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The Perils of Revenue Sharing

2010 August 23
by Victor Matheson

This report from ESPN highlights one of the incentive problems associated with revenue sharing. According to leaked financial documents, the Pittsburgh Pirates, despite (or perhaps because of) fielding one of the worst teams in the league, managed to earn large profits in both 2007 and 2008 due to a combination of low payroll and high league revenue sharing. Several sports economists are quoted and all tend to agree that the Pirates are making profit maximizing decisions given the system in which they operate. “If they won and were forced to increase their payroll from $34 million to $75 million or $80 million … how profitable would they be? There’s a ceiling in terms of gate revenues, ” said Dave Berri and Roger Noll, a Stanford University economist, follows with, “Probably the Pirates would be less profitable if they tried to improve the team substantially.”

So what are possible solutions to this sort of incentive problem given the desire to allow small market teams to compete? At least two solutions present themselves, and perhaps my colleagues or our readers can devise some more.

1. Institute a salary floor (perhaps in combination with a salary cap). While the salary cap gets all the press, the NFL also has a salary floor.
2. Base revenue sharing on market potential rather than actual revenues. Under the current system a small market team that performs well and sells a bunch of tickets get penalized for their success. While a market potential system would not eliminate the incentive problem, it would reduce it. Obviously, determining the market potential share would be tricky.

It should also be noted the Pirates received over $200 million from local taxpayers to build PNC Park. The poor performance of the team has significantly shortened the honeymoon period of the stadium leading to little long-term boost in attendance. Furthermore, it’s not clear that spending tax dollars to ensure large profits for the owners and 100-loss seasons for the fans was exactly what taxpayers had in mind.

Update (blame thank Skip…):  Deadspin has posted financial statements for the Pirates, Rays, Marlins, and Angels.  And here in part 2 for the Mariners.

Update 2: A quick look at page 3 of Tampa’s financial statement further shows the problem. In 2008, the Rays went out and resigned their young talent, spent an additional $20 million on payroll (a 58% increase over their 2007 spending), went to the World Series, and… made $7 million less than the year before.

18 Responses
  1. August 23, 2010

    Vic,

    It’s not revenue sharing per se, but the lack of an incentive to win. Like MLB, the EPL shares some revenue. But the trap door of relegation solves the incentive problem: the worst clubs have a limited ceiling, but they fight like the dickens to stay up. The Pirates don’t face the same cost of fielding a weakened team.

    Skip

  2. Victor Matheson permalink
    August 23, 2010

    Full credit to Skip for suggesting a promotion relegation system to solve the revenue sharing incentive problem. I almost listed that one myself, but stopped myself when I estimated the chance of MLB adopting such a system was approximately 0.000001%. Still, I would give full passing marks for that answer.

    Of course, even promotion/relegation doesn’t completely eliminate the problem. A team may still decide that dumping payroll and cashing in for one season before being demoted is the profit maximizing strategy. It’s just that the Pirates get to do this for 15 years in a row.

    P.S. Extra credit to Skip for posting links to the financial statements. Fun reading!

  3. Jason Winfree permalink
    August 23, 2010

    If you don’t like small market teams making large profits by fielding low quality teams, why not just get rid of revenue sharing? Revenue sharing just seems like a mechanism to keep salaries down and increase profits for small market teams. I’m not really sure how sharing revenue based on market potential would work. If you mean that small markets don’t share revenue, then that seems similar a luxury tax. I think your right that if you really want small markets to compete it seems like a cap or a stricter luxury tax (or maybe relegation) would work much better. But this all assumes that the goal of sharing is to help the Pirates win, which might not be the case.

  4. zlionsfan permalink
    August 23, 2010

    While a relegation system may encourage weaker teams to fight harder to win, it isn’t exactly an incentive to win, simply an incentive not to lose too often, and even at that, the consequences of relegation can be long-lasting. Without the financial benefits of playing in the EPL (larger crowds, better TV contracts) and with the ensuing consequences (less money to attract and retain top players), even a one-season stint in the Championship can cripple a club’s ability to compete in the Premiership even if it does subsequently win promotion.

    Through 18 seasons of the current structure, 23 of 53 promoted clubs have been relegated the following year. The average stay in the top flight for these clubs is less than 4 seasons; only two clubs (Newcastle United, Middlesbrough, Fulham, Blackburn Rovers, and Bolton Wanderers) have stayed up for 10 seasons or more, and only the last three are still there, although Newcastle won promotion back to the top flight for the current season. (The last three are actually entering their 10th consecutive seasons in the EPL.)

    Hardly any clubs winning promotion make more than a splash before sinking back into the bottom half of the table. The argument could be made that rather than increasing competitiveness throughout the league, the current relegation system simply strengthens the top teams; every team that falls into the Championship is another team that will find it next to impossible to contend at the top level should it return, and almost without exception, that team is replaced by another team lacking the infrastructure to challenge for a title.

    Newly-promoted teams have their hands full just avoiding relegation: 2001-02 was the only season where none of the three newly-promoted teams were subsequently relegated, and perhaps by no coincidence, all three are still there (the three mentioned above). There’s no guarantee they would fare any better if relegation weren’t lurking around every corner, and the current system does add quite a bit of excitement to the bottom of the table, but I’m not convinced it would address these issues even if it were possible to use it in baseball or other sports here.

  5. August 23, 2010

    Revenue sharing is essential to provide 30 MLB teams. The incentive to have a poor team to maximize shared revenue receipts is a problem, but the suggested cures, such as spending on player salaries does nothing except cause inflation in that salary segment. Maybe a system that compensates teams to the point they lose just a little money (1% ) would be better. Then teams would invest to increase revenue, be protected on the down side, and even large market teams would have an incentive to spend as well. However, that raises the issue of overall inflation that would occur if financial responsibility was cast aside and that would cause greater problems in MLB. The old MLB rule that for every action there is an equal and opposite reaction comes in here. So we can tamper with the revenue sharing system, but having Pittsburgh make money actually makes some sense, and we may lose from the tampering. Revenue sharing, after all, simply recognizes that all revenues are jointly created and should be shared as well. That is how leagues optimize efficiency.

  6. Ken permalink
    August 23, 2010

    Promotion/relegation can’t work for MLB. By way of being 81 games long and a sport that is significantly more dependent on local revenue (than, say, the NFL), baseball needs to have large populations to support teams.

    To go to promotion/relegation you either have to have situations where Las Vegas is playing in the Majors with a 10,000 person stadium, or you tell the taxpayers of these cities to build 35-45k person stadiums, I think we all know how well taxpayers building stadiums works out.

    There aren’t enough markets out there to make relegation work for MLB.

    Side question: What happens to the draft if any sport goes to promotion/relegation (the NBA is the sport that would make the most sense to switch to relegation, less games, smaller stadiums, one player can make a huge difference, more national following)

  7. Frank permalink
    August 23, 2010

    So the general theory on revenue sharing is that small market teams need the money to be competitive so that “everyone” is interested in the game and can support a team that has a chance to win a championship, right? That is, theoretically, people won’t watch baseball if the World Series is only drawn from a pool of 5 teams, and this financial support is supposed to be beneficial to national popularity of the sport to build a wider TV audience and maximize total revenue, right?

    But what if that’s not the case? What if the most overall revenue generating scenario is one where certain teams are ALWAYS winners.

    The equilibrium may be for the Yankees, Red Sox, Mets, Giants and Dodgers to be perennial winners and generate the bulk of revenue via television rights, merchandise, etc. and for the Royals, Pirates, Marlins to be perennial losers to serve as victims of these revenue generators (and boost national ratings of the Big 5 franchise by offering that sport in valuable markets).

    A good deal for the owners who all make the most money possible, not so much for fans in KC, Pittsburgh and Miami…

  8. Dan permalink
    August 23, 2010

    Ken:

    The other problem with MLB relegation (besides AAA teams needing major league stadiums) is that all teams have affiliates at AAA and AA levels. What happens if Louisville, the AAA affiliate of the Reds and stocked with their best prospects is promoted? If they lose the players on the Reds 40 man roster where do they go for replacements? Free agency? Good luck with that.

    The AAA teams would have to stock their teams separate from any MLB team and that would go against the primary purpose of minor leagues. When you combine the lack of MLB stadiums and the roster problems, relegation has zero chance of happening. A 0.000001% chance is wildly overstating the probability of relegation.

  9. Steve H in SLC permalink
    August 23, 2010

    “According to leaked financial documents, the Pittsburgh Pirates, despite (or perhaps because of) fielding one of the worst teams in the league, managed to earn large profits in both 2007 and 2008 due to a combination of low payroll and high league revenue sharing.”

    Let’s be fair here. Those “large” profits were around $15 million a year for 2007-08; $12 million per year if you include 2009. That’s basically enough to sign one solid, established major leaguer.

    If the Pirates had raised their player payroll to the median MLB level, they would have lost $20 million or so each of those years.

  10. Frank permalink
    August 23, 2010

    Two thoughts:

    #1 Would promotion/relegation work if the current 30 teams were split into 2 tiers? That is break’em out as the big money Yankees/RedSox/Mets/Phillies/etc and the small market KC/Pitt/Florida teams. The tiers would split different revenue pools, but nearly all other facets of the game would stay the same. You could even revenue share to a lesser degree to ensure that the lower tier teams would have a chance to move up and be successful.

    #2 How does this relate to college football, where you have similar disparity of revenue/income and incentives against team success. In the SEC, Florida is effectively subsidizing South Carolina in the same way the Yankees are subsidizing the Marlins, no? South Carlina would probably be financially better off by losing to Florida and keeping the Gators’s chancing of playing in the BCS title game alive than by “upsetting” Florida and making them play in a lesser bowl, no?

  11. August 24, 2010

    The discussion on the merits or demerits of relegation in MLB is an unintended consequence of my comment. The point of my comment was a) revenue sharing is widespread, and b) the threat of relegation attenuates its disincentive effects.

    The disincentive problem from combining revenue sharing & luxury taxes in a closed league system mars the competition, in my view. This is not a recent problem. The NFL’s Bungles are the innovators in the check-cashing business; the Pirates are just the most recent imitators.

    But as Vic said early on (comment #2), there is no chance of introducing promotion and relegation to MLB. Adjusting the terms of revenue sharing is the first place to look in addressing the disincentive problem, as Clark Griffith points out. Basing a team’s return from the revenue sharing pool on winning sounds promising. By now the Pirates would be bankrupt, and employing a new strategy, perhaps.

  12. Frank permalink
    August 24, 2010

    A big part of the problem is baseball’s reluctance to have franchises move. Maybe the Buccos need a moving van and a new location in, say, New Jersey. Perhaps the Royals should decamp for California.

  13. Frank permalink
    August 24, 2010

    Disagree with my doppleganger in name who suggests additional mobility of franchises. The prospect of moving franchises would lower revenues and franchise value.

    If people believed “their” franchises could move on a whim, they would not invest in them as heavily. Overall value would be stripped by this lack of uncertainty.

    Nice idea in theory, not so much in practice.

  14. Chris permalink
    August 24, 2010

    With the going rate for a small market baseball team at about $300 to $400 million, the “large” profits equate to a return on investment of about 3% to 4% annually before consideration of any future capital costs, which would likely knock those down real unleveraged returns to about zero. Recent sales show that appreciation of teams has been flat in recent years, so there is no exit strategy to offset the low returns. If the Pirates and Marlins are the only ones making these “large profits” that are less than the annual salaries of at least 50 players I can think of off the top of my head and getting chastised for it, it’s hardly any wonder they say that the best way to end up with a small fortune owning a sports team is to start with a large one.

  15. Sébastien permalink
    August 25, 2010

    The relegation couldn’t work, for the reason present above, and the floor/cap salaries is culturally impossible for MLB. So, let’s try a new way, probably impossible in practice but let’s think about it. What about slashing revenue of big market by opening/moving new teams IN this market. Let’s say two news teams in NewYork, one in Boston, an other in LA., etc. Moving teams from small market to existing big market could create some competition, downgrade revenue for huge big market team, and cancelled the problem of the small market by moving them. That’s the way you share revenue.

  16. Victor permalink
    August 25, 2010

    Obviously, Chris is correct that one can argue about what constitutes “large” in terms of profits. On the other hand, quite a few home owners or holders of 401K plans would happily have taken a 3% or 4% rate of return over the past few years.

    Similarly, suggesting that a the result of a few recent franchise sales that have taken place during the worst economic downturn of the past 75 years means that the large capital gains owners have typically experienced over the past century are a thing of the past is a stretch.

    Let’s just say that I’m not crying for any team owners, especially ones who field 100-game losers while making a 3-4% return on investment and simultaneously receiving taxpayer subsidized stadiums to play in.

  17. August 25, 2010

    Victor,

    The most likely solution to get approval from both players and some owners is just about what you mention. Have a team salary floor and enough revenue sharing to help those small market teams get enough revenue to get up to that floor. But, don’t have a salary cap.

    Players will vote for this (more total salary dollars being spent). Large market teams (who voted no on Selig’s current plan because of the reasons you mention that revenue sharing recipients simply pocket the money (because money is fungible…it doesn’t have the word “baseball” written on it)) will vote yes. Small market teams would rather pocket the money, but if they are supposed to currently spend their money on player improvement anyway. They shouldn’t be averse to this (especially given the current spotlight being shone on them).

    This issue was brought up when MLB first instituted its revenue sharing plan. Agent Scott Boras was shocked that the extra money wasn’t being spent (he should’ve taken one or our sports economics courses). The Pirates were actually called out about spending their money on their debt payments years ago instead of on players.

    I have those articles if you want them…

    – Dan

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