Chapter 3

Sports Franchises as Profit-Maximizing Firms

Profits Are A Touchy Subject

• Team owners are condemned if they worry about profits

• Corporate CEOs are condemned if they don’t worry about profits

• But bad things happen if teams ignore profits• Consider the 2002-2003 Ottawa Senators

– They had the NHL’s best record– They also filed for bankruptcy

The Importance of Leagues

• Leagues did not always exist– Professional baseball formed 7 years before MLB– Professional football existed 44 years before the NFL

• Before this teams barnstormed– Traveled from town to town – The returns were very uncertain – tied to winning

• The function of leagues– They set rules for behavior on the field – and off– They promote competition on the field– The limit competition off the field– They promote the sport

Setting Rules

• Helps the sport to spread– Teams must agree on how to play the game– Baseball grew only after it adopted the “Knickerbocker

Rules”

• Outlaws undesirable behavior– Betting on games– Performance enhancing drugs

• Helps sports become more popular– NBA has changed several rules

• Allowed the 3-point basket • Outlawed – then reintroduced – zone defenses

Limits Competition Off The Field

• Limits the size of the league– Too many teams hurts competition & fan interest– Too few leaves room for competing leagues to enter

• As American League did in 1901

• Protect each team’s territory– To move into Los Angeles, the NBA’s Clippers had

to pay a fee to the Lakers

The Economics of Clubs• Proposed by Nobel laureate James Buchanan• What is right size of club (or league)?• New members are a new source of revenue

– Entry fees are now hundreds of millions of dollars– Expansion also provides access to new markets

• New members might also be a drain– Teams must share revenue with more members– Competitive balance may become a problem

Finding the Right Size

• MLB had only one league in the 1890s– That’s why the National League is the “senior circuit”– National League feared having too many teams– Limited league to 8 teams

• But many cities grew rapidly in the 1890s– More cities were able to support teams– The NL became vulnerable to entry– In 1901, the American League entered “open” cities

Leagues as Marketers

• Individual teams do not provide enough marketing – Teams have little incentive to pay for advertising that

benefits other teams– Everyone want to free ride

• League-wide marketing is a public good– Non-rivalry:

• Team A’s benefiting from league-wide marketing doesn’t prevent Team B from benefiting

– Non-exclusion:• Team A cannot prevent Team B from benefiting from league-

wide marketing

Maximizing Profit

= TR – TC

• Leagues differ in the level of profit– NFL by far the most profitable– NHL by far the least profitable

• Leagues differ in the variability of profit– NFL team profits are by far the most even– Surprisingly, the Yankees are the least

profitable team in MLB

Gate Revenue• Revenue from ticket sales• If only gate revenue mattered

– Baseball would still be king– Hockey would rival football

• NFL shares the most– Home team keeps 60% – 40% is shared league-wide– Policy originated from the early weakness of NFL– It is one reason why team profits are so close

• Baseball now shares 34%• NBA teams share nothing

– Making the playoffs is a vital source of revenue

Revenue from Broadcast Rights

• TV became the largest revenue source in the 1960s

• TV is why football surpassed baseball– Commissioner Pete got the teams to agree on a single

contract for the entire league– Needed a limited antitrust exemption

• That’s why there are no NFL games on Saturdays until December

• Doubleheader Game makes a national game

• The NFL’s contract now gives each team $117M/year

Contrast to Baseball

• MLB was reluctant to put on TV or – Even opposed radio at first– They felt that fans watching at home should

be no better off than the fan in the worst seat

• MLB favored local coverage over national

• That’s why MLB has “small-market teams”– But the NFL does not

Venue Revenue

• Revenue from stadium – other than tickets– Naming rights– Signage– Parking– Especially luxury boxes

• Boxes are why the Dallas Cowboys are so valuable– It shares most of its media revenue evenly with NFL– It keeps only 60% of its gate revenue– BUT it has more luxury boxes than an other team

Luxury Boxes

• Cowboy Stadium has 300 luxury boxes– Far more than any other team

• Big source of revenue– Rent for 10s or 100s of thousands per season

• Teams do not share most box revenue– They count only admission in revenue sharing– Most box revenue counts as concessions

Naming Rights

• Team sells right to name facility – Originated in 1973 – Rich Foods paid Buffalo Bills $1.5 M over 25 years– Citigroup is now pay the Mets $400 M over 20 years

• Is it worth it?– Leeds, Leeds, and Pistolet (2008) find that naming

rights do little for the sponsor’s bottom line– Citigroup is latest sponsor to fall victim to the “naming

rights curse” (received $45 B bailout from government)

Revenue Sharing

• Sharing varies among leagues– NFL shares the most– MLB and NHL have recently increased sharing– NBA shares very few sources of income

• But its large – shared – TV contract dominates other revenue

• Some perverse results– Weak MLB teams like the Nationals and Marlins have

higher profits than the Yankees– The Bengals were highly profitable despite fielding

very weak teams in the 1990s and 2000s

Costs

• By far the largest is player salaries

• Others include travel, venue costs, and player development

• Opportunity costs are a major reason why teams have moved– Dodgers were profitable in Brooklyn but were

even more profitable in Los Angeles

A Paradox

• Ted Turner once owned both the Atlanta Braves and TBS, which showed the games– But the Braves made very little TV revenue

• Augustus Busch once owned the St. Louis Cardinals and Anheuser-Busch– But the Cardinals made very little from “pouring

rights”

Resolving the Paradox:Vertical Integration

• Charging less not always bad

• Consider two monopolists– Team provides game – Station broadcasts game

• Assume MC constant– Price charged by team

becomes MC of station– One monopoly price is

layered on top of another

$ $

D

MR

MC

MC

D

MR

P0

P1

If The Team and Station Combine

• Is 1 big monopoly worse than 2 small ones?

• Monopolist charges itself a lower price than it charges an outside firm– Money stays within firm

– Charges MC < P0

• Station has lower cost– Charges P2 < P1

– Everyone is better off

$ $

D

MR

MCD

MR

P0

P1

P2

Paper Losses and Real Profits

• Operating Income v. Book Profit– Operating income does not include interest payments– Operating income does not include depreciation

• The distinction allows teams to increase profit in fact by losing money on paper

Depreciation, Taxes, and Bill Veeck

• Veeck was MLB’s most innovative owner– He was a creative marketer

• Used 3’7” Eddie Gaedel as a pinch hitter• Introduced exploding scoreboards

– He was a principled owner• Integrated the American League in 1947• Opposed MLB’s reserve clause

• Saw unique loophole in tax laws– Team can depreciate their players

An Example of The Veeck Loophole

• In 1964 a group bought Braves for $6.2M– The claimed team was worth $50k – They attributed most of the value ($6.1M) to the players

• Declared players as depreciable assets– Straight-line depreciation over 10 years– Allowed the owners to deduct $612k/yr over ten years

• At a tax rate 50%, this cut taxes by ~$300k/yr• Over 10 yrs taxpayers paid half the purchase price

The “Subchapter S” Variant

• A sole owner can declare a “Subchapter S” firm’s income as personal income– This makes little sense if one looks at tax rates– Corporate rates were lower than personal rate

• Veeck faced CTR=52% & PTR=72%

• Paper losses can be profitable – consider the Braves– Braves $300k write-off could turn a $200k operating profit

into $100k book loss– At 52% CTR could write off $52k against corporate income– At 72% PTR could write off $72k against personal income

Loophole’s Loose Ends

• What happens when the team is fully depreciated? – Is the owner stuck with high-tax asset?– There are two ways out

• Tax laws allowed a one-time switchback from Subchapter S status

• The owner can sell the team and the new owner can start from scratch

• Veeck revolutionized the reason for owning a team• The loophole fell out of favor in the 1970s & 1980s

– Tax rates were reduced and flattened– The value attributable to players was limited– Recent tax changes have made it more popular again