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Cross-subsidization in professional sports: a socialistic omen for needed change.
Subject:
Professional sports (United States)
Professional sports (Analysis)
Professional sports (Economic aspects)
Professional sports (Social aspects)
Capitalism (Analysis)
Revenue sharing (Analysis)
Authors:
McCuddy, Michael K.
Meyer, Michael L.
Pub Date:
07/01/2007
Publication:
Name: International Journal of Business Research Publisher: International Academy of Business and Economics Audience: Academic Format: Magazine/Journal Subject: Business, international Copyright: COPYRIGHT 2007 International Academy of Business and Economics ISSN: 1555-1296
Issue:
Date: July, 2007 Source Volume: 7 Source Issue: 4
Topic:
Event Code: 290 Public affairs
Product:
Product Code: 7941000 Professional Sports; 9108851 General Revenue Sharing NAICS Code: 711211 Sports Teams and Clubs; 92611 Administration of General Economic Programs SIC Code: 7941 Sports clubs, managers, & promoters
Geographic:
Geographic Scope: United States Geographic Code: 1USA United States

Accession Number:
178900251
Full Text:
ABSTRACT

A major business challenge of professional sports in the United States is fostering competitive balance among teams in a league and promoting the overall health of the team franchises and the league itself. Effectively meeting this challenge is complicated by the basic economic structure of American professional sports--namely, being more of a market socialism system than a capitalistic system. Using the market socialism paradigm as an analytical prism, this paper examines revenue sharing--a prominent form of cross-subsidization--as a means of encouraging competitive balance and league and franchise health. Unfortunately, broadcast rights, gate receipts, and the luxury tax--which are three common subtypes of revenue sharing--have not produced the intended competitive balance and league and franchise health. Two solutions are offered for addressing the failures of revenue sharing.

Keywords: Professional Sports, Sports Economics, Economic Systems, Capitalism, Market Socialism, Cross-Subsidization, Revenue Sharing

1. INTRODUCTION

Professional sports, especially in the United States, comprise a major business institution which competes for its share of consumers' entertainment dollars in an environment wherein consumers have ever-increasing entertainment options. To draw a significant share of consumers' entertainment dollars, professional sports teams must develop and maintain fan interest by fielding competitive teams within a healthy league. How to accomplish this is a major challenge facing decision makers at both the franchise level and the league level.

Perhaps the greatest detriment to professional sports as a business enterprise is the existence of harmful, opportunistic behaviors by owners and players. The failure to effectively control, if not eradicate, these opportunistic behaviors is rooted in the basic economic nature of American professional sports. Although American professional sports exist within a capitalistic economy, professional sports are not really capitalistic in nature. Rather, American professional sports operate in a way that is more reflective of a socialistic economic paradigm.

This paper discusses the use of cross-subsidization of weaker teams by stronger teams as a means of maintaining competitive balance and health within a given sports league. The paper also explores cross-subsidization within a classification framework of economic systems, arguing that cross-subsidization is perhaps best understood as a form of market socialism. To support this argument, revenue sharing, which is a prominent form of cross-subsidization, is analyzed with respect to the defining organizational features of market socialism. Particular attention is given to three major subtypes of revenue sharing: broadcast rights, gate receipts, and the luxury tax. Unfortunately, these major subtypes of revenue sharing have fallen short in producing sustainable competitive balance in professional sports. Finally, two potential solutions are offered for addressing the shortcomings of revenue sharing. These solutions could help in developing and maintaining competitive balance and long-term league and franchise health within a market socialism system.

2. PROFESSIONAL SPORTS ECONOMICS

From a governing perspective, the structure and operation of professional sports embraces a number of unique economic ideas that, while not revolutionary to the collective human society, stand in contrast to those economic principles embraced by the capitalist economic system of the United States. Fort and Quirk (1995, p. 1265) provide a primary example of this in describing the collective decision making in professional sports leagues as "classic, even textbook, examples of business cartels." They also point out the unique nature of a sports league's product as the competition on the field, rather than a tangible good (Fort and Quirk, 1995, p. 1265). Given the nature of the product then, it would seem to follow that the overall health of the league, and the individual teams, depends on maintaining fan interest by providing competition that is highly desirable as entertainment. However, the league must help to engineer this competition in some way, or risk losing one or more weak teams due to waning interest in their perpetual "cellar-dweller" status (Szymanski, 2003, p. 1140).

While a myriad of economists have attempted to understand the formula for achievement of competitive balance, none has successfully developed a widely agreed-upon and workable method for league implementation due to their collective lack of an adequate definition of competitive balance. Buzzacchi, Szymanksi, and Valletti (2003, p. 168) illustrate the shortcoming: "The measure widely cited in the existing literature is the standard deviation of winning percentages in a season. According to this measure, the greater the variance in outcomes in a season, the less balanced is the contest. The principal weakness of this measure is that it takes no account of the identity of the teams across seasons." Thus, the argument is made that a team's ability to remain consistently competitive in terms of winning percentage over a period of years is a better measure of balance than is the number of teams in close competition during a single season.

In an effort to achieve greater competitive balance, several common initiatives have been undertaken by multiple American professional sports leagues. Cross-subsidization of weaker teams by their stronger counterparts has arguably been the most common tool in this effort, with systems of revenue sharing, salary caps, reserve clauses, collective bargaining, and luxury taxes being implemented in various forms. Cross-subsidization refers to any system whereby one franchise's economic resources are utilized to assist another franchise in the same league. Cross-subsidization can occur directly when revenue sharing programs tax a high revenue team and use that revenue to support a lower revenue team. Or it can occur indirectly when an economically stronger franchise's use of its own economic resources results in a positive economic effect for an economically weaker franchise.

Rottenberg's (1956, p. 255) seminal work on cross-subsidization yielded the generally accepted invariance principle which claims, in essence, that the level of talent in a league will be evenly distributed regardless of league restrictions designed to achieve competitive balance. Vrooman (2000, p. 364) reaffirms Rottenberg's theory and expands upon its assertions with an understanding that the various cross-subsidization systems implemented over the years have failed to achieve measurable and attributable success due to their being based on the assumption that all owners of franchises will behave as "pure profit-maximizers" and will have no win-maximizing motivation. Zimbalist (2003, p. 507) further suggests that a league in which all owners have the same motivations and objectives for ownership does not exist, and that a generalization as such is flawed. Instead, it is proposed that owner motivations be considered relative to how the team is affected by and impacts the owner's other assets. Ferguson, Jones and Stewart (2003, p. 422) believe that the desire to win is present on some level in nearly every owner, and that this desire will not be completely overshadowed by a profit motive, as evidenced by free-agent bidding wars and salary trends in the last decade.

Although a majority of the expert economic opinions on the subject of cross-subsidization have shared the opinion that an effort should be made to curtail wildly opportunistic behavior that may damage competitive balance (Mason, 1997, p. 215), many economists remain at odds as to whether the players' or owners' opportunistic behavior is more damaging to the league. Adams and Brock (1997, pp. 721-722) assert that, left unchecked, the profit motive in both the player and owner cartels will pose a serious threat to league balance. In contrast, Miceli and Scollo, (1999, p. 62) and Vrooman (2000, p. 367) suggest that the reserve clause, labeled as a vehicle for owner greed and player exploitation in the arguments supporting the successful fight for free-agency, is a positive aspect of profit-motive behavior in which the owners simply attempt to recover the cost of developing a player for service at the major league level.

The application of the reserve clause in American professional sports has varied by league. The underlying principle that defines this clause across leagues grants lifetime negotiation rights to the franchise that holds a player's contractual rights. In other words, a player cannot, at the end of his contract, test the interest of other teams in paying him a higher salary for his services. He is bound to his current club, and cannot sign with another unless his contractual rights are sold to that club or he is included as part of a player trade. This practice results in significantly lower player salaries than a system of free agency, thereby leading to higher owner profit.

The chairman of the San Diego Padres, however, laments the difficultly that small market clubs have in retaining this talent after the costs are recovered as the main factor behind the notable absence of small market clubs beyond the first round of post-season play (Moores, 2002, p. A18). Despite a multitude of theories, it is apparent that no model for identifying and eradicating the most damaging of opportunistic behaviors has been successfully designed and implemented. The failure to effectively control, if not eradicate, harmful opportunistic behaviors rests, in part, on the fundamental economic nature of American professional sports.

3. THE RELEVANCY OF ECONOMIC SYSTEMS TO PROFESSIONAL SPORTS LEAGUES

Baseball, long touted as the "great American pastime," was conceived in and continues to operate in one of the great bastions of market capitalism. Yet professional baseball (MLB), like other major professional-level sports, including football (NFL), basketball (NBA), and hockey (NHL), do not themselves operate completely as microcosms of market capitalism. Instead, these professional sports leagues have socialistic policies and practices strongly embedded in their operations.

To appreciate and embrace this assertion, it is necessary to have a basic understanding of the comparative nature of economic systems and how the defining and differentiating features of economic systems can be applied to professional sports. Gregory and Stuart (1999, p. 14), "classify economic systems in terms of the organizational features that they exhibit." Four general organizational features--(1) structure, (2) market and plan, (3) control and income, and (4) incentives--can be used to differentiate among the traditional economic systems of market capitalism, market socialism, and planned socialism (Gregory and Stuart, 1999, pp. 10-28). Figure 1 shows how these four features vary across the three market systems.

As Gregory and Stuart (1999, pp. 14-15) argue, organizations exist in many different forms ranging from simple proprietorships to large corporations to entire communities and societies, and ranging across private and public domains. All of these organizational forms can be characterized as possessing some degree of the dimensions of structure, market and plan, control and income, and incentives. Just as these features can differentiate among economic systems, so can they be used to distinguish among less complex organizational forms. Although the various professional sports leagues in America represent an organizational form of lesser complexity than the economic systems of nations and societies, these sports leagues still can be analyzed within the context of the framework shown in Figure 1.

The authors of this paper submit that the control and income feature is especially relevant to the analysis and understanding of professional sports leagues in America--particularly in the context of revenue sharing, which is a very important characteristic of the operations of these leagues. The organizational feature of control and income revolve around ownership, or property rights. Property rights enable the owner to make decisions and take actions to: (1) dispose of the property, (2) utilize the property, or (3) use the products and/or services generated by the property. Property ownership may also be private, public, or collective. Which rights are owned by who will define the nature of an economic system as well the allocation of system outcomes (Gregory and Stuart, 1999, pp. 21-22).

"Insofar as human capital and physical capital and natural ability are not likely to be evenly distributed, especially when such things can be passed from one generation to another, private ownership of the factors of production raises the likelihood of an uneven distribution of income and wealth among the members of capitalist societies. Exactly how unevenly income and wealth are distributed will depend on the distribution of human and physical capital and also on the redistributive role of the state" (Gregory and Stuart, 1999, p. 109). We argue that the uneven distribution of human and physical capital in professional sports has fostered the development of the redistributive role of the leagues in the form of revenue sharing, and as such has created, promoted, and reinforced these sports leagues as socialistic enterprises. Jaroslav Vanek, an early advocate of the cooperative or participatory form of market socialism, identifies five characteristics that define this form, including one that is especially relevant to the concept of revenue sharing in professional sports leagues. Vanek (1971, p. 9) argues that in the cooperative or participatory form of market socialism, income will be shared and such sharing is to be equitable.

Indeed, as has been argued about socialism as an economic system--namely that "one of the most critical features of socialism was achieving a distribution of income more equitable than under capitalism" (Gregory and Stuart, 1999, p. 24)--it can also be argued that revenue sharing in professional sports leagues in America serves to achieve a more equitable distribution of income. Later in this paper, the authors will discuss how this socialistic objective of more equitable distribution of income becomes problematic for the long-term sustainability of truly competitive professional athletics. Although planned socialism should produce the favorable outcome of distributing income relatively equally among participants, it nonetheless is inefficient in allocating resources, processing information, and motivating participants (Gregory and Stuart, 1999, p. 132). Market socialism, however, "offers the potential of combining the 'fairness' of socialism with the efficiency associated with market allocation" (Gregory and Stuart, 1999, p. 138).

4. APPLYING MARKET SOCIALISM TO REVENUE SHARING IN PROFESSIONAL SPORTS

Revenue sharing is the single economic vehicle that is most likely to elicit comparisons of the governing practices of professional sports league to those of socialism. As discussed earlier, the primary factor in instituting a system of revenue sharing is the need to enhance competitive balance through cross-subsidization of weaker teams by their stronger counterparts. This will, in theory, lead to an even distribution of revenues. However, this becomes problematic in a system where the ownership of the franchises is, by and large, private. The nature of private ownership can be most easily characterized by autonomy in decision making. Yet, private ownership will naturally be at odds with the league governing system--especially when the owners give the league collective decision-making authority. Quite expectedly, not all of the league's decisions will harmonize with the desires of the individual private owners--the wealthiest of whom will sometimes view revenue sharing programs as "welfare" for other owners not willing to work as hard (Atkinson, Stanley, and Tshirhart 1998, p. 28). The ongoing debate between league and franchise personnel as to the ideal level (if any) of the cross-subsidization that is necessary to maintain competitive balance is a clear illustration of this rift. Across the four major American sports leagues various sub-types and degrees of revenue sharing (or cross-subsidization) are being implemented. Among these sub-types are the collective sale of broadcast rights by leagues, gate revenue sharing, luxury taxes on excessive payroll, salary caps, and a host of other niche programs too numerous and varied to identify for the purposes of this article.

4.1 Revenue Sharing from Broadcast Rights

The collective sale and even distribution of national television broadcast rights is likely the most prominent of the revenue sharing subtypes. This is a relatively clear example of the use of a market socialism-based vehicle to achieve an equitable distribution of revenue. This practice is spawned by a league-initiated desire to provide all teams with a solid revenue base, and to prevent the most able owners from grossly over-selling their own rights and using the funds to escalate competitive imbalance. The control and income feature of market socialism, as discussed earlier, is largely classified by collective ownership of property rights. In this case the league, whose leadership is collectively approved by the individual owners, is exercising control of the most significant property of professional sports--namely, the product of competition.

The NFL is the most proficient in this area, having negotiated mega contracts with all but one of the four major networks (not to mention ESPN and the NFL Network). The revenues generated by these contracts are distributed evenly among the league's franchises, providing a stable revenue base for all teams. Intuition might indicate an improvement in competitive balance as a result of this distribution. Although this significant inflow of revenues to each team is a cushion to offer security in meeting team payroll, the even nature of the distributions does little to stabilize revenue levels among franchises. Indeed, the richest of teams remain that way--even in the NFL. Despite Fort and Quirk's (1995, p. 1291) observation that, "[s]trong drawing teams, which contribute more audience than weak-drawing teams, certainly are subsidizing weak-drawing teams because each is receiving an equal share of national TV revenues," this subsidy does not appear significant enough to level the revenue playing field.

4.2 Gate Revenue Sharing

Another sub-type of revenue sharing that is debated among owners and the league is gate revenue sharing. Each league has its own standards for this type of sharing, with the NFL again leading the pack in the most equitable sharing of these revenues with a 60/40 split in favor of the home team. Unlike the more decisive economic classification of the collective sale of broadcast rights as market socialism, the sharing of gate revenues fits less cleanly into any of the three economic systems discussed previously. In gate revenue sharing, the control and income feature contains elements of both private ownership and collective ownership. Although the revenues being shared are the result of the sale of property rights (i.e., tickets to the contest on the field) that is validated as official by the league, these revenues are jointly owned only by the pair of franchises competing in that particular contest. Thus, the collective nature of ownership of the contest is classified differently, and can even be viewed as private between the two teams, since these revenues are not shared beyond the participants.

Economics experts differ considerably as to the effectiveness of gate-sharing in achieving competitive balance. Marburger (1997, pp. 121-122) indicates that gate-sharing may result in the enhancement of competitive balance, although the current enforcement capabilities of each of the major sports leagues are insufficient for the true measure of this positive impact to be realized. Bandyopadhyay and Bottone (1997, p.18) second this finding in the assertion that "stricter enforcement of the various control policies... will eventually eliminate violations and establish true parity." In contrast, Fort and Quirk (1995, p. 1289) and Vrooman (2000, p. 367) present models that indicate the invariance of the impact of gate-sharing on competitive balance. Finally, Szymanski and Kesenne (2004, p. 170) assert that gate-sharing actually harms balance through the blunting of incentives for the weaker team to win. The conclusion is drawn that, because the weaker team will typically have lower margins and a lower threshold for achieving profit, the reduced talent investment resulting from gate sharing will have a greater impact and result in an even lower expenditure on payroll for this team, thereby leading to imbalance in the contest. The impact of gate revenue sharing on competitive balance is quite obviously a hot button issue among sports economists, and its merits (or lack thereof) are likely to remain anomalous until an effective measurement tool is developed to isolate gate revenue sharing in order to study its true effects.

4.3 The Luxury Tax as Revenue Sharing

Finally, a sub-type of revenue sharing exists that, although less applicable to the focus of this article, will still be touched on briefly. Some experts have harpooned the luxury tax in MLB, perceiving it to be a penalty for success rather than a penalty for stifling competition. Marchman (2003, p. 28) asserts that the luxury tax is improper for achieving competitive balance because it takes from the rich and rewards the poor, not because they are poor but because they refuse to improve their own situation. The luxury tax, as an alternative Robin-Hood-type mechanism, can be most adequately discussed as an example of a control and income feature more akin to the design of the market socialism system. The basis underlying this classification is market socialism's state/collective ownership of control and income elements--with the league assuming a state or government-like role as the taxing agency. The similarities end, however, when the league redistributes that revenue based not upon actual economic need, but rather upon "perceived" inability to generate revenue. The argument is put forth that "[this] revenue sharing plan penalizes high-revenue teams and rewards low-revenue teams. To put it another way, it rewards incompetence and punishes competence" (Marchman, 2003, p. 28). Although this appears to be the case, the deeper motivation behind a sharing of this type often lies more in the attempt to control the renegade owner of the stronger team, than to reward the struggling owner of the weaker one.

5. POTENTIAL SOLUTIONS FOR ADDRESSING THE SHORTCOMINGS OF REVENUE SHARING

Clearly, revenue sharing as a means of cross-subsidization has fallen short--far short--of achieving substantial and sustainable competitive balance among the franchises of American professional sports leagues. Although a myriad of arguments have been offered both for and against the various sub-types of cross-subsidization through revenue sharing, there is little accord between experts as to the most effective system design for the achievement of both competitive balance and long-term league and franchise health. However, two points that appear quite often in the literature suggest potential solutions to this perplexing and persistent dilemma.

First, though economists differ as to the severity of the problem, and on the immediacy with which a change must occur, a consensus nonetheless exists that the trends evident in the current system indicate the necessity for a change if the future is to remain bright for the industry. Bandyopahdyay and Bottone (1997, p. 8) suggest that if the current polarization of revenue distribution in all leagues continues as it is at present, then small market franchises will be forced to relocate. However, this cycle cannot continue, as there are not enough new markets capable of supporting professional franchises. Ultimately, with more non-sporting events competing for consumers' limited entertainment dollars, saturation will inevitably occur. This will lead to the folding of many small market franchises. Although this outlook is clearly alarmist in the outcomes it predicts in the absence of change, it serves to illuminate the critical nature of the problem and should push those in power to consider changes that are based on a concern for long-term sustainability.

Second, stricter enforcement of revenue sharing policies is needed, as is a clearer definition of what revenues are susceptible to sharing. Many loopholes in the existing system have allowed the large market teams to cop-out of much of the sharing through the reduction of taxable (shareable) revenues, thereby resulting in less subsidization for the small market teams and more imbalance in the league (Mientka, 2005, p. 34). Appropriate subsidy of small market teams is mandatory if competitive balance is to be attained. Without such subsidy, professional sports will likely be dominated continually by a few strong teams, and the leagues and many franchises will suffer as consumers spend their entertainment dollars elsewhere.

REFERENCES:

Adams, W., and Brock, J.W., "Monopoly, Monopsony, and Vertical Collusion: Antitrust Policy and Professional Sports", Antitrust Bulletin, Vol. 42 (3), 1997, 721-747.

Atkinson, S.E., Stanley, L.R., and Tshirhart J., "Revenue Sharing as an Incentive in an Agency Problem: An Example from the National Football League", The Rand Journal of Economics, Vol. 19 (1), 1998, 27-43.

Bandyopadhyay, S., and Bottone, M., "Playing to Win", Marketing Management, Vol. 6 (1), 1997, 8-19.

Buzzacchi, L., Szymanksi, S., and Valletti, T.M., "Equality of Opportunity and Equality of Outcome: Open Leagues, Closed Leagues and Competitive Balance", Journal of Industry, Competition and Trade, Vol. 3 (3), 2003, 167-186.

Ferguson, D.G., Jones, J.C.H., and Stewart, K.G., "Competition within a Cartel: League Conduct and Team Conduct in the Market for Baseball Player Services", The Review of Economics and Statistics, Vol. 82 (3), 2003, 422-430.

Fort, R., and Quirk, J., "Cross-Subsidization, Incentives, and Outcomes in Professional Team Sports Leagues", Journal of Economic Literature, Vol. 33, 1995, 1265-1299.

Gregory, P.R., and Stuart, R.C., Comparative Economic Systems, 6th ed., Houghton Mifflin Company, Boston, 1999.

Marburger, D.R., "Gate Revenue Sharing and Luxury Taxes in Professional Sports", Contemporary Economic Policy, Vol. 15 (2), 1997, 114-123.

Marchman, T., "Against Baseball Socialism", National Review, November 10, 2003, 27-28.

Mason, D.S., "Revenue Sharing and Agency Problems in Professional Team Sport: The Case of the National Football League", Journal of Sport Management, Vol. 11 (3), 1997, 203-222.

Miceli, T.J., and Scollo, C., "An Economic Analysis of the Reserve System in Major League Baseball", Journal of Business and Economic Studies, Vol. 5 (1), 1999, 55-65.

Mientka, M., "Baseball: The Business", AFP Exchange, Sept/Oct 2005, 30-34.

Moores, J., "Damn Yankees", The Wall Street Journal, May 14, 2002, A18.

Rottenberg, S., "The Baseball Player's Labor Market", The Journal of Political Economy, Vol. 64, June 1956, 242-258.

Szymanski, S., and Kesenne, S., "Competitive Balance and Gate Revenue Sharing in Team Sports", The Journal of Industrial Economics, Vol. 1, 2004, 165-177.

Szymanski, S., "The Economic Design of Sporting Contests", Journal of Economic Literature, Vol. 41 (4), 2003, 1137-1187.

Vanek, J., The Participatory Economy, Cornell University Press, Ithaca, NY, 1971.

Vrooman, J., "The Economics of American Sports Leagues", Scottish Journal of Political Economy, Vol. 47 (4), 2000, 364-398.

Zimbalist, A., "Sports as Business", Oxford Review of Economic Policy, Vol. 19 (4), 2003, 503-511.

AUTHOR PROFILES:

Dr. Michael K. McCuddy earned his Ph.D. at Purdue University in 1977. He holds The Louis S. and Mary L. Morgal Chair of Christian Business Ethics and is a Professor of Management at Valparaiso University. He served as editor-in-chief for The Challenges of Educating People to Lead in a Challenging World, published by Springer and sponsored by Educational Innovation in Business and Economics (EDiNEB). He is actively involved in a variety of research projects on ethical issues and educational innovation.

Michael L. Meyer earned a Bachelor of Arts from Marquette University in 2002. He is a J.D. and Masters of Science candidate at Valparaiso University, scheduled to complete his degrees in 2009. Prior to his studies at Valparaiso, he worked in marketing and corporate affairs with the Milwaukee Brewers of Major League Baseball. He also worked for two years as Director of Corporate Partnerships for the Kansas City T-Bones of the Independent Northern League of Professional Baseball.

Michael K. McCuddy, Valparaiso University, Valparaiso, Indiana, USA

Michael L. Meyer, Valparaiso University, Valparaiso, Indiana, USA
FIGURE 1. THE CLASSIFICATION OF ECONOMIC SYSTEMS

                                      ECONOMIC SYSTEM
GENERAL
ORGANIZATIONAL           MARKET           MARKET           PLANNED
FEATURES               CAPITALISM        SOCIALISM        SOCIALISM

Structure (i.e.,        Primarily        Primarily        Primarily
Decision-Making       Decentralized    Decentralized     Centralized
Structure)

Market and Plan        Primarily        Primarily       Primarily Plan
(i.e., Mechanisms        Market           Market
for Information
and Coordination)

Control and Income      Primary        State and/or     Primary State
(i.e., Property          Private        Collective        Ownership
Rights)                 Ownership        Ownership

Incentives             Primarily       Material and     Material and
                         Market            Moral            Moral

Source: Adapted from Figure 2.3 in Gregory and Stuart (1999, p. 26).
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