Salary Caps in Professional Team Sports - Balancing Competition or Balancing Costs in the National Hockey League? Economics Master's thesis Antti Lipasti 2015 Department of Economics Aalto University School of Business Powered by TCPDF (www.tcpdf.org) Aalto University, P.O. BOX 11000, 00076 AALTO www.aalto.fi Abstract of master’s thesis Author Antti Lipasti Title of thesis Salary Caps in Professional Team Sports – Balancing Competition or Balancing Costs in the National Hockey League? Degree Master’s Degree in Economics and Business Administration Degree program Economics Thesis advisor Marko Terviö Year of approval 2015 Number of pages 71 Language English Purpose of the study The aim of this study is to introduce North American major sports league salary cap systems. I summarize the development and the history of job market regulation in professional team sports. Different types of salary caps and leagues are presented to create a comprehensive understanding about the topic. The theoretical implications of a salary cap are presented based on previous literature. Previous studies suggest that a salary cap has two main motivations: to balance the competition and to lower player costs. In the empirical part of the thesis I keep my focus in the National Hockey League (NHL). I test whether the consequences implied by theory are consistent with the results in the NHL after the introduction of the first league-wide salary cap in 2005. My aim is to find out if the competition has balanced during the regular season and during the playoffs. Additionally, I examine consequences of lower player costs to the team owners and to the players. Data and methods Data on player salaries is collected from the USAToday website which has gathered NHL player salaries since the 2000-2001 season. Yearly player salary data consists of 700 to 748 observations and in total the data set includes 9372 observations. Data on teams’ success is collected from different statistical websites which are listed in the thesis. I use statistical analysis methods such as Gini coefficient and Herfindahl-Hirchman Index to examine and illustrate the differences before and after the salary cap. Results The results of this study mainly support those suggested by the theory. Regular season competition became more balanced after the 2005 salary cap. However, competitive balance in playoffs did not grow, contradicting the theoretical suggestion. League-wide player costs decreased after the salary cap but the growth in salaries rapidly revoked the decrease. Income inequality did decrease. The most expensive players experienced the greatest cut in salaries and the lowest paid players experienced an increase in salaries. Differences in positional average salaries decreased and the valuation of players on their position standardized. Keywords Salary cap, professional team sports, competitive balance, player costs, North American major sports leagues, the National Hockey League, income inequality Contents 1. Introduction ........................................................................................................................ 1 1.1 Definitions ................................................................................................................... 3 2. The historical overview and development of salary caps in North America ...................... 7 3. Different types of salary caps ........................................................................................... 10 3.1 Hard salary cap .......................................................................................................... 10 3.2 Soft salary cap ........................................................................................................... 14 3.3 Percentage of revenue salary cap .............................................................................. 15 3.4 Voluntary salary cap.................................................................................................. 15 4. Different types of leagues and teams ................................................................................ 17 4.1 Profit maximization in North American leagues....................................................... 17 4.2 Utility maximizing teams .......................................................................................... 19 4.3 The effects of salary caps on social welfare .............................................................. 21 5. Season 2014-2015 salary caps in North American major leagues ................................... 22 6. Institutional background of the NHL ................................................................................ 26 6.1 NHL salary cap.......................................................................................................... 28 7. Empirics ............................................................................................................................ 31 7.1 Data set ...................................................................................................................... 31 7.2 Research questions .................................................................................................... 33 7.3 Research methods ...................................................................................................... 33 8. Analysis ............................................................................................................................ 36 8.1 Is competition in the NHL more balanced after the introduction of the 2005 salary cap?............................................................................................................................ 36 8.1.1 Relation of team payroll and success ................................................................. 36 8.1.2 Regular season competition ............................................................................... 42 8.1.3 Playoff competition ............................................................................................ 46 8.1.4 Discussion and recommendations ...................................................................... 47 8.2 Has the salary cap limited the overall player costs of the teams in the NHL? .......... 49 8.2.1 What are the consequences to the NHL team owners? ...................................... 51 8.2.2 What are the consequences to the NHL players? ............................................... 52 8.2.3 Discussion on limited player costs ..................................................................... 58 9. Conclusions ...................................................................................................................... 60 References ................................................................................................................................ 64 Appendixes .............................................................................................................................. 68 I List of Tables Table 1: Salary and Cap Number of Troy Brouwer three year contract (thousands of $) ....... 24 Table 2: Player salary data set ................................................................................................. 31 Table 3: Average Herfindahl-Hirshman Indexes of wins ........................................................ 43 Table 4: Gini coefficients......................................................................................................... 44 Table 5: Positional Gini coefficients of salary ......................................................................... 53 List of Figures Figure 1: Salary caps and market equilibrium (Késenne 2000) ............................................... 11 Figure 2: Salary caps and owner profits (Késenne 2000) ........................................................ 12 Figure 3: The individual salary cap (Késenne 2000) ............................................................... 14 Figure 4: NHL salary cap system............................................................................................. 29 Figure 5: Teams’ average payrolls ........................................................................................... 37 Figure 6: Teams average payrolls’ standard deviation ............................................................ 38 Figure 7: Teams' average payroll and ranking after regular season......................................... 39 Figure 8: Teams’ average payroll and ranking after regular season, three periods ................. 40 Figure 9: Ranking after regular season and payroll covariance ............................................... 41 Figure 10: Payroll and number of playoff rounds correlations ................................................ 41 Figure 11: NHL teams' wins Herfindahl-Hirschman Index ..................................................... 43 Figure 12: Standing after regular season ................................................................................. 45 Figure 13: Wins during playoffs Gini coefficients .................................................................. 47 Figure 14: Combined team salaries in the NHL ...................................................................... 49 Figure 15: Teams’ payroll standard deviation ......................................................................... 50 Figure 16: Average franchise value of NHL teams (data from www.forbes.com) .................. 52 Figure 17: Accumulated positional salaries ............................................................................. 54 Figure 18: Positional average salaries...................................................................................... 54 Figure 19: Correlation of positional investments and playoff rounds (All teams) .................. 55 Figure 20: Correlation of positional investments and playoff rounds (Playoff teams)............ 56 Figure 21: Correlation of positional payroll shares and playoffs rounds (All teams) ............. 57 Figure 22: Correlation of positional payroll shares and playoffs rounds (Playoff teams) ....... 58 II 1. Introduction Professional sports player markets in North America have been regulated since the late 19th century and the earliest job market problems were found in the baseball labor market (Kahn 2000). Job market regulation has become more common in professional sports and academic research has increased especially during the past fifty years. More complex regulation methods and salary cap systems have been introduced as professional sports grow in their economic importance. The National Hockey League season 2004-2005 was cancelled due to labor dispute between the league and the players’ association. The labor dispute was followed by the first salary cap in the NHL’s history. Salary caps have two main motivations; firstly, to balance competition and secondly, to limit the overall costs of teams (Dietl, Franck, Lang & Rathke 2012). In this master’s thesis, I focus on salary caps in professional team sports. I introduce related literature and build comprehensive understanding about the theoretical results of setting a salary cap. In the empirical part, I examine if these results are found in the National Hockey League after the setting of the 2005 salary cap. In his study the Baseball Players’ Labor Market, Rottenberg (1956) discusses a number of market problems in the baseball labor market. He suggests that monopsony power is frank in the baseball labor market and competitors must be approximately equal size if any are to be successful. Rottenberg divides the market of baseball players into three markets: the market for free agents where the player is the seller, the market for signed players where teams are sellers and buyers, and the market for the current services of contracted players where the player is the seller and the team that holds his contract is the buyer. He argues that this so called “reserve rule” did not equalize the distribution of playing talent as it was supposed to and teams with higher bids were able to draw better players. Supporting Rottenberg, Neal (1964) states in his study the Peculiar Economics of Professional Sports that competitive balance is needed in professional sports and pure monopolism would be destructive. Neal suggests that the more frequently the standings chance, the larger will be the gate receipts. He concludes that in professional sports the league must be understood as the firm that acts as a natural monopolist. Within that league teams or athletes are the legally separate business firms that produce several joint products. 1 Staudohar (1998) focuses on the effects of salary caps in professional team sports. He presents labor market problems, such as salary caps, in four major leagues in the U.S.. In 1998 a salary cap was placed in two of the four leagues which are basketball and football leagues. Staudohar concludes that salary caps and payroll taxes may seem beneficial to owners but their effect is more symbolic and cosmetic than fundamental. In his study, the Impact of Salary Caps in Professional Team Sports, Késenne (2000) concentrates on competitive balance, the level and the distribution of player salaries, owner profits and total league revenue. In Chapter 3.1, I show Késenne’s idea in more detail as I consider it comparable to the salary cap in the NHL with some adjustments. Contradicting Staudohar (1998) Késenne argues that a salary cap improves the competitive balance and the player salary distribution, holds down the excessive top player salaries, and guarantees the club owners a reasonable profit rate. Kaijalainen (2013) examined in her master’s thesis how the first salary cap in the NHL altered wage determination and salary distribution. Her findings show that only the importance of experience increased remarkably when determining the player’s salary. Also, her findings suggest that the demand of the most valuable players has decreased and the demand for upper middle class (based on talent) has increased. The first aim of this research is to describe the theoretical implications of setting a salary cap on competition and teams’ player costs. Secondly, in the empirical part of the thesis I test whether the implications of a salary cap suggested by the theory hold in the NHL. To do this, I use player and team salaries which are available on the USAToday website and team success information collected from different statistical websites. I examine the league-wide changes and my research questions are: 1. What are the consequences on competitive balance and teams’ player costs implied by theory after the implementation of a salary cap? 2. Did the 2005 NHL salary cap balance competition? 3. Has the 2005 NHL salary cap limited the overall player costs of the teams? 3.1 What are the results of limited player costs to the team owners and to the players? A salary cap is expected to lower the player costs of a big market team and increase the player costs of small market team. Based on the leveling effect of a salary cap the talent distribution 2 should become more equal. Consequently, a salary cap should lead to a more competitively balanced league. Empirical findings in this study suggest that the 2005 salary cap made regular season competition more balanced. This result is based on the more equal distribution of wins, points and standings after the regular season. On the other hand, playoff competition after the salary cap did not become more balanced. Playoff rounds are distributed less evenly and the distribution of wins during playoffs has not changed. The 2005 NHL salary cap did limit the overall player costs of the NHL teams. Small market teams increased their spending and large market teams decreased their spending. Also, accumulated player costs decreased. The franchise values of the NHL teams started to increase. Players experienced a cut in average salaries and highest paid players felt the greatest cut. The thesis is structured as follows: chapter one focuses on creating an extensive background information and motivation for the thesis. Chapter two introduces the history of salary caps in North America. Chapter three illustrates the theoretical effects of different kind of salary caps. Chapter four shows that there are differences between leagues and their objectives. In chapter five, I present the salary caps at the moment in U.S major leagues. Chapter six collects important information about the National Hockey League. In chapter seven, I introduce the data set and provide empirical research questions and research methods. In chapter eight, I analyze the research questions in detail one by one. In chapter nine, I make conclusions and suggest some possible areas for further and future research. 1.1 Definitions When talking about salary caps there are some additional factors that need to be taken into account to fully understand the importance and relevance of salary caps. In this chapter, I introduce relevant concepts and define them briefly. Definitions will give a better understanding when reading the thesis as these concepts are highly linked to each other and need to be defined. Introduction to salary cap Salary caps in professional sports have two main motivations: firstly, to balance competition in professional team sports where economic powers between teams notably differ and secondly, 3 to limit the overall costs of teams (Dietl, Franck, Lang & Rathke 2012). The following definition for a salary cap is provided by www.businessdictionary.com: “the limit placed on a salary paid out to employees and enforced by the government or another organization”. In the case of professional sports, league management and player associations negotiate a salary cap that satisfies both parties. Most salary caps have upper and lower limits that define the range of a total team spending on player salaries. In professional sports, players are seen as employees and salary caps limit salaries paid for them. Késenne (2000) states that in order to guarantee a more or less balanced competition, sport federations and league authorities have always tried to regulate the player labor market and to prevent the concentration of all playing talent in the rich big-city clubs that can offer better salaries than the small-town clubs. As noted in Késenne’s statement, the market size of clubs is one main character when determining the economic power of the team. Teams located in metropolitan areas with for example more than 10 million citizens have a cutting edge when compared with small-town clubs with for example half a million citizens. Therefore, most talented players would be compensated more open handedly for their services in big-city teams. Salary caps are to diminish this phenomenon. Also, salary caps reduce self-destructing behavior like overpaying talented players when a team does not have economic stability and power to do this (Késenne 2000). Without salary caps, small-town clubs would have a higher need to pay greater salaries for their star players as salary caps would not limit the purchasing power of big-city teams. Consequently, big-city teams are not able to gather all the star players of leagues as a salary cap start to limit spending when the agreed spending limit is reached. Thus, smaller clubs have a possibility to attract more talented players with their offers. North American major leagues North America has four major leagues. These leagues are Major League Baseball (MLB), the National Basketball Association (NBA), the National Football League (NFL) and the National Hockey League (NHL). Most of the academic studies on professional team sports in North America focus on these four or on one of them. I introduce salary cap systems in all four leagues keeping my main focus on the NHL. 4 Playoffs and the Stanley Cup The NHL includes thirty teams that compete for the Stanley Cup which is the championship trophy awarded annually. During the regular season, all thirty NHL teams compete for playoff entry which is achieved by the sixteen most successful teams. These sixteen teams form a cup stage called the playoffs where teams play against each other in pairs. In every pair, team that first has four wins is the one to proceed to the next round. Two final teams left in the playoffs play in the Stanley Cup finals. The winner is declared the Stanley Cup winner. The rookie draft system All four major sports leagues in North America have experienced the effects of salary caps and rookie draft system. In a rookie draft event teams have a first possibility to sign young players that have come to a certain age. Teams draft players in reversed order of last season success; team that finished last in previous season will start the draft event of starting season. A rookie draft has a two-edged effect as noted by Rosenthal (1995): “The major positive aspect of the draft … is that the draft provides a way to distribute talent to teams and its goal is to do so both fairly and in such a way so as to maintain a competitive balance. On the other hand, the draft distorts the free market and eliminates the choice of amateurs to decide where they want to play and with whom to negotiate.” This is a common situation in professional sports where the demand and supply of labor are in many ways not comparable to regular job markets. Salary caps and draft system both lower the power of players for negotiating as longer contracts are introduced and it is possible for a team to own a players’ job supply for several years. Free agency Four major sports in North America all have a free agency system. Free agency system allows players to sell their services to other clubs after a certain period of time has elapsed (Staudohar 1998). In other words, players under contract are not allowed to make a new deal with other teams when they have a valid contract with one team. Team that owns the contract of a player can sell the contract of that player to another team meaning that a player can be sold without letting him know beforehand. When a player has been sold to another team, his or her contract is still valid and that player has an obligation to fulfill the original contract even though the 5 team (the owner of the player) has changed. Free agency is the only situation when players are not obligated to one team and have a power to negotiate their own contract. Monopsony power in professional sports labor markets The rookie draft system, lack of free agency regulations and limited amount of teams lead to a monopsony power of teams and leagues in player labor markets in professional sports. Boal and Ransom (1997) state that “numerous models of buyer market power have been developed that do not assume a single buyer or even a small number of buyers. Today the term "labor monopsony" is applied more broadly to any model where individual firms face upward-sloping labor supply.” In professional sports, players have multiple teams to negotiate with but league regulations limit players’ possibilities to negotiate with these teams. Boal and Ransom (1997) also argue that professional sports leagues in North America are organized with distinctive monopsonistic characteristics, such as the rookie draft, and agreements between teams that restrict the mobility of players within the league. According to these findings, professional sports leagues arguably have notable monopsonistic power. Teams might compete for talent but once a player is signed for one team league regulations lower the player’s negotiation power. Agency considerations help explain why salaries were related to performance, but surely wages would be higher in a contract system where players owned their contract rights and could negotiate freely with all teams in the league (Rosen & Sanderson 2001). More common labor contracts are known to have a few weeks term of notice and ability to negotiate with every company in the industry. Professional sports players have considerably low bargaining power as their multiple year contracts are owned by teams and can be sold without negotiations with the player. 6