This is an excerpt from Sport and Public Policy by Charles Santo & Gerard Mildner.
A labor market occurs when sellers of labor interact with buyers of labor. People in the workforce sell labor services to prospective employers in return for a payment. In a competitive labor market, buyers and sellers are numerous. Consider the labor market for accountants. In most cities, many firms employ accountants and many people are trained to work as accountants. A firm will hire an accountant only if the wage that it has to pay the accountant is exceeded by the value generated by the accountant. That value is known as the marginal revenue product (MRP), the value that an employee produces after all other input costs are taken into consideration. For example, suppose Andrea produces $1,500 in accounting services each week for her employer, firm A, and the cost of the inputs that she needs to do her job (e.g., a computer and an office) is $300 per week. Under these circumstances, firm A should be willing to pay her up to $1,200 every week. It would prefer to pay her less, of course, but it must take into consideration the other accounting firms that are competing for Andrea’s services. If firm B offers Andrea a higher wage than she currently receives, she may switch jobs. Similarly, although Andrea prefers to earn the highest possible wage, she realizes that many other trained accountants are in the market. If other equally skilled accountants are willing to work for less than Andrea’s MRP of $1,200, she may find herself unemployed if she insists on a wage of $1,200. The competition on both sides of the market is what determines the prevailing wage or salary and the number of people employed.
MRP is defined as the product of marginal product and marginal revenue (MRP = MP × MR).MP is a measure of how productive a worker is in terms of output, and MR is a measure of the additional revenue generated by each new unit of output. For a bakery, MP might be measured as the number of additional cakes produced when an additional baker is hired. MR reflects the additional revenue created when an extra cake is sold. The new baker’s value to the bakery is equal to the number of cakes he contributes multiplied by the revenue created by each new cake.
An athlete’s value, or MRP, can be thought of as the number of wins that he generates for his team multiplied by the value of each victory.
In a perfectly competitive market, in which athletes’ wages are equal to their marginal revenue products, only two factors can explain increasing player salaries: (1) an increase in marginal product or (2) an increase in marginal revenue. The first factor is straightforward; a player who improves and contributes more to the team receives a higher wage when the time comes to renew his contract. The second factor reflects demand, and it is driven by willingness to pay—the willingness of fans to pay for tickets, of networks to pay for broadcasting rights, and of advertisers to pay for slots during those broadcasts. To a large extent, athletes’ salaries are high because willingness to pay is high. In other words, fan interest in professional sports causes salaries to be large.
In professional sports, athletes tend to be paid according to their MRP. But several key factors distinguish the labor market for accountants or bakers from the market for athletes. First, athletes create enormous MRP for their employers. The New York Yankees pay third baseman Alex Rodriguez over $20 million each year because he generates at least that amount in ticket sales, television broadcasting rights, and other revenues. It is doubtful that any accountant can produce an MRP of a similar magnitude.
Second, there are far fewer athletes than accountants. The scarcity of athletes compared with accountants is another reason why salaries for the former exceed those of the latter. Simply put, many more men and women are qualified to be accountants than professional athletes. As an example, what percentage of the nation’s population is tall enough to play in the NBA?
Third, the labor market for athletes is not perfectly competitive; rather, it has characteristics of a bilateral monopoly. A bilateral monopoly consists of a single buyer (a monopsonist) and a single seller (a monopolist). Although the sport labor market is made up of many teams and many players, teams organize into a singleleague, which exercises monoposonistic power, and players organize into a singlelabor union, which exercises monopolistic power. Labor (players’ unions) and management (league officials) meet every few years to negotiate a new CBA; these negotiations can become contentious, and strikes and lockouts often result from an inability to reach a mutual agreement on the terms and conditions of the CBA. In some respects these negotiations are like the periodic bargaining that goes on between a teachers’ union and the school district, between city hall and the firefighters’ association, or between the autoworkers and the car companies. The group that has greater bargaining power tends to get their desired result. The same applies to a great extent in professional sports. The bargaining process is a battle in which players try to pull wages up to levels at or above their MRPs, and team owners try to push wages below MRP.
Fourth, unlike teachers, firefighters, or autoworkers, athletes’ salaries are only partly determined through negotiation of the CBA between the league and the union. With some exceptions (noted later), the player unions do not establish pay scales or bargain for specific wages for individuals. Rather, the unions establish guidelines that allow each player to bargain for a salary approximating his MRP (later we will see that the crux of the bargaining process is an accurate evaluation of productivity). Economists are generally skeptical of any distortions in the market, including monopolization. Professional sports provide an interesting exception. The introduction of a players union in a market dominated by a single buyer tends to result in players earning something closer to a competitive salary. As described in the next section, before the introduction of unions, players were at the mercy of team owners and earned far below their productivity.
Fifth, price controls are present in the labor market for athletes. Rookies are typically paid a minimum salary. In 2007 a first-year MLB player earned $380,000 and a rookie NBA player made $427,163. CBAs commonly include a pay scale for the years before free agency, but some leagues extend the pay scale even farther; for example, an NBA player with at least 10 years’ experience earned a minimum of $1,262,275 during the 2006-2007 season. The NBA and the NHL also have maximum salaries. If salary determination is beginning to sound complicated, it is. The best way to learn about specific salary policies and the myriad loopholes that exist is to read the specific CBAs for each sport (these are available online) and books like Edge’s (2004) or Yost’s (2006). But let us not lose sight of the main issue: Players want to be paid their MRP.
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