Chapter 3

1. Chapter 3 Sports Franchises as Profit-Maximizing Firms

2. 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

3. The Importance of Leagues • Leagues did notalways 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. Maximizing Profit • p = 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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)

16. 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

17. 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

18. 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”

19. 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 $ $ P1 MC P0 MC D D MR MR

20. 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 $ $ P1 P2 P0 MC D D MR MR

21. 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

22. 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

23. 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

24. 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

25. 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