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ECON 2P03 (10)
Chapter 2

Chapter 2 NOTES.docx

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Krishnakali Sen Gupta

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Chapter 2 THE ECONOMICS OF PROFESSIONAL SPORTS PROFIT MAXIMIZING SPORTS FRANCHISES Introduction • Any rational firm wants to maximize profits. • But fans condemn team owners who put making a profit ahead of winning. • Nevertheless, bad things can happen if teams forget about staying in the black. • Recall the 2002-2003 Ottawa Senators – they had the best record in the NHL but had to file for bankruptcy. Importance of Leagues • Leagues did not always exist • Professional baseball formed 7 years before MLB • Professional football existed 44 years before the NFL • Prior to the formation of leagues, teams played other teams on an ad hoc basis. • Most games were between teams in the same city. • Once transportation improved, teams could play teams from other towns. • This practice of “barnstorming” was popular but uncertain. • Couldn’t guarantee the other team would show up. • Couldn’t guarantee the size of the crowd. • Earnings were tied to winning. • To fans, a league is just a collection of teams who play each other. • Economically thinking, leagues behave cooperatively. • Teams are rivals that succeed at the expense of the other teams. • But a team’s success also depends on the success of the other teams and on the success of the league as an institution. • Let’s assume that teams are there to maximize profits and the league exists to help them do this. The Functions of Leagues • Setting the Rules à One of the most important functions  Teams have to agree how to play the game a) Having precise rules and enforcing them actually helps sports to spread b) e.g. baseball – only spread after the Knickerbocker rules were adopted in the 19 century • These were a set of 20 rules which are considered to be the basis for today’s game, although many have changed since 1845. • My personal favourite: • 13th. Aplayer running the bases shall be out, if the ball is in the hands of an adversary on the base, or the runner is touched with it before he makes his base; it being understood, however, that in no instance is a ball to be thrown at him. • Rules for behaviour are also important. • For example, players can’t bet on games and the use of performance enhancing drugs is banned. • Rules can change to enhance the popularity of sports. • For example, the 3-pt score in basketball and reducing the allowable size of NHLgoalie pads allows for higher scores (Americans like high scoring games). • Limiting Entry • Too many teams hurt competition and fan interest • Too few teams leave room for competing leagues to arise (like theAmerican league and theAmerican football league) • What determines league size? • When a new team enters there are benefits and costs to existing teams. e.g. all the major cities have teams in just about every sport  Adding teams to a market diminishes the existing team’s monopoly power  Adding teams means more substitutes and the demand curve for the existing teams becomes more elastic • Benefits: admission fees from new teams, additional fan base and media outlets. • Costs: any shared revenues spread over more teams, reduces existing teams’ability to threaten to move when negotiating with their current home cities. • If revenues decrease with the addition of one more team, the marginal revenue curve would slope downward. • Expected because the most profitable cities are added first, with the smaller, less profitable cities added afterwards. • If costs increase with the addition of one more team, the marginal cost curve would slope upward. • Equilibrium number of teams where MR = MC. • • If teams in a league are making positive economic profits, new teams will want to enter. • Threat of new entry puts downward pressure on prices and profits. • This gives existing firms the incentive to keep out new teams. • If potential owners can’t join a league, they have an incentive to start a new one. • Anew league’s success is uncertain, since all the good markets will already have teams from the existing league. • For example, the rival World HockeyAssociation (WHA). • The WHAplayed from 1972-1979. • After that, 4 WHAteams joined the NHL (Edmonton Oilers, Quebec Nordiques, Winnipeg Jets, Hartford Whalers). • Except for the Oilers, the other 3 eventually relocated to Denver, Phoenix and Charlotte respectively. • Neale (1964) sees leagues as multiplant monopolies (we mentioned this briefly in the introductory slides). • For instance, part of the excitement of a single game comes from how the outcome relates to league standings which involves all the teams in the league. • Leagues coordinate the number of games played (output) and prices, even if this means less profits for some members. • The league negotiates major TV contracts. • Restricting the number and location of teams gives owners a guaranteed source of ticket and media revenue plus a restricted market for apparel sales. Marketing  Individual teams would only advertise in their home market  They have little incentive to pay for ads that would benefit other teams  Teams would want to free ride • Leagues take a multilevel approach to marketing. • Teams contribute to joint ads run at the league level. • Leagues work to create a specific image to increase demand for the sport as a whole. • Notice that marketing at the league level is something of a public good. • It’s non-rival – One team benefiting from advertizing doesn’t take diminish the benefits enjoyed by the other team • It’s non-excludable – One team can’t prevent another team from benefiting from the benefits of advertizing Profit • P = TR – TC • Leagues differ in the level of profitability. • The NFL is the most profitable; the NHL the least. • NFL team profits are the most evenly distributed. • While profit is TR –TC, profit is also closely related to a team’s operating income. • NFL teams have higher operating incomes than other teams, but it doesn’t mean that high operating incomes are always related to highest market values (the price a buyer would pay to purchase the team). • For example, in 2012, the league’s most valuable franchise, the Dallas Cowboys, had a market value of $2.1-billion with operating income of only $226.7-million. • By comparison, the Yankees (MLB’s most valuable franchise) had a market value of $1.85-billion and operating income of $10-million. • Why the huge differences? • For one, market value reflects the potential benefits a new owner might enjoy. • The team may not be maximizing profits. • Some owners would rather win than maximize profits. • Owners may profit in other ways, such as owning a cable TV outlet (Yankees, Mets and Red Sox all do). • NFL franchises are the most valuable; NHL the least. • No surprise here – the Leafs are the most highly valued team, with market value of $1-billion and operating income of $81.9-million (league high). • The highest valued NBAteam is the NY Knicks, with market value of $1.1-billion and operating income of $83-million. • Hendrick Motorsports is the highest valued NASCAR team, with market value of $350-million and operating income of $13.5-million. Revenue • Teams generate revenue from: • Gate receipts (ticket sales) Rg • Local and national broadcasting rights RB • Merchandise / licensing income RL Other stadium-related income (luxury boxes, concessions, stadium naming rights…) RS • Gate Receipts • Higher ticket prices mean greater revenues. • If a team can increase demand for tickets, it can charge higher prices. • However, teams realize that demand fluctuates depending on who the visitor is. • More and more, teams are charging more for high demand games instead of a single price for a given seat. • Teams also will try to increase demand through marketing, but if the team is a loser, this may not help. • In the LR, teams will increase demand by its fans only if it can build a successful team. • This means acquiring or developing talented players, which drives up team costs. • For an increase in SR profitability, teams can spend a lot of money hoping to increase revenue or cut costs. • Some teams, however, are just more popular than others (more successful, larger fan base, long history). • For example, in the early years of the NFL, teams came and went each season. • The league instituted the most generous (still) revenue sharing policy – home team keeps 60% of the gate and the remaining 40% goes into a pool that is distributed among all teams (plus $100-million reserved from total shared revenues, including broadcast rights et al, to help out the “poorest” teams). • This means that an NFL team’s gate revenue is • RG = .6RH + .4RP • That is, Gate Revenue = .6*Home Game Revenue + .4*Gate Revenue Generated byAll Other Teams • This policy also explains why operating incomes and market values are so much closer in the NFL than in other major US leagues. • The NBAand NHL* do not share gate revenue, so making the playoffs is a huge source of revenue. • Since 2003, MLB teams put 34% of net revenues into a common pool. • In the NHL, the top ten money making clubs contribute to a fund shared by the bottom 15 teams. Clubs are only eligible for subsidies if they rank in the bottom half of league revenues and are in markets with 2.5 million TV households or fewer. The league makes sure they make money off of playoff teams by taking 50% of all playoff revenue. The team gets 50% and the league takes the other half. • Revenue from Broadcast Rights • All 4 major sports plus NASCAR earn huge revenues from broadcast rights. • The NFL and NBAshare revenues equally among the teams. • This money probably keeps several franchises from bankruptcy. • The NFL earns the highest revenue from selling broadcast rights – about $20-billion total TV revenue each year.* • The NHL has the lowest national (US and Canada) TV broadcast revenues – about $350-million annually*. • MLB has national contracts, but local network contracts are also a major source of revenues. • Local network revenues are not shared. • NHL teams also rely heavily on local TV revenues. • The CFL revenue from TSN works out to be about $4-million per team. • *These are the best figures I could find on the web. • TV is the big reason why football surpassed baseball in the US. • At first, baseball was reluctant to televise nationally (or even radio broadcast). • They felt that fans watching at home should be no better off than the fan in the worst seat. • Favoured local coverage over national – that’s why they still have small-market teams. Broadcast revenues  Are a fixed revenue which has no impact on output à In our revenue equation, Rb would be a constant  However, televising games could impact gate receipts à Fans can prefer watching on TV, rather than in a stadium in a blizzard à That’s why for example, the NFL has “blackout” rules for games that aren’t sold out • Of course, networks will only broadcast games if they see this activity as profitable. • The demand to televise games is a derived demand – derived by the demand from sponsors to buy advertising time. • Some networks will overpay if it means viewers may watch other shows they broadcast or it will attract more affiliates (using the sporting event as a loss leader). • TV revenue is by far the largest source of revenue for sports. • Leagues have even changed the way they play in order to accommodate TV broadcasters. • Games take a “TV time out
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