Review of Industrial Organization 11: 135-139, 1996. 135

Book Review

The Market Structure of Sports. Gerald W. Scully, editor. Chicago, University of Chicago Press, 1995, v + 207 pp.

Over the past two decades Gerald Scully has made some of the most signifi- cant contributions to our understanding of sports economics. The Murket Structure of Sports is his latest entry to this burgeoning field. In this volume he examines: (1) intra-team salary hieriarchies and what affects the distribution of earnings among players; (2) the determinants of team winning and losing cycles, and the effect of those cycles on the frequency and price of franchise transfers; and (3) managerial efficiency, the effect of winning (or losing) on managerial tenure, and whether the replacement of the field manager is an effective strategy.

The volume is divided into four parts, three of which analyze the issues listed above. The fourth part of the volume (the introduction) includes a concise history of professional team sports in America. It also describes the source and implications of imperfect competition in both player and product markets, explaining how labor market restrictions have little effect on competitive team playing strength but a substantial impact on who receives the enormous rents derived from the inelastic demand for sports entertainment, and how the leagues’ control of expansion and team locations serve to maximize existing franchise values and rents extracted from cities. The introduction also explains how the various leagues insulate their anti-competitive practices from antitrust enforcement.

The introduction occupies a fourth of the book. It is a well written comprehensive non-technical initiation to the economics of professional team sports. One does not have to have endured graduate classes in economic theory and econometrics to understand and enjoy it. It could be used in an undergraduate class. But it seems out of place in a volume that otherwise uses methods, techniques, and language that will be familiar only to the professional economist (and others whose everyday vocabulary includes “additively separable production functions,” “probability density functions,” and the “Nash-Coumot Assumption”).

In Part II Scully applies rank-order tournament models to explain why there are large differences in financial rewards for small differences in playing skills among professional team sports players. His analysis of the incentive effects of salary hierarchies within professional sports teams is an important and novel contribution

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to the understanding of sports labor markets. The basic insight is that demand depends on customers’ confidence that players are giving their maximum effort. To induce the optimal effort, teams base player compensation on rank performance rather than piece-rates. Thus we observe that the gap between the earnings of starting players and substitutes greatly,exceeds the gap between the abilities of starters and subs.

Scully’s model implies not only that players’ investment in playing skill rises as compensation grows, but that it is the better players who invest relatively more in distinguishing themselves from the ordinary players as salaries accelerate. The model predicts that the dispersion of earnings among players should increase were veterans to secure the right of free agency, which is consistent with the actual experience of baseball and basketball since the mid 1970s. Since almost all players have relatively modest alternative earning opportunities, it is the “star” players who are exploited the most during periods of greater employer monopsony power.

A wage profile that falls short of marginal productivity in the early years of a career and exceeds it in later years may also induce teams to invest optimally in the development of players’ human capital, and may serve to allocate risk between players and teams in an efficient manner. It may also induce consistent effort. Free agency, however, should discourage temporal trade-offs between wages and productivity. Empirical evidence shows that the recent competition for free agents has lead to a much earlier peak in player salary that is closer to the peak in player performance.

In an interesting chapter on the distribution of player earnings Scully argues that when team performance depends on complementarities among players (e.g. offensive guards blocking for running backs) or when team performance depends on the weakest-link on the team (e.g. if the left defensive end is slow, the offense will run repeatedly toward his area of responsibility) the distribution of earnings will be more equal. This is because when complementarities are important out- standing players contribute less than they do when the production technology is more individualized (e.g. baseball). As the defense focuses its attention on the out- standing players, their marginal contribution to team success diminishes, while the marginal contribution of the less outstanding complementary players grows. When team performance is only as good as the weakest-link in the production process (e.g. auto racing), the team will sacrifice outstanding performance at its strong positions to shore up the weakest-link, thus leveling marginal productivity among team members. Thus we observe a greater dispersion of earnings in baseball than in football, and in sports not subject to weak-link production, like singles tennis and golf, than in, say, auto racing.

Scully demonstrates that participants in sports with more annual contests have less equal incomes, because luck plays a less prominent role in determining the championship when more contests are staged. He also shows that the use of seeded play (e.g. professional tennis) leads to more income inequality than arises from tournaments in which each filayer competes on an equal basis against everyone else

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in the field (e.g. professional golf). More equal revenue division among clubs (e.g. the equal split of television revenues among all National Football League teams) and more equal gate splits both lower the incremental value of superior player performance and equalize earnings among players. Monopsony power and team payroll caps have a similar leveling effect on salaries. When it costs a lot to enter the sport (e.g. auto racing) the prize distribution must be sufficiently flat to induce entry by the least likely winners, or else there won’t be a credible field. Thus low finishers receive more of the purse and earnings are more equal in expensive sports like auto racing than in golf or tennis.

In Part III Scully addresses the market for sports franchises. He first develops a theory to explain the systematic ten to fifteen year cycles in winning and losing among many professional sports teams. His explanation is based on the tendency of teams to retain aging star players when young replacements would contribute more to the team’s winning. The retention of the stars is not necessarily irrational, however, as the old heros attract paying customers in spite of their largely depreci- ated skills. Thus revenue (and profit) maximization may be consistent with cycles in winning because customer demand for player characteristics other than their direct contribution to winning depends on familiarity with the players.

Scully argues that teams develop reputations as “winners” or “losers”, based on where they are in the winning cycle, and that these reputations affect the frequency and price of franchise sales, with “take-over specialists” more likely to bid for a team with a bad reputation because they believe they can convert it into one with an average reputation. The frequency of sales, however, must depend on &#erences in expectations between buyers and sellers. But Scully’s model does not explain why the potential buyers are more likely to be successful in transforming a loosing team into a winning team than would existing owners who are sufficiently patient to wait for the cycle to go around. The price of a team at the bottom of its winning cycle should not be especially low, since the natural cycle based on the acquisition and retention of team playing capital insures that any owner will eventually experience a transformation of the team’s bad reputation into at least an average reputation (the Chicago Cubs notwithstanding).

Scully recognizes the problem: “Because the evidence on momentum suggests that there are cycles in reputations, the payment of a premium for a winning franchise would seem irrational” (p. 112). To explain franchise sales then, Scully appeals to the “winner’s curse,” and asymmetrical information. Both can certainly explain franchise sales, but no reason is given to expect the winner’s curse or asymmetrical information to vary with a team’s winning cycle. After all, if potential buyers understand Scully’s theory of cycles, they should not be more inclined to believe that they could resurrect a team from the depths of the cycle than prevent one at the top from sliding naturally into those depths. Although the explanation is questionable, Scully does show that there are about twice as many sales of franchises at the bottom of the winning cycle than of those at the top.

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The book hits the bottom of its reputational cycle in Chapter 6. Here Scully attempts to evaluate the profitability of professional sports franchises, an important exercise if we are to assess the extent to which the professional team sports industry is workably competitive in spite of its exclusive territories and limitations on the number of franchises. He uses estimates of franchise values and operating profits for 1990 and 1991 from Financiu/ Wurld for each team in the four major professional team sports to compute an overall annual return to the investment in a professional sports team. On average, over all the teams in all four major team sports, Scully figures the annual profit rate at 27%, split about equally between operating profitability and capital appreciation. This figure is the sum of the average annual rate of increase in franchise value and the average ratio of annual profits to annual revenue. Such a calculation, unfortunately, is akin to adding four apples and four oranges and claiming a total of eight apples. Total annual return on cupitul should be the sum of the annual appreciation rate in franchise value and the average annual rate of profit on invested cupitul (not revenue). Returns on revenue are sensitive to the stage of production and value added of the enterprise (wholesale and retail businesses can simultaneously experience low rates of return on revenue and high rates of return on their limited invested capital). Returns on revenue are not what investors use to determine where to allocate marginal capital expenditures. Consequently, this chapter, and the estimated rates of return to professional team sports are a disappointment.

In Part IV Scully examines the market for coaching talent. The analysis begins with an assessment of “coaching efficiency,” the residual from a regression of winning percentage on the ratio of a team’s scoring relative to its opponents scoring. As such, coaching efficiency seems to exclude much of what most people think coaches do - make decisions that help increase their own team’s scoring and limit the opponents scoring. The residual seems to reflect primarily the distrilmtim of a coach’s team’s scoring relative to that of opponents. A coach of a good team (one that on average scores more than its opponents score) would win more than expected if he reduced the dispersion of his team’s and the opponents’ scoring, because, on uveruge, his team wins. A coach of a poor team (one that on average scores less than opponents score) would win more than expected if he increased the dispersion of his and the opponents’ scoring, because, then occasionally his team would outscore the opponents.

The empirical results show that teams that: (1) on average outscore their oppo- nents win relatively more contests the longer is the season; (2) the teams of baseball managers and basketball coaches who also play are less successful than the teams of full-time managers or coaches; and (3) average managing efficiency rises over time. The average tenure of head coaches is about five years. Scully finds that head coaches must continually improve their performance to survive through the first five years of their tenure, but beyond that the pressure is reduced.

When baseball managers are fired, their club usually improves by one rank in the standings. Basketball clubs with new head coaches usually experience an

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improved record too, but the evidence is less convincing. From this evidence Scully concludes that manager (or head coach) termination patterns have been rational. I had expected something different. On the basis of the prior analysis of coaching efficiency - the difference between actual and expected winning based on a team’s and its opponents’ scoring - I anticipated a comparison of the efficiency rating of managers or head coaches before and after a firing. A straightforward comparison of the team’s success in the championship race is, unfortunately, dependant on where the team is in its natural winning cycle. Scully also finds no evidence that long-time baseball owners are any better than short-timers at deciding when to fire a manager. This is apparently not a skill honed by practice.

This is a peculiar little book. The lengthy introduction, while quite good, does not fit with the rest of the volume, and the remaining three sections are not well integrated. This is not to say the book is without merit. The part on the distribution of players’ earnings is a gem. I plan to add it to the reading list for my course on The Economics of Sports. The part on the profitability of franchises would be quite valuable if returns on invested capital had not been co-mingled with returns on revenues.

JOHN J. SIEGFRIED* Vanderbilt University

Nashville, Tennessee 37235 US.A.

* This review was done while the author visited the University of Adelaide, Adelaide, South Australia.

Review of Industrial Organization 11: 141-143, 1996. 141

Book Review

Coordination and Information: Historical Perspectives on the Organization of Enterprise. Naomi R. Lamoreaux and Daniel M. G. Raff, editors. Chicago, University of Chicago Press, 1995,345 pages, $68.00 cloth, $22.50 paper.

Coordination and Znformation is a National Bureau of Economic Research con- ference report, and a sequel to a 199 1 publication, Znside the Business Enterprise, which was edited by Peter Temin and also published by the University of Chicago Press. Like the earlier work, this investigation studies the role of information in economics and business enterprise, but the focus of the papers in this report is more on information as a determinant of coordination devices, and thus of firm and industry structures. Some of the essays focus in particular on asymmetry in information, and the resulting complexity of the coordination of economic activity. The authors of the eight papers in this volume come from a range of academic backgrounds, bringing together the perspectives of economists and business histo- rians. While remarkably consistent in style across the authors, the book itself is a hybrid of historical analysis, institutional detail, and applied economic theory.

The editors have categorized the essays according to the nature of the problems they address. Three papers focus on information and coordination problems “within the firm;” three more investigate information issues “at the boundaries,” addressing issues relevant to both firm and industry structure; and the final two papers look at asymmetric information and institutional arrangements “between firms,” and thus industry structure itself. The authors make no effort to construct a systematic theoretical treatment of information problems, but instead string together a series of mostly historical case studies. Taken by themselves, the essays are a diffuse collection, but the editors provide a framework for reading the studies collectively in an introductory comment that describes the motivation for the conference and report, and provides an overview of the chapters themselves.

This entire project (the conference and report) seems driven by the notion that the traditional treatment of the firm in economic theory is inadequate. Acknowl- edging the important contributions of Oliver Williamson and others in economic theory, the editors assert that economic analysis is moving beyond the conceptu- alization of the firm as the “black box” of production, into a more sophisticated and rigorous understanding of the economics of the firm. Their perception appears

142 BOOK REVIEW

accurate, supported by the developing literature on economics within the firm, even at the textbook level (see, for example, Milgrom and Roberts, 1992). While economists are developing a better theory of the firm, the editors argue, busi- ness historians in the tradition of Alfred D. Chandler, Jr., are bringing their own examples and analyses of firm operations to bear on studies of the coordination of firm activity, thus putting some flesh on the bones of economic theory. This book is written, compellingly I might add, with the attitude that cooperation between these complementary disciplines enhances the final product - our understanding of coordination and information in industry.

Each essay, along with its companion commentary, constitutes in essence a chapter in book. The first three essays address intra-firm aspects of information and coordination. Daniel M. G. Raff looks at compensation systems for workers as a function of the technology used in production, specifically in the context of the automobile industry in the early twentieth century. The evolution of automobile production technology changed the way workers worked, and prompted changes in wage and incentive systems in response to the difficulties of monitoring workers. In the second essay, Daniel Nelson gives a historian’s view of the impact of industrial engineering and the diffusion of managerial techniques on the coordination of economic enterprise in the late nineteenth and early twentieth centuries. In the third chapter, W. Bernard Carlson provides a case study of organizational coordination and technological innovation in the context of a case study of the Thomson-Houston Electric Company during the 1880s.

The second section of the book, ‘At the Boundaries’, takes up issues that involve the scale, scope, and size of the firm as well as industry structure, and thus extend to the concerns of traditional industrial organization. Michael J. Emight writes on ‘Organization and Coordination in Geographically Concentrated Industries’. A host of questions ranging from vertical integration and supply relations, to asymmetric information and asset specificity, and on to industry cartelization are addressed in this essay on localized industries, which draws out as instructive examples the Hollywood motion picture industry, the Prato, Italy, wool textile industry, and the Swiss watch industry. David C. Mowery’s essay, ‘The Boundaries of the U.S. Firm in R & D’, explores the historical development of and reasons for the evolution of research and development within American firms, instead of outside the boundaries of the firm, or within specialized research firms. The book’s sixth essay concludes the second section, and is written by Tony Freyer. He contrasts the role of antitrust law in the U. S. with Great Britain’s experience, and attributes some of the differences in corporate and industry structures to the different legal environments.

Kenneth A. Snowden leads off the final section of the book with an essay exploring the development of interregional mortgage lending channels from 1870 to 1940, looking ultimately at the connections that evolved between life insurance companies and mortgage companies. The essay underpins the institutional details of interregional mortgage lending with theoretical developments in principal-agent

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problems and monitoring to yield a most interesting and informative discussion. Finally, Charles W. Calomiris concludes the book with a comparison of the evolu- tion of German and American financial systems, in which he evaluates ‘The Costs of Rejecting Universal Banking’.

Coordination of economic activity within firms merits more attention than tra- ditionally given by industrial organization economists, so this book is a useful addition to the literature. Nonetheless, some economists who specialize in indus- trial economics - particularly those not inclined to appreciate the somewhat anec- dotal historical case study -may contend that some of the analysis in COU~&~&~U~ u& ZL$O~MU~~O~ lacks rigor and empirical verification. In any case, economists will recognize the more formal underpinnings of developments in the theory of information in economics, including game theory and principal-agent approaches, even in the chapters with a less theoretical or more historical bent. Each essay is well-researched and documented, but lively discussion is not compromised for the sake of formal analysis; prose dominates the presentation and there is no use of algebra or geometry, and relatively few charts and tables.

I found reading COO&~U~~O~ und Znformution enjoyable - a rare enough attribute - and each essay provided a novel perspective, some of which will change the ways in which I think about industrial economics. Industrial organization schol- ars with an interest in problems of asymmetric information, vertical integration, or coordination within the firm are a natural audience for this book, particularly the latter essays that focus on the boundaries of the firm and inter-firm arrange- ments. Students - including undergraduates - will find the book accessible with only a moderate background in economic theory. Teachers of courses in microeco- nomics, industrial organization, economic history, and management or managerial economics may find useful material here as well. Even if the book in totality does not merit assigned reading, many readers will tind some of the individual case studies presented here at least worthy of a look.

Reference

Milgrom, Paul, and John Roberts. Eronomics, Orgukzatiorz, and Marzagement. Englewood Cliffs, N.J.: Prentice Hall. 1992.

RANDALL E. WALDRON Urziverdy of South Dukotu

U.S.A.