Chapter 2. The Functions of Leagues Setting the Rules à One of the most important functions

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1 Chapter 2 THE ECONOMICS OF PROFESSIONAL SPORTS PROFIT MAXIMIZING SPORTS FRANCHISES Introduction Any rational firm wants to maximize profits. But fans condemn team owners who put making a profit ahead of winning. Nevertheless, bad things can happen if teams forget about staying in the black. Recall the Ottawa Senators they had the best record in the NHL but had to file for bankruptcy. Importance of Leagues Leagues did not always exist Professional baseball formed 7 years before MLB Professional football existed 44 years before the NFL Prior to the formation of leagues, teams played other teams on an ad hoc basis. Most games were between teams in the same city. Once transportation improved, teams could play teams from other towns. This practice of barnstorming was popular but uncertain. Couldn t guarantee the other team would show up. Couldn t guarantee the size of the crowd. Earnings were tied to winning. To fans, a league is just a collection of teams who play each other. Economically thinking, leagues behave cooperatively. Teams are rivals that succeed at the expense of the other teams. But a team s success also depends on the success of the other teams and on the success of the league as an institution. Let s assume that teams are there to maximize profits and the league exists to help them do this. The Functions of Leagues Setting the Rules à One of the most important functions Teams have to agree how to play the game a) Having precise rules and enforcing them actually helps sports to spread b) e.g. baseball only spread after the Knickerbocker rules were adopted in the 19 th century These were a set of 20 rules which are considered to be the basis for today s game, although many have changed since My personal favourite: 13th. A player running the bases shall be out, if the ball is in the hands of an adversary on the base, or the runner is touched with it before he makes his base; it being understood, however, that in no instance is a ball to be thrown at him. Rules for behaviour are also important.

2 For example, players can t bet on games and the use of performance enhancing drugs is banned. Rules can change to enhance the popularity of sports. For example, the 3-pt score in basketball and reducing the allowable size of NHL goalie pads allows for higher scores (Americans like high scoring games). Limiting Entry Too many teams hurt competition and fan interest Too few teams leave room for competing leagues to arise (like the American league and the American football league) What determines league size? When a new team enters there are benefits and costs to existing teams. e.g. all the major cities have teams in just about every sport Adding teams to a market diminishes the existing team s monopoly power Adding teams means more substitutes and the demand curve for the existing teams becomes more elastic Benefits: admission fees from new teams, additional fan base and media outlets. Costs: any shared revenues spread over more teams, reduces existing teams ability to threaten to move when negotiating with their current home cities. If revenues decrease with the addition of one more team, the marginal revenue curve would slope downward. Expected because the most profitable cities are added first, with the smaller, less profitable cities added afterwards. If costs increase with the addition of one more team, the marginal cost curve would slope upward. Equilibrium number of teams where MR = MC. If teams in a league are making positive economic profits, new teams will want to enter. Threat of new entry puts downward pressure on prices and profits. This gives existing firms the incentive to keep out new teams. If potential owners can t join a league, they have an incentive to start a new one. A new league s success is uncertain, since all the good markets will already have teams from the existing league. For example, the rival World Hockey Association (WHA). The WHA played from After that, 4 WHA teams joined the NHL (Edmonton Oilers, Quebec Nordiques, Winnipeg Jets, Hartford Whalers). Except for the Oilers, the other 3 eventually relocated to Denver, Phoenix and Charlotte respectively. Neale (1964) sees leagues as multiplant monopolies (we mentioned this briefly in the introductory slides). For instance, part of the excitement of a single game comes from how the outcome relates to league standings which involves all the teams in the league. Leagues coordinate the number of games played (output) and prices, even if this means less profits for some members. The league negotiates major TV contracts. Restricting the number and location of teams gives owners a guaranteed source of ticket and media revenue plus a restricted market for apparel sales.

3 Marketing Individual teams would only advertise in their home market They have little incentive to pay for ads that would benefit other teams Teams would want to free ride Leagues take a multilevel approach to marketing. Teams contribute to joint ads run at the league level. Leagues work to create a specific image to increase demand for the sport as a whole. Notice that marketing at the league level is something of a public good. It s non-rival One team benefiting from advertizing doesn t take diminish the benefits enjoyed by the other team It s non-excludable One team can t prevent another team from benefiting from the benefits of advertizing Profit P = TR TC Leagues differ in the level of profitability. The NFL is the most profitable; the NHL the least. NFL team profits are the most evenly distributed. While profit is TR TC, profit is also closely related to a team s operating income. NFL teams have higher operating incomes than other teams, but it doesn t mean that high operating incomes are always related to highest market values (the price a buyer would pay to purchase the team). For example, in 2012, the league s most valuable franchise, the Dallas Cowboys, had a market value of $2.1-billion with operating income of only $226.7-million. By comparison, the Yankees (MLB s most valuable franchise) had a market value of $1.85-billion and operating income of $10-million. Why the huge differences? For one, market value reflects the potential benefits a new owner might enjoy. The team may not be maximizing profits. Some owners would rather win than maximize profits. Owners may profit in other ways, such as owning a cable TV outlet (Yankees, Mets and Red Sox all do). NFL franchises are the most valuable; NHL the least. No surprise here the Leafs are the most highly valued team, with market value of $1-billion and operating income of $81.9-million (league high). The highest valued NBA team is the NY Knicks, with market value of $1.1-billion and operating income of $83-million. Hendrick Motorsports is the highest valued NASCAR team, with market value of $350-million and operating income of $13.5-million. Revenue Teams generate revenue from: Gate receipts (ticket sales) Rg Local and national broadcasting rights RB Merchandise / licensing income RL Other stadium-related income (luxury boxes, concessions, stadium naming rights ) RS

4 Gate Receipts Higher ticket prices mean greater revenues. If a team can increase demand for tickets, it can charge higher prices. However, teams realize that demand fluctuates depending on who the visitor is. More and more, teams are charging more for high demand games instead of a single price for a given seat. Teams also will try to increase demand through marketing, but if the team is a loser, this may not help. In the LR, teams will increase demand by its fans only if it can build a successful team. This means acquiring or developing talented players, which drives up team costs. For an increase in SR profitability, teams can spend a lot of money hoping to increase revenue or cut costs. Some teams, however, are just more popular than others (more successful, larger fan base, long history). For example, in the early years of the NFL, teams came and went each season. The league instituted the most generous (still) revenue sharing policy home team keeps 60% of the gate and the remaining 40% goes into a pool that is distributed among all teams (plus $100-million reserved from total shared revenues, including broadcast rights et al, to help out the poorest teams). This means that an NFL team s gate revenue is RG =.6RH +.4RP That is, Gate Revenue =.6*Home Game Revenue +.4*Gate Revenue Generated by All Other Teams This policy also explains why operating incomes and market values are so much closer in the NFL than in other major US leagues. The NBA and NHL* do not share gate revenue, so making the playoffs is a huge source of revenue. Since 2003, MLB teams put 34% of net revenues into a common pool. In the NHL, the top ten money making clubs contribute to a fund shared by the bottom 15 teams. Clubs are only eligible for subsidies if they rank in the bottom half of league revenues and are in markets with 2.5 million TV households or fewer. The league makes sure they make money off of playoff teams by taking 50% of all playoff revenue. The team gets 50% and the league takes the other half. Revenue from Broadcast Rights All 4 major sports plus NASCAR earn huge revenues from broadcast rights. The NFL and NBA share revenues equally among the teams. This money probably keeps several franchises from bankruptcy. The NFL earns the highest revenue from selling broadcast rights about $20-billion total TV revenue each year.* The NHL has the lowest national (US and Canada) TV broadcast revenues about $350-million annually*. MLB has national contracts, but local network contracts are also a major source of revenues. Local network revenues are not shared. NHL teams also rely heavily on local TV revenues. The CFL revenue from TSN works out to be about $4-million per team. *These are the best figures I could find on the web. TV is the big reason why football surpassed baseball in the US. At first, baseball was reluctant to televise nationally (or even radio broadcast). They felt that fans watching at home should be no better off than the fan in the worst seat. Favoured local coverage over national that s why they still have small-market teams. Broadcast revenues Are a fixed revenue which has no impact on output à In our revenue equation, Rb would be a constant

5 However, televising games could impact gate receipts à Fans can prefer watching on TV, rather than in a stadium in a blizzard à That s why for example, the NFL has blackout rules for games that aren t sold out Of course, networks will only broadcast games if they see this activity as profitable. The demand to televise games is a derived demand derived by the demand from sponsors to buy advertising time. Some networks will overpay if it means viewers may watch other shows they broadcast or it will attract more affiliates (using the sporting event as a loss leader). TV revenue is by far the largest source of revenue for sports. Leagues have even changed the way they play in order to accommodate TV broadcasters. Games take a TV time out where players stand around while commercials are shown to viewers. The combination of substantial revenues from a league-based broadcasting deal and revenue sharing among teams in the NFL means that teams don t have to stay in large cities to be profitable. For example, LA lost the Rams to St Louis and the Raiders to Oakland, smaller markets. The costs of these moves were spread across the entire league, but the benefits to the teams were not. For example, the Rams get to keep revenues from 124 luxury suites (not shared; more on this in a minute). Nevertheless, the move of teams from a large to a small market could hurt the NFL s ratings as a whole (loss of a large fan base). This could drive down the revenues the league could command from selling broadcast rights and reduce the revenue teams receive. This would be a tragedy of the commons. Stadium Revenue Apart from gate receipts, teams earn revenue from: à parking à concessions à luxury boxes à stadium naming rights à signage Revenues from the sale of box seats are generally treated as concession revenue. Where gate receipt sharing exists, teams get to keep most of these revenues to themselves. Since these seats are mostly sold on a seasonal basis, these revenues are a lump sum. Parking and concession revenues depend on attendance and are more variable. Teams also earn revenue from signage and sponsorship. Think of the ads on the boards at hockey games or on the cars and clothing of NASCAR drivers. Revenue from selling naming rights can be substantial. For example, Staples is paying the owner of the LA Kings over $100-million over 20 years to have the arena named the Staples Center. Tim Hortons is having Ti-Cats stadium named after it ($ undisclosed) Costs Largest costs for teams are player salaries

6 Over 50% of total costs Other costs include travel + venue costs Administrative costs, coaches, staff salaries, marketing Travel expenses increase as the size of the team increases, with the number of away games and distance travelled. The NHL and MLB also have substantial player development costs because they keep an extensive minor league system (farm teams). These costs are over $5-million per club per year, and considering how few players make it to the majors, it works out to be over $1-million per major league player. Opportunity Costs When franchises move from one city to another, it s in search of higher profits. The greater the fan loyalty, the more likely the team will receive public funds toward a new stadium. The opportunity cost of not moving is the profit forgone by not moving. So, not all teams move because they are losing money. Usually an owner cites the need for more boxes, lower lease payments, better practice facilities, etc when thinking about moving a team. Hence the move of the Dodgers to LA (they were the most profitable team in the NL). Vertical Integration Sports teams have become increasingly more interwoven with the TV outlets that broadcast their games. Up until 2008, Time Warner owned MLB s Atlanta Braves and broadcasted games on their TBS cable network rather than put up broadcast rights for competitive bidding by other networks. The Braves showed lower revenues than other teams but the owner didn t care. Time Warner was making its money from its TV station. It didn t care from which subsidiary it earned its revenue. Ownership of both the team and the broadcaster is an example of vertical integration the ownership of different stages of production, and cross-subsidization the movement of revenue and expenses from one part of the company to another. Some teams that own TV stations: Leafs Leafs TV Raptors Raptors TV Lakers Lakers TV Man U, Arsenal, Liverpool & Chelsea Celtic & Rangers Barcelona & Real Madrid While it would seem that integrating the team and the broadcaster might form some kind of super monopoly and hurt consumers, economic theory shows it may actually improve consumer well-being. Here s why: Two firms each have monopoly power in their own markets. Say they are located on a river.

7 One firm sits upstream and produces and floats downstream a good that the other firm uses to produce a finished consumer good. The upstream firm charges the downstream firm a monopoly price which the downstream firm regards as part of its MC. This inflated MC is used to determine the downstream firm s output and price it charges its consumers. In our context, the upstream firm is the team which provides games to the downstream firm, the broadcaster, to be delivered to consumers. To keep it simple, let s assume that both have constant MC and that the MC of the broadcaster is constant at the price it pays the team (that is, it has no other costs). Team provides the game Station broadcasts the game Price charged by team becomes MC of station One monopoly price is layered on top of another TEAM STATION If the station buys the team, it has no reason to charge itself a high price for broadcast rights. The cost of the game to the station is now just the MC of production. The single, integrated firm applies its monopoly power only once. The result is more games at a lower cable subscription price. If the team and station integrate: Station charges itself a lower price Money stays within the firm Charges MC < P0 Station has lower cost Charges P2 < P1 Everyone is better off $ $ D MR MC D MR P0 P1 P2 TEAM STATION The owner of both the team and the broadcaster will try to maximize joint profit. The price at which the team sells to the station is called the transfer price. A change in transfer price changes accounting profits (for tax purposes) but not the overall profitability for the owner. For example, if profits of the broadcaster were regulated, the owner could minimize its earnings by charging the station a higher transfer price. This would simply mean that the team would show higher profits.

8 In other words, be skeptical of accounting profits. The Veeck Loophole Bill Veeck, owner of MLB s Cleveland Indians, saw a unique loophole in US tax laws: In 1949, he depreciated his own players. The most flagrant use came in 1964 by the new owners (a syndicate) of the then Milwaukee Braves. The syndicate bought the Braves for $6.2-million. They claimed team was worth $50k They attributed most of the value (~$6.1-million) to the players They declared the players as depreciable assets. Straight-line depreciation over 10 years Allowed the owners to deduct $612k/yr over ten years At a tax rate of 52%, this cut taxes by ~$300k/yr Over 10 years, taxpayers paid half the purchase price of the team. The loophole is now known as a Roster Depreciation Allowance (RDA). It can only be used at the time of purchase of a team. From new owners could write off 50% of the purchase price over 5 years because of declining player values can write off 100% of purchase price over 15 years. What happens when the players are fully depreciated? Owners could sell the club, allowing the new owners to reorganize and start the process all over again. Problems 1. Suppose that each team in a league has a demand curve for generic advertising (a league-wide nonteam specific campaign) equal to Q = 1,000-5p. If there are 20 teams in the league, and ads cost $175 each, how many ads will the teams want to purchase as a group? 2. Suppose an owner pays $500 million to purchase a hockey team that earns operating profits of $50 million per year. The new owner claims that $200 million of this prices is for the players, which he can depreciate using straight-line depreciation in five years. If the team pays corporate profit taxes of 40 percent, how much does the depreciation of the players save the owner? Owner can claim a depreciation expense of $200 million / 5 = $40 million per year for each of 5 years The reduction of profits is $40-million per year, which would have been taxed at 40% per year à tax would have been = 40% (40 million) = 16 million per year Over 5 years, that s 5 ($16 million) = $80 million saved by the owner on their tax bill 3. The emotional benefits of owning a team (increased media attention, increased prestige in the community) increase the taste for owning a team. Illustrate how this affects the price of a club. The increase in taste pushes the demand for a franchise out to the right (from D0 to D1). Assuming, for simplicity, that the supply of franchises is fixed, the higher demand results in a higher equilibrium price. This higher price is the ego premium. 03x01

9 4. Consider an upstream team (T) and a downstream TV station (S). The team sells its output (QT) only to the TV station. The station s production technology has QT as its only input. Further, one unit of QT produces exactly one unit of the station s output (QS). This means QT = QS, and we can simply call both firms output Q (=QT = QS) For each unit of output (game) that the station buys from the team, it costs the station another $2 to get it ready to sell to the consumer. We have the following costs: Team: MCT = 4 = AVCT, FCT = 195 Station: MCS = (PT +2) = AVCS, FCS = 88 Demand for the station s output (by consumers/buyers) is given by PS = 100 2Q A. Assume the team and station are separate firms, acting independently to maximize their own profits. a) What is the equation for marginal revenue for the station? A short cut: for linear demand, MR has exactly twice the slope of the demand curve. b) Derive an equation showing how much output the station will produce as a function of the price it must pay to the team for its output (PT). To max profits of the station, set MCS = MRS (PT + 2) = 100 4Q PT = 98 4Q The team can only sell its output to the station so PT = 98 4Q is also the inverse demand curve for the team s output. It shows how much the team can sell to the station at each price PT. c) Calculate the profit maximizing price, quantity, and level of profits for the team. d) Calculate the profit maximizing price, quantity, and level of profits for the station. B. Assume that the team and TV station become a vertically integrated (VI) firm. a) Calculate the price consumers pay, and the quantity they buy, when the VI firm maximizes its profits. MCVI = the cost of processing at the team stage plus the cost of processing at the station stage Buyers demand for the final product is still PVI = 100 2Q where PVI is the price buyers will pay to purchase the final output the TV broadcasts: b) Calculate the VI firm s total profits. Compare them to when the team and TV station acted independently. Profit for the VI firm is greater than the sum of the profits of the team and station when they acted independently ( = ). C. Assume that, within the VI firm, the station pays a transfer price (PT) to the team for its output; and that the team and station still report their own separate profits. a.) What transfer price makes the team earn zero profits? The station earns all the profits, which we know equal from above. b) What transfer price makes the station earn zero profits?

10 The team earns all the profits, which we know equal from above.