidized stadium, that potential new franchise sites are willing to provide. Among the potential relocation sites, Northern Virginia (Washington, D.C.) probably is the closest to being ready to provide an attractive stadium deal. The market value of a team in the D.C. area, assuming a mostly free state-of-the-art stadium, would be near $500 million; however, because several teams might be willing to relocate if the opportunity arose, competition among them would drive down the subsidy to the point at which other cities were willing to enter the bidding for those teams. In addition, the market value of a Northern Virginia franchise would be suppressed if MLB ruled that the new team had to compensate the Baltimore Orioles for invading the Oriole's territory.

The other cities that are potential relocation sites, in roughly their order of attractiveness to a team owner, are the New Jersey suburbs of New York, Charlotte, Portland, Las Vegas, New Orleans, Sacramento and Nashville. In addition, San Jose is a very attractive relocation site if the Oakland A's either fold or relocate.

New York easily could support a third team and probably is the single most attractive site for a team to relocate; however, the Yankees and the Mets have a better case than the Orioles that a New Jersey team would invade their territory, and so are more likely to succeed in demanding compensation for placing a third team in the New York area, which would suppress the value of a Jersey franchise. Nevertheless, even assuming a substantial compensation ($100 million each), a franchise in New Jersey, if it comes with a new rent-free stadium, would still be worth on the order of $400-500 million.

No prospective location other than Northern Virginia has committed to provide a stadium, and Charlotte, when given the opportunity to attract the Minnesota Twins, rejected the idea. Nevertheless, from among this list, one more city probably would be willing to provide a subsidized stadium, in which case the market value of a team that was available to relocate there would be in the range of $200-400 million, depending on the details of the stadium deal. By comparison, the price of a franchise in the 1997 baseball expansion was reported as $200 million for two sites, Arizona and Tampa, that are not as attractive as Northern Virginia or New Jersey, and roughly comparable to the rest. In practice, because this fee was amortized over several years, the actual cost was more like $150 million; however, since that expansion, baseball's income has increased substantially, including a large increase in television rights fees, so that baseball teams in even the lower rung of markets are worth substantially more today than they were in 1996.

Because alternative sites in which existing teams would be worth at least $200 million are available, this number represents a realistic lower bound for the price that the remaining teams would have to pay to induce two weak franchises to fold voluntarily. Moreover, an amount in this range also is likely to be the practical lower bound as well. If Major League Baseball offered substantially less than the value of the team in the best alternative location, an option available to an owner of a team targeted for contraction would be to sue baseball for damages equal to the difference between the price that baseball offered and the value of the team elsewhere. If Major League Baseball (MLB) follows its own rules, it can only force a team to fold if it is seriously violating league rules or not fielding a representative team. Because the on-field performance of the weakest teams is not below the historical standard of performance for a team to remain in good standing within the sport, the remaining owners would face a serious legal hurdle to justify simply forcing any team out of the sport.

MLB could claim that a lower price for folding teams is justified because the sport would not permit the teams to move, but this, too, is an argument that would face difficult sledding in court for two reasons. First, MLB has allowed teams to move in the past, and in recent years has allowed some teams to use the threat of relocation as a lever to obtain stadium subsidies. Second, in at least some cities willing buyers at prices exceeding $200 million would be easy to identify. Most likely, MLB would prefer simply to pay a reasonable price for these franchises than to fight a protracted legal battle that it could lose. Thus, the most likely price to be paid to the folding teams is in the upper range of the reported numbers.

The costs of contraction involve more than simply buying the teams. One potential liability for the owners is the unexpired portion of the stadium leases of the teams that are being eliminated. Already a state court has ruled that the Minnesota Twins must be permitted to play out their contractual agreement with the local stadium authority, but even if this decision is overturned on appeal, baseball still is likely to have to pay damages to the stadium authority for breaking the lease.

Another potential liability is the unexpired portion of multi-year contracts for players who do not make another major-league roster. Folding two teams will eliminate 50 major league positions, and at least some of the players who will be dropped or demoted to the minor leagues will file a grievance if they do not make a major-league roster and their salary commitments in their existing contracts are not honored.

Still another potential liability will arise from folding twelve minor league franchises that have working agreements with the two teams that are eliminated. Minor league baseball is booming, with AAA franchises commonly valued at $20 million or more, and even A franchises selling for several million. MLB could face the prospect of being forced to buy out twelve minor league teams as well as the two major league teams, and a total cost of over $50-75 million. And MLB also may be required to pay damages for breech of contract for each of the stadiums in which these teams play.

Although we can not say precisely how much MLB will have to pay to eliminate two franchises, the cost of buying out the two major league franchises are likely to be at least $400 million, and including litigation costs, the costs arising from problems with stadium leases, player contracts and minor league agreements probably will add at least another $100 million. Thus, the price tag for folding two teams is likely to be at least $500 million, and easily could be more.

The Benefits of Contraction to Existing Teams

Nearly all of the benefits from contraction for the remaining 28 teams arise from the effects on two important sources of shared revenues.

The first significant benefit is that each remaining team would receive a larger amount from "central revenues" - the revenues that are collected by MLB for broadcasting and licensing rights, and then split evenly among all teams. These revenues amount to about $20 million per year, with the largest component being the roughly $14 million per team per year that is paid by Fox for its television rights.

The second main benefit is that two weak teams no longer receive windfalls from the sharing arrangements currently in force for local revenues. Under current rules, each team contributes 20 percent of its "net" local revenues (gross revenues from ticket sales, premium seating, concessions and local broadcasting minus an allowance for in-stadium costs) to a central pool, which in 2001 amounted to about $400 million. About $300 million (75 percent) of the pool is paid in equal amounts per team ($10 million each), and the rest is paid to teams with below-average revenues, based on the difference between the team's revenues and average revenues. These payments average about $8 million for the 12 teams with the lowest revenues.

The teams that are possible contraction targets have much smaller local revenues than the rest of MLB. For example, in 2001, Montreal drew 642,745 fans for its home games, which probably yielded about $8 million in ticket revenues. By contrast, the average attendance for the other teams was about 2.4 million, with ticket sales in the range of $35-40 million. Montreal receives in the range of $12 to $15 million in net local revenues, while the baseball average is in the range $65 to $70 million. As a result, Montreal pays under $3 million per year into the revenue sharing pool, but it probably receives back about $28 million, for a net gain of about $25 million. Thus, taking both central fund income and revenue sharing into account, if Montreal folded, the net effect on the remaining teams would be to increase revenues by about $45 million.

The other contraction targets had far higher attendance than Montreal. Attendance in these cities was: Miami - 1,261,226; Tampa - 1,298,365; and Minnesota - 1,782,926. Net local revenues for these teams probably are in the range of $40-50 million. These teams benefit from revenue sharing, but not by nearly as much as Montreal. Thus, folding one of these teams would boost the revenues of the remaining teams by about $25-30 million.

Although the contraction proposal has been tied by the press to player salaries, in reality contraction is not likely to have an effect on player salaries. Whereas in the year of contraction there will be more "major league players" than positions on teams, the effect of contraction will be that the weakest MLB players are demoted to the minor leagues. These players, for the most part, earn low salaries (at or near the league minimum) and do not offer playing skills that will enable them to compete for positions with front-line players. Because baseball attendance and revenues depends more on the relative performance of a team than on the absolute quality of play, the best free-agent players will continue to command large salaries because they will continue to attract more fans. Hence, contraction is not likely to have a significant effect on the amount that each of the remaining teams pay in player salaries.

Another possible effect of contraction is on average attendance of the remaining teams. All four of the teams that are mentioned as contraction targets have below-average attendance at away games. In 2001, the away attendance of this group ranged from 2,089,480 for the Marlins to 2,289,466 for Tampa Bay. These figures are slightly below the average of 2.4 million, so that the remaining teams might experience a slight attendance and revenue increase if they play more games against the remaining teams. However, this effect could be offset by the fact that some other weaker teams will end up winning fewer games. In most seasons, the contraction targets win fewer than half their games, so that eliminating them will cause a net reduction in wins for the weaker remaining teams. Because baseball attendance is highly sensitive to the won-loss record of the home team, some franchises can be expected to suffer at the gate if contraction takes place, especially teams that are already fielding below-average teams and earning below-average revenues. The magnitude of this effect is unknown, but could be significant for some teams.

In addition, MLB runs some risk that some fans will be sufficiently repelled by contraction that they will attend fewer games, and watch fewer games on television. After the strike of 1994, baseball suffered at the gate, and did not fully recover for three years. Because MLB has not contracted before, the effects of folding two teams are unknown, unless, of course, contraction precipitates another strike, in which case the losses to baseball will be far greater than any of the costs and benefits considered above.

In summary, the net benefit of contraction to the remaining teams will be about $45 million annually in the case of Montreal and about $28 million in the case of the other contraction targets, not counting the risks to attendance discussed above. Whether this is an adequate return to the cost of contraction depends on the target rate of return of the owners, but assuming that the target pre-tax rate of return is about 14% (as it is for American investors in general), then, at a price of $200 million per team plus $50 million in other costs (such as folding minor leagues teams), owners would need to expect a return of $35 million to find the deal worthwhile. Thus, Montreal probably is worth folding from the standpoint of the rest of the teams, but the other weak franchises probably are not. Because symmetry of scheduling requires folding either two teams or none, the remaining teams probably are facing a roughly break-even decision. Taking into account litigation costs and the effect on the attitudes of fans, MLB probably will be left slightly worse off folding two than not folding any.

Other Motives

The preceding analysis does not take into account many other factors that should enter into the owners calculations. The first is the effect on the collective bargaining negotiations with the players. Perhaps the owners believe that contraction will disrupt the unity of the players association. There simply is no way to estimate reliably whether the contraction announcement will harden or soften the position of players, and thereby increase or reduce the costs to the owners of successfully negotiating a new agreement. Most likely, neither the owners nor the players truly know what the effect will be, in which case the contraction threat introduces significant financial uncertainty to the short-term future of baseball. Uncertainty itself is a form of financial cost - for example, will contraction-induced collective bargaining troubles reduce season ticket sales for 2002? If there is a chance that this will happen, the financial attractiveness of contraction to the remaining teams is further reduced.

The second motive could be that the owners want to replace the relocation of teams with a formal expansion process. Rather than move, say, Miami and Montreal, they may seek to have the cities that now lack a team enter a bidding process for new expansion franchises. For this to work, MLB must be able to buy existing franchises for a lower value than the expansion fee. Most likely, the market value of an existing team that can relocate is less than the expansion fee for a new team. When a team relocates, it usually suffers at the gate when it is playing as a lame duck in its old city. Some of this cost is passed on to other teams as the lame-duck collects more revenue sharing when its own revenues tank. Since the new location is not likely to build the stadium until a commitment to move is made, an existing team can suffer two or three years of poor revenues after the move is announced but before it can be completed. No such problem arises if contraction is followed in two or three years by expansion.

Because the weakest teams already have very small revenues, this effect is not likely to be very large. Montreal's financial performance can not be materially worse than it already is. For the other teams, this effect could amount to on the order of $20 million over three years, which creates a financial incentive to fold them now and then expand, rather than to relocate.

The third potential motive is to put more pressure on cities to pay a larger share of the cost of state-of-the-art stadiums. The stadium boom is showing signs of abating, with the San Diego deal on hold and new stadiums being rejected in Charlotte, Minnesota, and Montreal. By punishing two recalcitrant metropolitan areas for not providing a new stadium, baseball may believe that it will generate more political will to provide stadium subsidies.

The upshot of this analysis is that the MLB owners are not folding two teams because it will materially help the finances of existing teams. For contraction to make sense, the owners must be motivated by these other factors. Whether contraction makes sense from the perspective of the owners depends of many factors that are uncertain, including the reactions of fans, players and local governments. At best, MLB is rolling the dice, because it can not possibly know whether contraction will weaken the players union and cause cities to be more willing to subsidize baseball stadiums, while avoiding a negative response by its customers.