Competition Among Teams In Baseball

Dave Cameron of FanGraphs had a thought-provoking article earlier this week on the issue of free agent compensation. Cameron argues that teams should no longer be compensated for losing top players to free agency.

First things first: The MLB categorizes players by their ability levels using the Elias Ratings system (which is not an accurate assessment of a player's ability, but that's for another article). The top 20% of players at their positions are classified as "Type A" players and the top 21% to 40% of players are "Type B" players. When a team loses a Type A player to free agency, that team receives two high level picks as compensation in the next year's draft, one sandwich pick and one from the signing team. When a team loses a Type B player, the team receives just a sandwich pick. One caveat is that a team must offer arbitration to the player it is losing in order to be eligible for the compensation described.

To put it frankly, this scheme does next to nothing to improve competition.

Ostensibly, the system was created in order to help promote competition by compensating poorer teams that were unable to resign their free agents. Of course, when a team signs a player out of college or high school and develops him into a top MLB player, that team will be compensated after that player's departure into free agency. But this is true for any team, not just poor teams.

In practice, most free agents are not homegrown talent: they are established Major League veterans. This is because teams obtain a large degree of control over their draft picks while veterans sign contracts that are dictated more strongly by the market. As such, veterans tend to have shorter contracts than draftees. This means there is more turnover of veteran players and thus they represent a higher proportion of free agents each year. This means most of the compensation is being given to teams signing veterans, not to teams giving up players they originally drafted.

Major League teams (OK, some Major League teams) have gotten reasonably good at predicting future performance of players given a large enough sample size. That is, they can predict fairly well how a player will perform in the last year of any potential contract the team may offer him. To be even more to the point, this means a team can predict with fairly good accuracy whether a player will be Type A or Type B when his contract is up meaning the team can gauge the compensation it will receive if that player were to leave for free agency. This means a team can afford to offer a Type A or Type B player a higher valued contract than otherwise because the team knows it will get compensated when the player leaves.

This means the existing compensation scheme is likely raising the contract value of free agents since all teams know they can afford to pay extra for the free agents because they will get compensated by draft picks later. If teams were like most companies, the scheme would have no effect because teams could simply borrow from the future to pay costs now. Unfortunately for many baseball teams, however, their payrolls are fixed. This creates the potential for a situation in which a team could afford a top free agent if there was no compensation scheme but that with the existing compensation scheme, the same free agent will have a more expensive contract, making him unaffordable to the previously interested team. If there is any effect on contract purchase decisions under the existing compensation scheme at all, then they are hurting poorer teams.

There are several other problems with the existing scheme:

First, veteran players who were already Type A or Type B at the time of signing are probably the free agents most likely to be Type A or Type B players when their contracts expire. Type A or Type B players-flaws in the Elias Rating system aside-do actually tend to be good players, meaning they command higher priced contracts. This means these players will tend to be signed by wealthier teams, meaning wealthier teams will tend to get more of the compensation when these players leave their next contracts.

Second, in order to receive compensation for losing a free agent, a team must offer that player arbitration. The price of the contract offered under arbitration can be reasonably predicted and, obviously, teams that expect to be unable to afford a contract offered under arbitration will not offer arbitration to the player. This has the potential to eliminate poorer teams. Further, there is still some risk in predicting the contract under arbitration, meaning teams are taking a risk in agreeing to offer arbitration. Again, wealthier teams are more likely to take this risk. For example, if a team has $4 million a year to spend on a player and they expect that he will be offered between $3 and $6 million in arbitration, it will likely decide not to risk offering arbitration at all.

Third, Type A free agents provide an interesting case as there is a penalty to the team that signs a Type A player: the signing team will have to give up either a first or second-round pick to the team for which that free agent previously played. Again, however, the signing team can reasonably predict the compensation it will receive when the player leaves and the team can figure that calculation into the contract offered to the player. For example, if a team signs Adam Dunn, a Type A player, to a 2-year contract, it may predict that he will be a Type B player when the 2-year contract is up. This means that though it will lose a first (or second) round pick now, the team will likely receive a sandwich pick later. The difference in value between a first-round pick and a sandwich pick can then be figured into the contract offered to Dunn.

Fourth, draft pick value may well be very small, given the wild variability in the success of high draft picks. Thus, the compensation (and respective calculations figured into free agent contracts) may be so small as to be negligible.

Finally, and as somewhat of a philosophical point, even if the compensation scheme were designed to reward teams who developed a talented player from draft day to his first entrance into free agency, is such a scheme really desirable? As mentioned earlier, teams that draft young players are able to exert a large deal of control over those players, and, as a result, drafted players that eventually become Type A or Type B players under their first contract find themselves getting compensated far below market value for the first third or so of their careers.  Should a team really be rewarded for trapping a player in a contract that rewards him far less than he's due? Also, as time goes on, all teams will likely become about as good as one another at drafting players, meaning that all teams will be receiving the exact same amount of compensation from the existing scheme. And, even now, the comparative advantage offered by the draft to poor teams-that poor teams can pay their draftees far less than their worth-is slowly eroding as sports agents such as Scott Boras increasingly demand higher signing bonuses for top players.

The existing compensation scheme does not promote competition-if it does anything at all, it benefits wealthier teams. Thankfully, there are many other ways to improve competition. One way is for the compensation scheme to be redesigned so as to help only poorer teams. This may help the problem of poorer teams not having purchasing power in the free agent market, but it will likely not help those teams become more competitive. Baseball's main problem with regard to competition, I believe, is that teams are typically heavily subsidized by the government. More specifically, stadiums are highly subsidized. In Baseball Between the Numbers the authors argue that likely at most one team in the entire MLB would even be breaking even were it not for stadium subsidies. This means that teams do not have to perform well in order to stay in business, no matter what their revenues are. In how many other industries could an organization like the Kansas City Royals survive for so long?

But it is likely that government subsidies are not going away any time soon. That means competition will have to be encouraged through other means. The compensation scheme and other schemes such as the luxury tax seem to solve the problem of income inequity but not of competition. A scheme that seems like it would go a long way in increasing competition is a relegation system similar to that of European soccer leagues. In such leagues, teams performing in the bottom of their divisions are relegated to lower leagues and are replaced by top teams from the lower division. Such a relegation is likely extremely damaging to a top team's income-it would probably be so damaging in terms of lost media and attendance revenue for Major League teams that they would actually go out of business. Such a system could conceivably be created by reorganizing minor league teams and would provide a powerful competitive incentive for Major League teams to stay out of the league's bottom and for teams in the lower leagues to move into the upper division. At any rate, one would guess it would do a lot more for improving competition than giving away draft picks.