As promised last week, I want to put my economist hat on for just a minute to discuss the Albies extension, in which people argue that Albies and his agent are leaving $100 million or more on the table. There is nothing in economics that makes this impossible, but there are good reasons to think it is unlikely.
One way to see this is just to look at market comps, as Ken Rosenthal does here. Christian Yelich, Andrelton Simmons and Anthony Rizzo all signed similar buyout contracts for around $50 million. While Albies’ deal is well short of those deals, none of those deals is anywhere near $135 million. But that’s not really economics… it’s more in the realm of real estate valuation.
To an economist, each of Albies’ earnings for the next seven years assuming he doesn’t sign a deal is a random number, which, because economists are uncomfortable not using mathematical symbols, we can call Si, where S means salary and i ranges from 2019-2025. We know a lot (though not everything) about 2019-2020 and have some reasonable knowledge about what will go into the compensation for 2021, but the years after that, which will played under a new CBA are really hard to predict.
But to an economist this isn’t really a problem. Looking at markets to value uncertain streams of income over time is what economists do. But is this really a market? After all, it’s a negotiation between two entities: Albies and the Atlanta Braves. Where’s the market? Normally, when we think of markets, we think of Albies (who owns his labor) facing multiple bidders to buy his labor – it’s the multiplicity of bidders (or at least potential bidders) that makes a market. In the absence of multiple bidders, we have the situation known as (to economists, who like categories nearly as much as they like equations) bilateral monopoly. Albies owns his labor and he can only sell to the Braves. Economists have studied questions of bilateral monopoly for a very long time, and I’m here to tell you they haven’t come to any real conclusions about it that stand up robustly against real-world situations. So if there ain’t a market, economists have (IMO) little to say.
But as economists, we aren’t done. The next step to ask is: why isn’t there a market? Even though a deal for 2019-2025 can only be signed between Albies and the Braves, that doesn’t mean there couldn’t be options for others to provide salary competition for the Braves. To abstract from some of the issues of uncertainty, let’s say that we know Albies’ salary for the next seven years assuming he is capable of performing at a major league level and that we further have a firm estimate of his probability of being major league quality in each of the next seven years. (In so doing, we are sweeping under the rug variations in how valuable Albies is, but you’ll have to take my word on it that these variations change the method I’m about to propose only in a technical way.) So every year, Albies would be paid, in the absence of a buyout, either Sci or 0, and the probability in each year of nonzero salary is pi. (I switched from S to Sc to point out that Sc is certain.) Per Szymborski above, we are trying to figure out if the sum of pi x Sci over the years (i) is $135 million, or anywhere near it. (Actually Szymborski seems to adjust for risk by subtracting 18 WAR from ZIPS which doesn’t really get at all the risks, but I’m not really trying to debate Szymborski except insofar as he thinks Albies left more than $100 million on the table.) As economists, we would then use some interest rate to discount this to present value and use a lot more notation to do so, but I’ll spare your browser’s weariness over Greek fonts. Note that this value could be as low as zero (ignoring the fact that he already made the team this year) and as high as the sum of Sci, which Szamborski seems to peg at $282 million.
It is an observation in economics that most people prefer certainty to uncertainty, and that Albies would therefore be willing to give up some expected pay to sign a deal which eliminates this uncertainty. This gives Albies some minimum number that he must get to forego his uncertain stream, and we know the deal he signed must exceed that number, but that doesn’t tell us anything about how the market would value his services. A lot of people have argued that Albies is willing to take this deal because he didn’t get a big bonus, he doesn’t come from wealth, yadda, yadda, yadda. This is all true, and perfectly well explains why he’d sacrifice a lot of potential upside. This little piece isn’t about Albies’ incentives to accept a deal like this, so long as he had negotiated the best deal the Braves could offer. And to get them to give their best offer, he has to explain why, whatever his inclination to get certainty, he’s not going to take less than a competitor for paying him is available.
So who are these hypothetical competitors? They aren’t baseball teams. They are financial firms who could invest in Ozzie Albies or who could profitably pay him not to accept the Braves offer, maintaining the certainty, but making Albies better off. Suppose blazon, inc. (a hedge fund I just made up) looks at Albies’ future pay and think he’s very likely to earn at least $135 million in expectation over the next seven years even without an extension. Then they can cut him a deal. We’ll pay you more than the Braves… considerably more. In return, you agree to give whatever the Braves pay you to us. Let’s say we agree to pay you, say $60 million, similarly structured. You do better than you do under the Braves offer and we pocket the (uncertain) difference between what the Braves pay and what we pay you.
There is a further wrinkle here. Since this deal with Albies is only a small part of the hedge fund portfolio, and they can take many other risks that aren’t correlated with the risks of this contract, they can afford to offer up to the expected value of the contract (less interest and profit). The uncertainty doesn’t cause them to discount much at all. (Albies can’t similarly diversify without signing a deal like this.) So why would blazon, inc. offer close to $135 million if that is the correct expected value? Well, first they need to leave room for profit. But mainly because they are in competition with other similarly well-heeled hedge funds. If they don’t offer this, someone else will outbid them.
So Albies valuation of what he is willing to take as a certainty equivalent of his uncertain stream (a little more econ jargon – why not?) doesn’t matter. It doesn’t matter because he isn’t really in a bilateral monopoly situation. He’s in a real monopoly position, charging whatever the market will bear.
OK, I hear you mutter (because economists can hear under-your-breath muttering over the Internet) but isn’t this a little hypothetical? No one has ever signed such a contract. So this market I’m saying Albies can use doesn’t exist.
Well, if the mere nonexistence of a market could dissuade economists from characterizing it we’d just be accountants. First, we have no idea whether such markets exist or not. We don’t know what deal Bryce Harper might or might not have signed six years ago. He might have taken exactly just such a deal. So might’ve Jason Heyward. Unless they talk about it, how would you know?
Certainly, it would be entirely unsurprising if Heyward or Harper borrowed against their free agent payday. Borrowing is not exactly the same, because the lender gives up the upside. If Harper borrowed $5 million after his rookie season, the lender can’t do any better than get back the loan with interest. But borrowing is an interesting case. If you were a bank, would you lend Albies $100 million? Or even $35 million? Well, it depends on the interest rate. Suppose you lend Albies $10 million every year for seven years at an annual interest rate of 20%. At the end of seven years, he pays you back the $70 million plus another $59 million. Where does he get this money? Well, we figured that his expected payment over this period was $135 million, so he’s got $6 million left over. And if he doesn’t earn the money, he spends the $70 million and declares bankruptcy. (This is a little flippant. There are various things a real lender would do to keep Albies from frittering away the money if he got injured in year 2, for example, but ignore that for the moment.) And the lender’s 20% return compensates them for the risk.
But even beyond the lending market, the equity market (my hedge fund example) is certainly starting to take off. See, for example this Tyler Cowen article, (which mentions income pooling for minor league baseball players, a related concept I’ll discuss below) or this article from the New York Times. They do this in the context of equity investments in college students in lieu of college loans. This is a real market, although it’s different than the market I’m talking about because when you do these deals in bulk you aren’t really concerned with precise estimates of value from each student who takes them. Much closer are these sorts of deals for musicians. It started with paying David Bowie for the rights to his back catalog but has morphed into markets to invest in the future income of new artists.
There are real problems with investing in the future income of individuals. The big problem is what economists call moral hazard. Once Albies is paid, what’s his incentive to put in the hard work to earn the money? For pre-arb baseball players, there’s an obvious answer: they need to do the hard work in order to earn the next contract. While this isn’t a guarantee (I can guarantee that there will be some slackers) it’s really no different than the problem the Braves have: they only offer these contracts to people they are pretty sure won’t slack off.
So it’s hard to figure circumstances in which the Braves are willing to pay Albies for a long-term buyout and some third-party financier is not. (Not to say there are no such circumstances. In particular, the Braves can presumably monitor their investments better than our hedge fund could. But remember Jeff Kent.) But here’s the lesson in economics: a financial firm might have to discount a deal with Albies by even $20 or $30 million, but the more money you think Albies left on the table, the higher the incentive would be for someone else to do this deal. But this means that the true value of Albies contracts must be much lower than $135 million, or Albies would not have signed the extension.
In addition, the deal need not be for all of Albies’ income. Suppose our hedge fund offered $35 million for half of Albies’ income over the seven year period. Albies now gets no less than he would have gotten in the Braves deal and he keeps half the upside above that. And if Albies is really expected to earn $140 million, the hedge fund can expect a profit (not counting the opportunity cost of money) of $35 million.
The labor pooling concept mentioned above doesn’t address the time structure of compensation, but it does address the uncertainty. In pooling, a group of minor league players with similar prospects agree to share to some degree their joint salaries. So guys who never make the majors (and arguably earn less than the minimum wage, but that’s another essay for another time) can be at least partly subsidized by those who made it and got a big payday. This helps to cushion the uncertainty of not knowing how far your skills will take you. You get some money back on the downside but sacrifice income on the upside. Deals like this won’t help the guys with the big pay days, but demonstrate that internal markets to allocate the extraordinary risks of trying to be one of the best 750 baseball players on the planet can be hedged.
But labor pooling does bring the most obvious indication that Albies’ expected value can’t be anywhere near $135 million. While the equities markets I’ve talked about above are speculative, there’s an actually existing market right now that Albies could use to create competition: the insurance market. We know teams routinely insure their long-term contracts. There’s nothing to stop players from doing so as well. (To be fair, the moral hazard problems are more intense, but there are ways around it.) I could go to Lloyds of London today and ask them to ensure that I will earn at least $135 million in the next seven years playing baseball. The only problem is that the insurance premium would be about $137 million. Albies can go to Lloyds during negotiation with the Braves and say: how much to guarantee the difference between what I make in baseball in the next seven years and, say, $100 million? They’ll give him an answer, say $25 million (I’m making this number up because I’m an economist, not an actuary.) When the Braves offer Albies a $35 million contract, he says to them: “Pound sand. For $25 million (which someone will surely lend me) I can guarantee $100 million over the same period. That’s $75 million net to me, which beats your piddling little offer. Match it (ie $75 million) or I’m not extending.”
Since we know this market exists, it forms a lower bound on any acceptable Braves extension offer. So we know Albies’ net insurance offer can’t be any higher than the $35 million. (I’m ignoring the buyouts here.) So either his expected value isn’t really $135 million, or the cost to insure that is in excess of $100 million, which is sort of saying the same thing.
So, the upshot is that either Albies and the financial markets refused to do a deal that would profit them both, or the amount of expected value of Albies’ future contracts through 2025 is well under $135 million. I suspect the latter, mostly because (a) economists believe that people don’t usually miss profitable opportunities to make beneficial trades when the payoffs are large; (b) the people who have estimated this $100 million lost are people with an ax to grind and no skin in the game; and (c) no one seems to think that Albies has poor representation – what is it exactly they do in negotiations other than explain why it would be irrational Albies to accept the deal on the table irrespective of his level of desire for certainty. (Obviously, they can deny Albies has much of a desire for certainty, but economists have a jargon-y name for that as well: cheap talk.)
Returning to the real-estate-valuation comps above, this doesn’t mean that the Braves might not have shorted Albies by $10 or $15 million. Their position as the direct beneficiary of his services (his labor creates wins and wins create attendance) means that they have a direct profit position that Albies has to pay to induce financial equivalents. That profit means that the Braves can always afford to offer somewhat more than others, and that therefore Albies’ best competing offer will be lower than the Braves can afford. But by $10 or $15 million, not $100 million. And just ask Le’Veon Bell: $20 million is chump change.
A famous economics joke is that two economists are walking down the street when one of them sees a $20 bill on the sidewalk. The other one says: that can’t be a $20 bill, because if it were someone would have picked it up already. I can confidently state that (a) this joke is only mildly funny; and (b) factually untrue, since I once found a $20 bill in the back of a cab while I was riding with another economist. But I can also confidently state that if Ozzie Albies saw an additional $100 million lying in the street, he’d probably scoop it up. So it’s probably not there. That’s no joke.