The Law & Economics of Optimal Sports League Design



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The Law & Economics of Optimal Sports League Design

Stephen F. Ross & Stefan Szymanski*
I. INTRODUCTION

Since the first professional sports league – the National League of Professional Baseball Clubs -- was formed in the late 19th Century, North American sports leagues have with rare exception adopted the same structure: owners of individual clubs in different cities individually undertake to run their own clubs, and jointly agree to organize an annual sporting competition leading to the designation of a league champion. The imprimatur of no less than the United States Supreme Court has been placed on this design of a sports league. Citing Judge Robert Bork, the Court observed that the marketing of contests between competing clubs “would be completely ineffective if there were no rules on which the competitors agreed to create and define the competition to be marketed.”1 A critical aspect of the sports industry, the Court found, was that “horizontal restraints on competition2 are essential if the product is to be available at all.”3



Not all courts share this view of the nature of sports leagues. In two important decisions, Australian courts have recognized that a key function of a sports league is to provide “competition organizing services” and, in order to develop a competition, to acquire the services of clubs to compete in its competition.4 Indeed, the evolution of a national rugby league competition in Australia demonstrated the distinct functions of clubs and leagues. The traditional competition was organized by the Australian Rugby League, an entity controlled by a board of directors representing clubs participating at the top level of competition as well as a variety of other clubs and individuals involved in the sport; the courts have found that clubs competed among themselves for the right to participate in the annual top-tier competition.5 Even in the United States, the fastest growing sports competition exists among stock car drivers, who not only compete in individual races but whose success in races over the course of a season determines the winner of the lucrative Winston Cup. Here, the competition organizer is not a venture of competing drivers, but rather a separate, for-profit entity, NASCAR, controlled by the family of Bill France, who founded the competition.6
The vibrancy of these competitions demonstrates that the typical North American system is not inevitable. Rather, the traditional model reflects a conscious decision to vertically integrate the “upstream” function of organizing an annual competition with the “downstream” function of operating clubs in that competition. This vertical integration has important consequences for the efficient operation of the competition. Antitrust decisions have implicitly acknowledged the different economic consequences when price, output, and innovation are determined jointly by competitors, and when they are instead determined by a single firm. Thus, the competiting pipe manufacturers found to have engaged in per se illegal price fixing in the landmark 1899 Addyston Pipe decision were allowed to merge into a single entity.7 The Supreme Court expressly noted that an agreement by competing firms not to compete in each other’s geographic markets is illegal, even though an agreement by an upstream firm that its downstream affiliates would not compete might not be.8

The purpose of this Article is to critically analyze the legal and economic implications of the prevailing choice of sports league design and to suggest an alternative more likely to promote efficiency, and to avoid cartel-like inefficiencies. Part II details our concern that, assuming that a league does not face reasonable substitute (e.g. a rival league), the existing structure leads to inefficiencies in the determination of the number and location of franchises, the sale of broadcast, marketing, and sponsorship rights, the effective oversight of club management, the efficient allocation of players among teams, and an optimal balance between domestic and international competition. Specifically, we suggest that transactions costs significantly impede efficient agreement in club-run leagues. Identifying the core function of a league as the organization of competition, we explain why key decisions relating to the identity, number, and location of participating clubs should be made by an economic entity independent of the participating clubs. We argue that a vertical separation between leagues and clubs, with responsibilities assigned in franchise agreements between the league and each club, provides the best way to facilitate the efficient organization and marketing of the competition. In addition, we note significant legal advantages that a vertically separate league would have in operating more flexibly than club-run leagues. Part III examines how to implement the proposed restructuring. First, we suggest ways in which current leagues or outside investors could take the initiative to create a new business entity (perhaps “NFL, Incorporated”) that, when combined with the remaining value of clubs as franchisees, should significantly exceed the combined current value of the teams in a club-run league. Although investment bankers and outside investors should find it profitable to seek to purchase the assets and rights necessary to become the competition organizer, the same transactions costs that preclude efficiencies among club-run leagues also inhibits these leagues’ adoption of a more efficient structure. Specifically, owners may well reject a profitable restructuring because of an inability to agree on how to distribute the gains. Thus, the Part concludes with a discussion of legal theories that might bring about the involuntary restructuring of sports leagues along the lines discussed in this Article if owners were to reject restructuring efforts without legitimate justification.


One final point merits attention in this introduction. We assume for purposes of this article that the major North Amerivan sports leagues face neither product market competition nor a viable entry threat sufficient to force tem to avoid the inefficient practices we discuss herein. At the same time, we assume that each league’ insulation from rivalry is not subject to imminent threat from antitrust intervention.9 Thus, this article accepts the continuing ability of leagues to exercise market power but suggests ways to facilitate greater efficiencies within that context. In short, we suggest that both profitability and the provision of services responsive to consumer demand would improve if sports leagues looked more like McDonald’s and less like the United Nations.
II. THE CASE AGAINST VERTICAL INTEGRATION IN DOMINANT SPORTS LEAGUES
A. Thinking About Sports Leagues as a Product of Upstream Competition Organizing and Downstream Club Participation
In this section, we adopt the approach of Australian courts and think of a sports league as product created by the combination of upstream “competition organizing services” and downstream “clubs participating in the competition.” Upstream services are those which enable the competition to take place but do not necessarily have to be provided for by the competitors themselves. Most obviously, these include rules basic to the integrity of the game and the means to enforce these rules and sanction those who violate them. The desirability of an independent provider of these services is already recognized in by most North American club-run leagues with provisions that grant broad authority in that regard to an independent commissioner.10 At the other end of the spectrum, downstream services are functions that are best fulfilled by the individual clubs, such as organizing the team, training the players, organizing spectator services in the form of seating and ticketing, providing refreshments and other amenities at the stadium, and similar activities. The focus of this Article, however, are the myriad activities that can be organized either by an independent governing body or by collective action among participating clubs (or even a combination of both). These services include the determination of the number of teams admitted to the league, the determination of player contract and trading rules, rules controlling policies in relation to ticket prices, stadium facility standards, the sale of broadcasting rights, the extent of revenue sharing and the allocation of such revenues. Traditionally, these decisions are made in North American sports leagues by a governing body composed of a representative from each club, with a super-majority required for major changes or initiatives.11 In contrast, we consider the alternative of a vertically separate entity, The League, that would control many of the decisions in the middle category discussed above, and would determine when these functions are best carried out at the club or league level.
In this section, we seek to demonstrate that the tendency of club-run leagues to put the interests of individual clubs above the interest of the league as a whole, and the substantial transaction costs that prevent optimal results, leads to significant inefficiencies in the operation of these leagues. Not only does this reduce the potential profits available to providers of sports entertainment, but – because of the lack of effective product market competition for the dominant sports leagues – this results in output that is reduced and unresponsive to consumer demand compared to that which would be provided by a sports league owned by an entity separate from participating clubs.
B. Economic theory of vertical integration and its application to sports leagues
Economists and lawyers have long debated the economic effect and appropriate antitrust treatment of vertical integration. The issue has revolved around the Chicago-school argument that a monopolist would not choose to vertically integrate if this were to cause a reduction in output (thus reducing monopoly profit) and that therefore vertical integration can only be motivated by efficiency (output enhancing) motives.12 This model views the relationship between an upstream supplier and a downstream manufacturer as a simple principal-agent relationship in which efficiency requires the total surplus generated by the relationship to be maximized. Maximization might be inhibited, however, (1) where both firms have market power, if the upstream firm dictates a linear price schedule which maximizes its own profit, because the downstream firm’s effort to achieve its own monopoly price will result in the price to consumers being higher than is optimal for profit maximizing by both parties;13(2) if firms under-invest in promoting the product because of a desire to free-ride on promotional efforts of others;14 or (3) firms under-invest for fear that the partner firm will renegotiate wholesale prices to avoid repaying the sunk cost element.15 Although these problems could theoretically be dealt with through arms length contracting,16 the Chicago school insight was that vertical integration would be an equally efficient solution. Because, in this view, the burden of monopoly cannot be increased through vertical integration, such integration must be due to the parties recognition that the costs of integration are less than the costs of contracting.17
Not all economists share this sanguine view of vertical integration. The standard concern is a fear that vertical integration could be used as a means to foreclose entry into a related market, while maintaining vertical separation would allow rivals to compete in upstream or downstream markets.18 Another concern is that vertical integration can relax downstream competition. For example, whether integration is complete or long-term via exclusive dealerships, it can relax incentives for competitive downstream firms to pressure upstream firms for lower prices and for upstream firms to incite downstream rivalry.19
The concern that vertical integration will relax downstream competition seems particularly applicable to sports leagues. Certainly, vertical integration into the upstream services by the clubs -- scheduling, marketing, and organizing the competition itself -- is a plausible way to relax economic competition between the teams, because it permits the clubs to agree on matters like exclusive territories for live gate and television rights sales, labor market restraints, and revenue sharing. Indeed, economic theory supports the argument that decisions made by a club-controlled body subject to a super-majority are unlikely to be optimal. In any partnership where the payoffs to decisions are shared the marginal benefit to each partner accruing through the sharing arrangement is smaller than the total benefit and therefore no partner has the incentive to vote in ways which maximize total payoffs.20 Efficient allocation of resources within a team requires the services of a “residual claimant,” a separate economic actor who has the incentive to make optimal decisions, pay each member of the “team” their opportunity cost, and then retain the surplus.21 We detail, in subpart C below, how the absence of this independent actor results in inefficiencies in a variety of markets in which sports leagues operate.

Sports leagues’ unique features make this aspect of vertical integration particularly problematic. In order to preserve the integrity of the competition, an actual or potential competition organizer possesses a unique disincentive to integrate forward into the operation of participating clubs. Although antitrust decisions treat vertical restraints imposed by pressure from downstream firms more harshly,22 and even doubt its widespread existence,23 because of the unique inter-dependence among clubs in a competition, competition law tends to tolerate such agreements.24 If a league is run by the teams themselves they are liable to make agreements among themselves that may limit the extent of economic competition in order to simultaneously enhance the overall quality of league play (acceptable under antitrust law) and limit the extent of economic competition for the sake of increasing profits (unacceptable under antitrust law).25 Contrary to the Supreme Court’s dicta, however, it is not necessary that competitors agree on these matters; the industry certainly can be structured so that these measures are determined by a vertically separate competition organizer, as is the case in Australia, with NASCAR, and with individual sports like golf, tennis, or track and field.26
Moreover, it is important to distinguish the typical vertical integration of a single upstream firm and a single downstream firm from an integration that effectively results in the upstream functions being performed by a cooperative of downstream firms. Club-run leagues still face the problems of double marginalization, free riding, opportunistic behavior,27 and costly contracting that vertical integration is presumed to avoid. Because vertical integration appears less likely to achieve these predicted efficiencies in the sports context, and because of the particular potential for vertical integration to cause a welfare-reducing relaxation in inter-club competition, the general Chicago School presumption that vertical integration is efficient is particularly unwarranted with regard to sports leagues.
C. Comparing Club-Run and Vertically Separate Leagues
Although the foregoing economic analysis would prevent an assumption that vertical integration is efficient, any particular league’s decision to operate as a club-run league cannot be proven inefficient as a matter of theory. A comparison of the economic structure of club-run and vertically separate leagues, however, does demonstrate that separately-run leagues have the proper economic incentives to reach efficient results, while clubs do not. Noting again our acceptance of the existence of a single dominant league in the major North American sports, which itself causes predictable anticompetitive effects,28 our claim is that the design of a traditional club-run sports league results in even greater inefficiency than would result from the activities of an efficient, profit-maximizing monopolist.
We contrast club-run leagues with a new type of independent business entity (“The League”) that would organize a competition. This entity would then contract with separate firms (the clubs) as franchisees with the right to participate in the competition that The League will organize. Franchise agreements would set forth conditions for termination, rules of the game, revenue streams that would be retained by the franchisees, and revenue streams that would be re-allocated by The League back to franchisees (as revenue sharing or as prizes for competitive success). Thus, well-drafted franchise agreements would assign to The League those marketing activities that can most be efficiently performed centrally, while preserving incentives for club innovation in any markets where such innovation is forseeable. The League would determine the number and location of franchises, subject to side payments provided for in the franchise agreement if necessary to protect franchisee expectations. The League also would negotiate a collective bargaining agreement with the players’ union that would determine the structure under which clubs would compete for players’ services.
This part examines the incentives for club-run leagues to make efficient decisions in six important areas, and concludes that, in comparison with The League, collective action problems are likely to lead club-run leagues to adopt practices that result in a smaller “pie” because of the inability of the clubs to agree on how to share the proceeds of profit-enhancing initiatives. As a result, club-run monopoly leagues produce fewer franchises, fewer opportunities for broadcasting or webcasting of their games, less effective licensing of merchandise, greater tolerance for inefficient front-office management, a less efficient allocation of players among teams (in part due to inefficient sharing of revenue that might promote competitive balance to enhance consumer appeal), and a greater bias in favor of club competition at the expense of the dynamic growth of international play that fans may prefer. We suggest that, in contrast, a vertically-separate structure is likely to result in a more efficient allocation of revenue streams between The League’s shareholders and franchisees, and re-allocations to create incentives to improve the sport’s consumer appeal. As a result, consumers will benefit from receiving an entertainment product delivered more efficiently and responsively to their demand, and investors should also see profits increase from these realized efficiencies.
1. Optimal number and location of franchises.
Sports leagues that do not face competition from close substitutes will artificially suppress the number of franchises in the league.29 Club-run leagues will necessarily reduce output by even more than a profit-maximizing single-firm monopolist would, and will avoid locations that may be more efficient but may hurt individual club owners’ interests.
The optimal number of clubs within a league competition depends on the revenue expected from additional clubs, additional costs associated with additional clubs, and any lost revenue that arises because of reduced demand for games involving existing clubs.30 Revenue may increase with an additional club because of the new set of fans attracted to matches and/or the increased attractiveness of matches to existing fans due to the involvement of the new club. Costs increase due to the overhead involved in supplying an additional team to the league, and any increase in operating costs due to an increase in the number of players hired and greater competition for services of players. Revenues to existing clubs may potentially fall for several reasons: (a) the substitution by fans of matches involving the new club for matches involving an existing club, (b) the total quality of the league may be diminished by the additional of a club (e.g. because talent become spread too thinly and the overall quality of each match declines),31 and/or (c) because the number of games between popular teams is reduced by the need for these teams to also play against expansion clubs (i.e., to make room for more games with the Tampa Bay Devil Rays, the New York Yankees play fewer games against the Boston Red Sox).
A profit-maximizing league will expand whenever it will be profitable to do so – i.e. whenever net marginal revenue exceeds marginal cost. A club-run league, however, will not expand unless net average revenue exceeds marginal cost.32 Indeed, if (as is common) a super-majority vote is required for expansion, a profitable expansion will be rejected by a club-run league unless the increased revenue from the new team that is shared with other owners (such as expansion fees, increased broadcast rights fees because of higher ratings, greater sales of merchandise) makes a super-majority of clubs better off. This is because each club’s representative votes for the amount of expansion which maximizes their own club’s profits.
Of course, if transactions costs were zero, the members of the league would be able to agree a set of side payments which ensures efficient expansion. However, where transactions costs are not zero, then efficient contracting may well not occur.33 Clubs in North American sports leagues all share revenues from collective sales of television rights and licensing; each club’s analysis of whether to vote for expansion will also consider the club’s reduced share of these revenues. Club-run leagues are also likely to under-expand as part of explicit or implicit agreements to protect local markets from competition. Many suggest, for example, that Major League Baseball’s refusal to expand to the Washington, DC area is due to vigorous opposition from the Baltimore Orioles.34
In contrast, The League has the incentive to draw up franchise agreements that preserve the flexibility to add or relocate teams when the trade-off is favorable. We would expect that, like any other franchisor, The League would determine the number and location of franchises authorized to participate in the competition. In light of the dynamic nature of demand for a sport, we predict that The League will follow the now-typical franchisor practice of granting non-perpetual franchises, with specified terms for non-renewal,35and will not guarantee geographic exclusivity but will provide in its franchise agreement some mechanism for flexibility in this regard.36

To illustrate, suppose that reliable market research were to demonstrate that overall baseball profits would increase if the Montreal Expos were relocated to the Washington, DC area and two expansion teams were added in suburban New Jersey and Connecticut:37 that is, the sum of increased revenues from expansion fees, live gate and stadium related sources at these three new locations, and marginally increased revenues from broadcasting and increased licensing and merchandise, exceeds lost revenue from Montreal-based sources, marginally lost revenue from the New York and Baltimore teams in close proximity, and increased costs of operating two new teams. The League would be expected to proceed with the expansion after compensating existing clubs for losses pursuant to carefully drafted provisions of the franchise agreement. However, under current rules the rest of the clubs would not agree unless the expansion fees exceeded the reduction in their pro-rata proportion of shared revenues from 3.333% to 3.125%, and the New York Mets and Yankees and Baltimore Orioles could plausibly lobby a significant minority of owners to block the expansion out of fear that future expansion or relocation might be adverse to their interests.



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