Fundamental Economics: High Salaries of Pro Athletes Are Justified

Going to a professional baseball game is as American as apple pie.  Our “national pastime” has garnered fans of all ages and continues to have a dominant role in our society and culture.  As the popularity of baseball and other professional sports have increased over the years, so have the salaries of the athletes who play the game.  Many people complain about the enormous salaries that these athletes receive.  A common sentiment is that athletes are paid far more than their relative “worth” in comparison to such jobs as teachers, doctors and firefighters who all perform essential work that our society cannot do without.  In simplistic terms the massive difference in salaries may seem unjust.  However, through fundamental economic reasoning, we will discuss why athletes deserve their large wages as well as the consequences when athletes are paid too much.

As with any company, the owner is the person that ultimately determines the worth of a particular employee in the form of how much they are willing to pay for their services.  Owners of pro sports teams must carefully examine their potential investments (players) in order to avoid paying too much, which could have catastrophic financial implications.  In many cases the wage of a particular athlete is directly proportionate to the revenue in which they create for their franchise, at least that is the intention.  In 2000, Tom Hicks, owner of the Texas Rangers, signed Alex Rodriguez to one of the most lucrative contracts in baseball history- $252 million over 10 years.  Mr. Hicks did not arbitrarily arrive at this staggering number, but rather he had to estimate the “worth” of Rodriguez in terms of additional revenue he will create.

Marginal Revenue Product

One way to calculate a player’s worth is to measure their Marginal Revenue Product (MRP), which takes into account a player’s past performance, marketability potential, as well as physical attributes such as age, experience, height, etc. in order to gauge a player’s market price.  In this environment the player would likely be paid close to the highest expected MRP.  Since this decision is based largely on limited information and uncertainty, we typically see that athlete wages are far above the actual MRP.  The team that offers the largest wage above the actual MRP secures the player, which consequently results in the player being paid far more that he is actually “worth.”

Before offering Rodriguez a contract, Mr. Hicks had to compute the change in revenue from the franchise when employing one more unit of labor; in this case the additional unit of labor was Alex Rodriguez.  According to economic theory, the cost of employing Rodriguez must not exceed the additional revenue that he is expected to generate for the Texas Rangers.  If the additional revenue generated is less than the $25 million per year that it costs to employ Rodriguez then the investment is deemed a failure, as the team will lose money.  However, if the additional revenue exceeds the cost then Rodriquez’s outrageous wage is justified.

Ideally, the owner of a team expects that each of his athletes will generate additional revenue for their team beyond the wages the athlete receives.  If a players is able to generate multiple millions of dollars in revenue then his worth is just that- multiple millions of dollars per year.  Therefore it is economically justified for pro sports owners to offer such lucrative contracts because they understand the marginal benefit exceeds the marginal cost.  If the opposite were true and marginal cost exceeded marginal gain then the owners simply would not employ those athletes.

Miscalculating MRP and its Consequences

In 2004 Alex Rodriguez was traded to the New York Yankees.  A player being traded to a different team is very common in professional sports however this particular trade was rather unique.  In retrospect it appears as though Rangers’ owner Tom Hicks made a major miscalculation in determining Rodriguez’s worth.  A stipulation of the trade with the Yankees was that Hicks must pay $67 million of the $179 million remaining on Rodriguez’s $252 million, 10-year contract.  In the end, Hicks reduced his labor by one unit (Rodriguez) yet he is paying roughly $9.5 million per year and is receiving zero output since Rodriguez is not even on his team.  Hicks’ major blunder in assessing Rodriguez’ MRP had major financial implications on the team’s bottom line.

Supply and Demand

The large contract offered to Alex Rodriguez is a great example of economist Adam Smith’s theory called “diamond-water paradox.”  Water is an essential component to fostering life, however a diamond ultimately has little significance.  However a diamond is worth far more on market than water.  Fundamental supply and demand principals help unravel this anomaly.  Simply stated, the supply of water is far more abundant that that of diamonds.  Since diamonds are relatively rare, the demand is much higher and therefore the price is higher.  Conversely, water is not a scarce resource, which creates a low demand and thus a low price.  This is exactly the case with professional athletes.  There is a large demand for high quality athletes and owners will pay top dollar to sign them.  Additionally, the actual supply of high quality athletes is rather small.

This is not the case with the majority of other profession such as firefighters, gardeners or doctors.  Economist Sherwin Rosen proclaims some tasks have become so routine that any competent person will achieve the same outcome.  As such, it is much easier for a person to attain the skill necessary for a given task.  For example, there is not much difference in terms of outcome when the best gardener weeds a yard versus the second best gardener, or even the worst gardener as the task is rather restrictive.  This is not the case in pro sports.  The outcomes vary greatly.  Since winning is at a premium, owners will often overpay to secure superior talent no matter how minute the difference in talent may actually be. According to Rosen, sports are such that poor talent is an inadequate substitution for superior talent.  Said another way, pro athletes are far more specialized than their counterparts in other areas of the labor market.  Increased specialization leads to increasing differences in relative income.  So, whether or not you agree with athletes receiving large salaries is irrelevant.  The open market has determined that pro athletes’ outrageous salaries are economically justified.  However, if you’re a pro team owner, be cautious as a miscalculation can have dire financial consequences- just as Tom Hicks.

This entry was posted on December 16. 2008 at 13:11 and is filed under sports. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or trackback from your own site.